Iceland has plunged into its deepest economic recession in decades after succumbing to a widespread financing crisis and a collapse of domestic demand. The meltdown of Icelandic banks unfolded against the backdrop of faltering global capital markets, which reached a climax in September 2008 with the failure of Lehman Brothers. By the fourth quarter of last year, almost all OECD countries were experiencing sharp declines in real GDP and world trade was plummeting. After years of rapid expansion, the economic situation in Iceland also turned for the worse when the country’s three main banks collapsed, capital markets seized up and financial relations with foreign countries were shut down. While Iceland is in part a victim of the international crisis, its severe plight largely results from a recent history of ineffective bank supervision, exceptionally aggressive banks and inadequate macroeconomic policies. The government has devised a medium-term adjustment programme to restore policy credibility and economic growth, which is being implemented in the context of an IMF Stand-By Arrangement. The origins of Iceland’s severe banking and macroeconomic difficulties and policies for a sustainable recovery are discussed in this Economic Survey.

The global financial and economic crisis has struck Iceland with extreme force. Iceland’s three main banks, accounting for almost all of the banking system, failed in October 2008. They were unable to resist the deterioration in global financial markets following the failure of Lehman Brothers. The banks had pursued risky expansion strategies – notably borrowing in foreign capital markets to finance the aggressive international expansion of Icelandic investment companies – that made them vulnerable to the deterioration in global financial markets. They had also grown to be too big for the government to rescue. When access to foreign capital eventually closed, the banks failed. Non-financial firms and households were also vulnerable to the deterioration in global financial conditions, having taken on a lot of debt in recent years based on inflated collateral values. In some cases, the debt was foreign-currency denominated, without matching foreign-currency assets or revenues. In the wake of the banking crisis, the government obtained an IMF Stand- By Arrangement to provide favourable access to foreign capital markets and creditability for the recovery programme. Even so, the recession is likely to be deeper in Iceland than in most other OECD countries owing to the seriousness of the banking crisis and the weakness of private sector balance sheets.

Monetary and fiscal policies face huge challenges: the banking sector has collapsed; the economy is in the midst of a deep recession; the exchange rate has plunged; capital flows have been frozen; inflation is elevated; public debt has risen; source of revenues have disappeared; social needs have increased; and the unemployment insurance fund has been nearly depleted. Against this difficult background, this chapter discusses what policy makers should do in order to restore balance in the Icelandic economy and lay out the foundations for a sustainable recovery. The key recommendations are to seek entry in the euro area and implement the fiscal consolidation measures necessary to comply with the IMF programme.