Assessment and recommendations

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.