Iceland: From boom to bust and back again Visitors from Lehigh University 14 May 2010 Thórarinn G. Pétursson Chief Economist and Monetary Policy Committee member

Imbalances build up

A monster banking system emerges... The final steps in privatising the banks where taken in 2003 From then, they expanded rapidly Fed by the global liquidity abundance and appetite to take risks Financed through debt accumulation

... In size and speed of expansion almost unprecedented

Private sector balance sheets also expanded rapidly...

... Asset price bubbles emerged...

... And huge economic imbalances built up

The bubble bursts

It started with a collapse of the currency... The ISK and asset price bubbles were fed by easy access to global liquidity at very low interest rates As uncertainty increased in 2007 this access became gradually more difficult... ... And suddenly stops completely early 2008... ... Leading to a collapse of the currency

... Followed by a collapse of other asset prices ...

... And eventually the whole banking system fell

Large economic adjustments

The large currency deprecation led to an inflation spike...

... With sharp increases in unemployment...

... And huge contraction in consumption... A sharp contraction in consumption followed the crisis as households deleveraged and tried to restore their balance sheet A 8% contraction in 2008 and a 15% contraction in 2009 A significant share of the consumption contraction directed towards imported durable goods A large import content of domestic expenditure Import penetration falls With a small manufacturing sector, a part of the crisis is therefore exported

... But net exports provided a buffer for output

Recession deep in international and historical comparison

Policy responses to the crisis

Monetary policy Initial responses High leverage and significant FX borrowing The ISK collapse wreaked havoc in domestic balance sheets The initial focus of monetary policy Fostering stability of the ISK while the restructuring and recovery of balance sheets takes place Avoid disorderly capital outflows further weakening the ISK Conventional monetary policy (high interest rate) and unconventional monetary policy (capital controls) used

The króna has stabilised as risk premia has subsided

Monetary policy Policy in the aftermath of the crisis With currency stability enhanced, monetary policy has gradually been eased as inflation subsides and inflation expectations become re-anchored Capital controls have given monetary policy more room for easing stance to support the real economy

Fiscal policy Tightening needed to ensure debt sustainability Fundamental changes in Government finances The crisis led to an enormous turnaround from a fiscal surplus to a large deficit 2007: +4% of GDP 2008: -13% of GDP Gross debt increased from below 30% of GDP in 2007 to 96% in 2009 Expenditure cuts and increased taxes needed to ensure a gradual closing of the deficit and a sustainable debt path

The economic outlook

Economic outlook Recovery set to start in Q3/2010

Economic outlook Disinflation continues as ISK remains stable