When I was still at the Bank for International Settlements, I gave a speech here in Iceland on financial globalisation to an audience of high-level European bankers. In that speech I discussed the risks associated with the internationalisation of banking and said: “ … emergency liquidity assistance will be complicated or even impossible for central banks to deliver when internationally active banks face liquidity problems in currencies other than that of their home country. Iceland is a case in point”.1 That is essentially what happened in the autumn of 2008. But this was in May 2007, before the international financial crisis emerged in August that same year. Then it became gradually more obvious and the Icelandic authorities tried to build defences and seek international support, but with limited success. Given the lack of international cooperation, the Icelandic authorities were forced to consider radical solutions. Although they were probably not articulated fully at the time, these solutions entailed several goals: preserving a functioning domestic payment system, ring-fencing the sovereign in the case of bank failures, limiting the socialisation of private sector losses, and creating the conditions for the reconstruction of a domestic banking system. In essence, the adopted solution saved the domestic operations of the banking system and let the international part to go into a resolution process. The new banks were created by carving the domestic assets and liabilities out of the old, failing banks. The new banking system amounted to 1.7 times GDP.
Comprehensive capital controls were an important element in the programme, but their rationale was to help to stabilise the exchange rate in a situation where the currency had fallen more than 50% in 2008, where foreign króna positions that were a legacy of carry trade and capital inflows amounted to around 40% of GDP, and where a large fiscal deficit that had to be financed in the domestic market had developed. The capital controls therefore gave monetary policy more scope to help stabilise and turn around the real economy once inflation came down. Franek will discuss the IMF programme in more detail, but I would like to make one more remark regarding fiscal consolidation, as it is such an important part of the story. The crisis hit Government finances hard, as can be seen from this slide. BIS central bankers’ speeches  3  It was therefore of vital importance that Government debt was relatively low immediately before the crisis. However, fiscal consolidation was needed earlier than some considered optimal at the time from a demand management perspective, in order to regain internal and external confidence and open market access. The effort was huge, as can be seen from this slide, but back-loaded, as automatic stabilisers were mostly allowed to work in 2009. And it did not derail the recovery that began around the middle of 2010.