domestic borrowing costs that take place. this foreign currency borrowing is intermediated by the domestic banking system, where the financing is more short - term than the lending. thus the banking system has a growing balance sheet in fx, with a maturity mismatch but limited lolr facilities to backstop it. in short, financial risks are accumulating, both in the financial sector and among firms and households. at the same time, the economy is increasingly in an unsustainable position, with an overvalued currency and big current account deficit. the bis central bankers ’ speeches whole thing then comes crashing down when foreign financing comes to a sudden stop, heralding a currency crisis and even a banking crisis as well. before i go further, let me warn you, though, that this is only part of the explanation of the financial crisis in iceland. the offshore activities of the banks and old - fashioned macroeconomic mismanagement were equally important, if not more so. on this topic, i refer you to other speeches and publications by myself and others. 2 what can and should be done about the problems i have laid out? in answering that question, we should take into account that the biggest problems occur when global factors – cross - border financial integration and associated capital flows – and domestic vulnerabilities interact negatively. in principle, solutions could be directed at any or all of these. some are obvious in their design and relatively easy to implement, especially if they can be implemented unilaterally by individual countries. others are more complex in their design or require global, regional, or big - country action that is not necessarily forthcoming. one potential solution is to enter a monetary union, thus eliminating the small country monetary policy problem. it would also reduce the financial risks emanating from currency mismatches and foreign currency maturity mismatches in the balance sheets of domestic banks. but as this is currently not on the agenda in my own country and recent developments have demonstrated that it is no panacea – with pros and cons that extend far beyond my topic her – i will not dwell on it further. there is no doubt that flaws in the international monetary and financial systems exacerbate the problems that i have mentioned. reforms that would reduce the current asymmetries in the adjustment burdens of surplus and deficit countries, or would to a greater degree internalise the global externalities of the monetary policies of central banks issuing major reserve currencies, could reduce

have other explanations. thus co - movements in asset returns could be due to common shocks and the low level of correlation between short and long rates due to monetary policy credibility. looking at the totality of the evidence and case studies, however, it seems difficult to escape the conclusion that global financial integration was a big underlying driver, although there were also other factors at play. new zealand appears to be a relevant example here. during significant parts of the 2000s – before the gfc – the policy rate in new zealand was raised to counteract demand pressures at the same time as the us maintained an easy stance. new zealand ’ s long rates were flat or falling for most of this period. i could tell a similar but slightly more complicated story from my own country. the tendencies that i have described can be problematic in their own right but in no way fatal, as the experience of new zealand and others attests to. it is when they interact badly with other economic and financial risks that can face small, open and financially integrated economies – such as the global credit cycle, domestic financial vulnerabilities, policy conflicts, and asymmetric shocks – that we can have a lethal cocktail. this was the case in iceland. to demonstrate this, let me take a stylised example which is, i admit, heavily influenced by the experience of my own country. a small, open, and financially integrated economy develops a positive output gap that is larger than in the rest of the world. the economy is booming and is seen as a good investment by outside investors. this occurs in a situation where the global credit cycle is in a strong upswing. the result is capital inflows and upward pressures on the exchange rate. the country has a floating exchange rate and has adopted a flexible inflation targeting regime. monetary policy therefore reacts by raising interest rates due to the risks that the booming economy poses for future inflation. this, however, widens the interest rate differential vis - a - vis the rest of the world and sucks in even more capital through carry trade and other channels. the currency therefore appreciates further. this helps to limit inflation, both directly, through lower imported inflation in terms of domestic currency, and indirectly, by directing demand abroad. but the effect of monetary tightening on domestic demand is limited through the processes i have described, where long rates react weakly to the increase in the policy rate. in addition, firms and households increasingly borrow in foreign currency in order to avoid even those limited increases in