Yet efficient market forces “should” eliminate these disequilibria by having wages adjust to ensure full employment always and forever. Monetary Policy is not only a response to these rigidities; it is made effective by them. In capital markets, there is ‘momentum everywhere’. From bonds to equities to currencies and commodities, past winners seem to enjoy further winning streaks, while past losers persist in trailing behind. 4 Yet efficient market forces ‘should’ eliminate these predictable movements before they become apparent. *** The belief that markets always clear had two dangerous consequences. 5 First, if markets always clear, they can be assumed to be in equilibrium; or said differently “to be always right.” If the received wisdom is that the market is efficient, then bubbles can neither be identified nor their potential causes addressed. Such thinking dominated the (non)reaction to US subprime and housing booms. Consider that many market participants find it more profitable to anticipate each other’s behaviour than to divine the fundamentals. 3  For a review of this broader phenomenon, see Padoa-Schioppa, T (2010), “Markets and government before, during and after the 2007-20xx crisis”, The Per Jacobsson Lecture, June. 4  Asness, C, Moscowitz, T and Pedersen, L (2013), “Value and momentum everywhere”, Journal of Finance, LXVIII, No. 3, June. 5  See also Turner, A (2010), “Market efficiency and rationality: why financial markets are different”, Lionel Robbins Memorial Lectures, London School of Economics.
How can these risks best be mitigated in practice? Let me comment on the range of possible options that stop short of direct regulation. Prudential regulations, in the form of capital or leverage requirements, have not been considered a necessary or desirable step to date within the official sector in the United States, and are not on the horizon. Investors in hedge funds have a compelling direct interest in ensuring they are well managed. A more discerning and pro-active approach by investors in hedge funds should help to reduce the risk of failure by a major fund. The increasing share of institutional money allocated to hedge funds and the growing role of funds of funds could help reinforce the ability of the investor class to provide such market discipline, in particular if these types of investors undertake more extensive due diligence. There has been and continues to be a lot of interest in inducing or requiring hedge funds to disclose information that would make it possible to know more about the scale of leverage in particular funds, the risk of concentrated positions that could amplify volatility if unwound quickly, and other aspects of the risk profile of the fund. These efforts are motivated in part by discomfort about what we do not now know and a sense that knowledge itself, by reducing uncertainty, could reduce risks.