in 2009, with fiscal consolidation taking hold in 2010. this was important in two respects. first, it limited the negative demand effects of fiscal consolidation precisely when the recession was at its steepest. second, it sent a signal that adverse public sector debt dynamics would be addressed over the medium term, thus reducing risk premia in domestic and foreign interest rates facing the sovereign. graph 1 shows the progress that has been made so far with fiscal consolidation and the plans embedded in the fiscal budget for 2011. provided the plans are carried out, the consolidation involved will be impressive in both historical and international comparison, with a roughly 9 percentage point improvement in the non - cyclically adjusted fiscal balance from 2009 to 2012, even though there will be a significant slack in the economy for most of the period. although it has been delayed and has faced obstacles on the way, the reconstruction of the domestic financial sector is far advanced. the three major commercial banks have been recapitalised, with foreign creditors taking a majority stake in two of them and the state holding a majority in the third. at the end of june, all three had capital ratios above 16 %, most of it common equity. as a result, iceland ’ s banks meet basel iii requirements more than two times over. the recapitalisation of the savings banks is in its final stages. in june of this year, however, question marks were raised about the capital position of the banking system when the supreme court of iceland ruled that linking isk loans to exchange rates was illegal. the banking system had a large number of such contracts on its books. the precise scope of the problem was uncertain, but more importantly, it was not clear what interest rates these loans should carry when they were no longer exchange rate - linked. should they carry contractual foreign rates or some typical isk rate, such as the benchmark rate published by the central bank of iceland? in the former case, the blow to the capital position of the banking system would have been very serious indeed, requiring massive recapitalisation and possibly jeopardising the overall stability of the system. those responsible for financial stability gave a sigh of relief when the supreme court ruled in mid - september that loans with illegal exchange rate linkage clauses should carry reference isk rates published by the central bank of iceland. after this decision, it is clear that the blow to capital ratios should be well manageable and only a very limited recapitalisation will be called for, if any. the

reconstruction of the domestic financial sector paves the way for badly needed debt restructuring among households and businesses. this issue has remained unresolved due to delays in recapitalising the banks and the uncertainty following the first supreme court ruling. but it has also lagged because the framework for such debt restructuring has been a highly contested political issue. we have seen that iceland has made significant progress on three main policy fronts. but before investigating how this progress has stabilised the economy, let us turn back to the recession in the icelandic economy. as i said earlier, iceland was well on its way into recession in 2009 before the banks collapsed in the autumn of 2008, and actually before the currency crisis materialised earlier in 2008. in fact, the central bank had been predicting a recession in 2009 since at least 2006, as can be seen from the graph that shows predictions for 2009 gdp growth at different dates. the predicted recession was supposed to be a mild one, but then we need to bear in mind that recession forecasts tend to be dampened while the times are still good! when all three shocks had hit, the mood changed dramatically, as can be seen from graph 2. the bleakest forecast was made in may 2009, when gdp was predicted to contract by 11 % in 2009 and unemployment for 2010 was forecasted to reach 11 %. however, the outcome turned out to be much better – a contraction of 6. 8 % – and the prospects for peak unemployment have also improved markedly. i think this due not to ordinary forecast errors but to various factors that supported domestic demand and export production in 2009, some of which were temporary. these included temporary permission to withdraw a specified maximum amount from third pillar savings, with use amounting to 1½ % of gdp in 2009. this measure is akin to a fiscal stimulus of a similar size. but these factors also included other measures to support households, which mitigated the decline in private consumption. furthermore, the delay in corporate and household restructuring, although detrimental in the medium term, postponed some of the short - term contractionary effects that tend to accompany it. finally, the low real exchange rate stimulated exports and other traded goods sector activity. moreover, the composition of iceland ’ s exports is such that they are somewhat less cyclically sensitive than, for example, exports of motor vehicles and consumer durables. the net result was that iceland ’ s exports held up well in comparison to world trade overall, as can be seen in graph 3. some of