in any book ( such as giving an already overheated economy a demand stimulus ), and those more closely related to the orthodoxy prevailing at the time : freely floating exchange rates, interest rate policy focusing mainly on low inflation in terms of goods and services, and good micro - supervision ; and let the markets do the rest. the first factor is perhaps of interest here. the process runs as follows : domestic interest rates at the longer end of the maturity spectrum tend to become more closely correlated with the global rate, or the rate of the largest trading partner, and less correlated with the domestic policy rate. this means that monetary transmission tends to go increasingly through the exchange rate channel, which is only a problem, however, if the exchange rate behaves badly. unfortunately, there is a lot of evidence to suggest that it does. uncovered interest rate parity ( uip ) does not hold except over long horizons. interest rate differentials give rise to widespread carry trading, which is by nature a bet against uip. exchange rates bis central bankers ’ speeches thus diverge from fundamentals for protracted periods, followed by sharp corrections. so the exchange rate often seems to be as much a source of shocks and instability as a tool for adjustment and stabilisation. ultimately, these cycles can take the boom - bust form and, in extreme cases, can result in serious financial instability or crisis. the research on this phenomenon is still ongoing, but there is a lot of evidence to suggest that the problem would not disappear even if macroeconomic policies in the traditional sense were perfect. this process was important in the icelandic episode. the capital inflows were driven by the traditional push and pull factors. but when a benign upturn originally driven by fdi in the energy - intensive sector turned into overheating, and fiscal and other demand levers pulled by the government were either insufficiently used or pulling in the other direction, monetary policy was overburdened and the increased interest rate differential that resulted pulled in further capital and carry trade positions. let me now turn to the banking part of the story. before the collapse, the banking system had expanded very rapidly, growing in just five years from a combined balance sheet of less than 2 times gdp at the end of 2003 to 10 times gdp. most of this expansion was cross - border, and a significant part of it was really off - border, having little to do with iceland, as both financing and investment took place abroad. around two - thirds of

border banks was dealt with and the lessons learned from it. it is now more widely known in our circles than it was to begin with and less controversial. for more, i can refer you to various publications and speeches of mine and others. but the main reason is that, as far as iceland is concerned, the problem is solved for the near future : we are simply not going to do it. we are not going to establish international banks headquartered in a very small country with its own currency without an access to a sufficient regional or international financial safety net. this does not preclude that we, as well as others, will with time forget the lessons of the crisis and find ways to create problems or even failures of our banks, but it should be a much more domestic and contained affair. so what did we do? deposits were given priority over unsecured bond holders prior to the failure of the banks. at the point of failure, smaller domestic banks were carved out of the failing private cross - border banks, which went into resolution governed by law. it was not a clean split, which later became a major impediment to lifting capital controls ; however, that impediment has now been removed. although they were not necessarily clearly articulated at the time, these measures were guided by the following goals : to preserve a functioning domestic payment system, ring - fence the state in the case of bank failures, limit the socialisation of private sector losses, and create the conditions for rebuilding a domestic banking system. 1 / 2 bis central bankers'speeches i have already alluded to some of the lessons learned, which relate to large, internationally active banks in small countries and the flaws in the framework for cross - border banking. this is by now well accepted and is partly what a banking union is all about. but it will not fix the problem for eea countries outside the eurozone, due to potential fx risks on banks ’ balance sheets. let me now turn back to the other story about macroeconomic management and financial stability in sofies. here the issue is that, with ongoing global financial integration, the interest rate channel of monetary transmission weakens in sofies, as longer domestic rates increasingly co - move with longer rates in the big countries. inflation targets could still be reached through the exchange rate channel, but exchange rates are not necessarily smooth reflections of underlying fundamentals. instead they tend to be excessively volatile and are sometimes misaligned for protracted periods. uip does