Norman T L Chan: When markets fail Speech by Mr Norman T L Chan, Chief Executive of the Hong Kong Monetary Authority, at the 6th Caixin Summit 2015, Hong Kong, 6 November 2015. *  *  *  1. The topic of my speech today (“When markets fail”) is a little controversial as there are some who do not accept the premise that markets can fail. They believe that markets are capable of self-correcting and will eventually achieve the most efficient price discovery and resource allocation. However, I have some reservations about this notion because our experience tells a slightly different story. Markets do sometimes fail to perform their price discovery and resource allocation functions. In some more serious cases, market failures have even led to destabilising financial shocks and crises. 2. Indeed, the 2007–08 global financial crisis, which ravaged the US and Europe, clearly repudiates the general belief that market failures and financial crises will only occur in third world countries or underdeveloped economies. On the face of it, the bursting of the US property bubble triggered the collapse of the subprime mortgage market, which in turn led to the financial crisis in the US. However, if we look more deeply, we find that prior to the crisis, the banking and financial systems had been churning out a great number of subprime mortgage-backed securities. In addition, various derivative instruments using subprime mortgage-backed securities as underlying assets, like CDO2 and CDO3, added layers of risks like snowpack.
Looking at the post-war period, whenever the unemployment rate has increased by more than 0.3 to 0.4 percentage points, the economy has always ended up in a full-blown recession with the unemployment rate rising by at least 1.9 percentage points. This is an outcome to avoid, especially given that in an economic downturn the last to be hired are often the first to be fired. The goal is the maximum sustainable level of employment – in other words, the most job opportunities for the most people over the long run. Some of you may be wondering whether the risk of a recession isn’t already quite high? And, if so, doesn’t this imply a need for special care in adjusting monetary policy? After all, the current economic expansion is more than six years old – a bit long in the tooth by post-war standards. Even so, recession risk did not play a major factor in my thinking. Economic expansions don’t simply die of old age. They primarily end either because monetary policy is kept too loose for too long, thereby necessitating a subsequent sharp tightening in monetary policy to prevent a significant inflation overshoot, or because some large adverse shock hits the economy that the central bank cannot easily offset. Mitigating the first risk of being forced to choke off the expansion argues for getting started with policy normalization now rather than holding off. With respect to the second risk of unanticipated shocks, this is obviously very difficult for the central bank to insulate the economy from.