ability to offer funding to those who take on economic risk. but in the recent past the focus of finance has gradually shifted. from helping the real economy hedge economic risk, the focus of finance has quietly moved toward the creation of financial risk. financial risk is different from economic risk. it is deliberate exposure to asset price changes. building an exposure to a change in the value of an asset is not bad per se. but we have to distinguish between arbitrage and directional positioning. arbitrage is an essential market force. indirectly, it helps production and trade. directional positioning, instead, can amplify and even creates gaps in asset prices. it does so by acting on expectations of future price changes. unlike in the case of arbitrage, these price gaps are notional – indeed, “ speculative ”. they are often large only because they are not suitably discounted for risk. when perceived market risk is moderate, failing to discount for risk is not a severe omission. indeed, in the ten years that led up to the crisis, financial risk was thought to be low and declining. but, the notion that risk was low and declining was largely an illusion. individually, diversified financial strategies looked all as rational attempts to unload risk to those parties in the system which were more willing to bear it. in the aggregate, however, diversification was subject to a sort of fallacy of composition. individual strategies were diversified. but the aggregation of a complex web of identical strategies – all designed to shed risk individually – generated a lack of diversity for the financial system as a whole. in the end, it turned out that the system could not diversify risk away. furthermore, the complexity of the financial web made this fact more difficult to identify. a c. e. o. of an important bank had a terrible image to describe the euphoric state of the markets, only few weeks before the crisis started. he said that : “ when the music stops, in terms of liquidity, things will be complicated. but as long as the music is playing, you ’ ve got to get up and dance. we ’ re still dancing ”. the “ dancing ” in the metaphor was an irresponsible credit boom, where banks scrambled for borrowers, and the borrowers could dictate the conditions for credit. confronted with a similar landscape of market euphoria and industrial hardships in the 1920s, churchill said : “ i would rather see finance less proud

developed during the economic contraction ending in 2010 was gradually absorbed between 2011 and 2013. measured productivity growth has been negligible or non - existent and gdp growth therefore labour - intensive. as a result, unemployment has declined rapidly and demand pressures have developed in the labour market. according to the forecast published yesterday, the positive output gap is expected to peak next year at 1½ % of gdp. domestic demand will grow well in excess of gdp during the forecast horizon, which extends into 2018. terms of trade are projected to improve significantly this year, contributing to a larger current account surplus than would otherwise occur, but the improvement will reverse to an extent in 2017 and 2018. the sizeable current account surplus of the past few years will therefore shrink significantly during the forecast horizon and will have nearly disappeared by 2018. rapid growth in domestic demand under conditions of full utilisation of resources has often proven dangerous to icelanders. other things being equal, such a situation calls for monetary and fiscal tightening. our initial position is unusually good this time, as can be seen in a strong current account surplus, a central government surplus and declining government debt, and inflation that is still below the target. but the tug - of - war between large pay increases and the bis central bankers ’ speeches global tendency towards deflation will determine how much and how rapidly this situation deteriorates in the coming term. in my speech at the central bank ’ s annual general meeting, i expressed considerable concern about the unrest in the labour market and the consequences that it could have for economic stability. in the speech, i noted that wage pressures that jeopardise the inflation target are generally considered a sign of both demand pressures in the economy and excess demand in the labour market, which must be met with tighter monetary policy. however, this was not consistent with a slack that was just about to disappear and a sizeable current account surplus. i mentioned another possible explanation : that the consensus on wage differentials had broken down at the same time that the opening of the labour market vis - a - vis abroad put pressure on those differentials – in some cases, in the direction opposite to that demanded by labour market organisations. this is consistent with theories indicating that, other things being equal, if there is a broader consensus about income distribution, a lower level of unemployment will be consistent with low and stable inflation. other possible explanations should be borne in mind, however, in any interpretation of developments in the labour market. one is that the recent improvement in