Inflation is predicted to fall back to the target around the middle of next year, although this will depend on exchange rate developments. 6  BIS central bankers’ speeches  The second relates to deleveraging, or reduction of debt levels. Public and private debt levels are on a declining path, as can be seen from Figure 8. In the case of businesses in particular, a significant part of this takes the form of debt restructuring and write-downs. That, along with the resolution process of the failed banks, will reduce Iceland’s net external debt to a sustainable level over time (see Figure 9). This is a good thing, of course, but the deleveraging process has two short- to medium-term side effects that must be managed. The first one relates the negative effect of deleveraging on domestic demand. The second relates to its negative effect on the exchange rate, as economic entities with foreign debt, little or no foreign-currency income, and no access to foreign credit are forced to repay foreign debt faster than is optimal for them and the economy. This is part of our balance of payments problem. BIS central bankers’ speeches  7  That brings me to the third challenge, which is to break out of Iceland’s balance of payments crisis and lift the capital controls. Through fiscal consolidation and reinforcement of its FX reserves (see Figure 10a), Iceland has seen a steep drop in the perceived risk of the sovereign as reflected in CDS spreads.
This picture is broadly mirrored when turning from returns to labour to returns to capital. In the 1950s gross profitability of the financial sector relative to capital employed was broadly in line with the rest of the economy (Chart 16). But since then, and in particular over the past decade, returns to capital have far outpaced those at an economy-wide level. Chart 17 plots UK banks’ return on equity capital (ROE) since 1920 (Alessandri and Haldane (2009)). Although conceptually a different measure of returns to capital, the broad message is the same. Trends in ROE are clearly divided into two periods. In the period up until around 1970, ROE in banking was around 7% with a low variance. In other words, returns to finance broadly mimicked those in the economy as whole, in line with the gamble payoffs in Chart 6. But the 1970s mark a regime shift, with the ROE in banking roughly trebling to over 20%, again in line with gamble payoffs. Excess returns accumulated to capital as well as labour. These returns were by no means unique to UK banks. Chart 18 plots ROEs for major internationally active banks in the US and Europe during this century. Two features are striking. First, the level of ROEs was consistently at or above 20% and on a rising trend up until the crisis. This is roughly double ROEs in the non-financial sector over the period. Second, the degree of cross-country similarity in these ROE profiles is striking. This, too, is no coincidence.