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In 1979 following a decade of hyperinflation, Iceland introducedVer{\dh}trygg{\dh} l\'an, negatively amortised, index-linked loans whoseoutstanding principal is increased by the rate of the consumer price inflationindex(CPI). The loans were part of a general government policy which usedindexation to the CPI to address the economic consequences of thehyperinflation. Although most other forms of indexation were subsequentlyremoved, loan indexation has remained, and these loans now comprise themajority of mortgages in Iceland. Although it is still often argued thatindex-linked loans helped to stop the hyperinflation, these arguments aretypically based on high level macro-economic interpretations of the Icelandiceconomy, they fail to identify specific mechanisms to support their claims. Inthis paper we take the opposite approach, and present a detailed analysis ofthe monetary mechanics used for the loans at the double entry bookkeeping levelof the banking system.  Based on this analysis there appears to be no evidence or mechanism thatwould support the claim that index-linked loans reduce or stop inflation. Onthe contrary: our research shows that the bookkeeping treatment of these loanswithin the banking system directly contributes to the banking system's monetaryexpansion rate, and hence index-linked loans act to increase the inflation rateto which they are linked, rather than reducing it. They consequently create apositive feedback loop within the banking system's monetary regulationoperating directly on the money supply. Since the feedback into monetaryexpansion only occurs at annual CPI rates above approximately 2%, we suggestone solution would be to stabilise the money supply to 0% growth, and weexplore some ways this could be achieved by modifying the Basel RegulatoryFramework within the Icelandic Banking System.

An examination of the effect on the Icelandic Banking System of Ver{\dh}trygg{\dh} L\'{a}n (Indexed-Linked Loans)