Norman T L Chan: 3Ds - an era of awakening?
Speech by Mr Norman T L Chan, Chief Executive of the Hong Kong Monetary Authority, at
the 4th Santander International Banking Conference: "A Global Financial System for a Global
Economy", Madrid, 18 October 2011.
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Good afternoon ladies and gentlemen,
I am honoured to receive the invitation to attend and speak at the 4th Santander International
Banking Conference today.
It is only a few short years ago that the world economy was shaken to its core by the Global
Financial Crisis. That we again face the threat of profound and traumatic disruption so soon
is a measure of the urgency that governments must employ to correct the structural
imbalances necessary to get the economy back on song for the long term.
Today I want to take up a little bit of your time explaining what I see as fundamental to
righting the ship so that it can survive in the roughest of seas.
Collapse of Bretton Woods System
After World War II, the World's Superpowers tried to maintain a system of semi (or quasi)
Gold Standard in which major currencies were fixed to the US dollar, which was in turn fixed
to Gold at US$35 an ounce. This global monetary system was basically a fixed rate regime,
which imposed an external discipline to restrain monetary expansion globally.
The Bretton Woods System became unsustainable as the US began to allow money supply
to grow well beyond the gold reserves held by the US Government. When the System
collapsed in 1972, the world's monetary system was converted to a fiat money regime in
which major international currencies freely floated against each other. The post-Bretton
Woods era represented a new era in which governments would be given more or less a free
hand to pursue their national interests and domestic policy agenda without the rigid
constraints imposed by a Gold Exchange Standard. Unfortunately, the initial experience
under the new regime was far from satisfactory.
In my view, financial and macroeconomic stability cannot exist without an effective monetary
anchor. For many centuries, the linkage to the precious metals had provided an external
monetary anchor. Of course, the Gold Standard or Silver Standard had many shortcomings
but it nevertheless provided an externally imposed discipline against monetary expansion.
However, under the fiat money and floating rate regime, financial and macroeconomic
stability can only be achieved if we have "3 Ds"! What does "3Ds" stand for? The first D
stands for "Monetary Discipline", the second "Fiscal Discipline" and the third "Market
Discipline". Conceptually, the removal of the external monetary anchor in the form of backing
by precious metals must be replaced by these three types of discipline. If any of these three
disciplines breaks down, then serious consequences or even a financial crisis may occur. Let
me address these three disciplines in turn.
Monetary discipline
Unlike a fixed rate regime in which a national government can only issue currency if it can
provide the backing (such as gold reserves), a floating rate regime allows national authorities
to issue currency freely to suit their domestic needs. As we know, national central banks play
a crucial role in controlling or influencing the supply of money. By changing interest rates or
the price of money, central banks indirectly influence the expansion of credit and thus money
supply. Good monetary discipline is clearly needed to ensure that money or credit expansion
does not become out of control. The initial experience in the US with the fiat money regime
was not at all successful or pleasant. There was runaway inflation, rising from 5.8% in 1970
to 11.2% in 1979, and, as a result, Paul Volcker of the Fed had to introduce drastic measures
to combat inflation by pushing interest rates to as high as 19%. It is now widely accepted that
the breakdown of monetary discipline will lead to financial chaos with huge shocks to
macroeconomic and financial stability.
After the recent Global Financial Crisis, we have come to realise how important it is to
maintain the appropriate monetary discipline. It has been argued by many economists that
one of the contributing factors leading to the Crisis was that the US policy interest rate was
set too low for a prolonged period, which further fuelled credit growth and the housing bubble
in the US. Of course financial innovation and the creation of highly opaque and leveraged
financial derivative products, such as CDOs, also helped amplify the severity of the problem
and transmit the shockwaves across the global financial system. The result: the global
financial system nearly collapsed.
Fiscal discipline
More often than not monetary discipline breaks down because of the lack of fiscal discipline.
One major reason why the US had to abandon the Bretton Woods system was the huge
fiscal burden of financing the war in Vietnam, which also led to a sharp deterioration of the
current account position of the US. There have been many examples of Government
spending beyond their means resulting in the piling up of government or public debt. In the
case of Argentina, the lack of fiscal discipline eventually brought down the Currency Board
System that had served as an anchor of monetary stability for Argentina since 1991. In the
case of Europe, the sovereign debt crisis that we are seeing now has been the consequence
of a breakdown of the fiscal prudence and discipline over many years. Very few people
would now doubt that macroeconomic and financial stability could be achieved in the longer
run in the absence of fiscal discipline.
Market discipline
This is probably the most complex if not intriguing dimension of the three disciplines needed
to maintain financial and macroeconomic stability. Traditionally, we all believe that market
forces would be the last guard when national authorities failed to exercise monetary or fiscal
discipline or both. In theory, the market should respond to a breakdown in monetary or fiscal
discipline by demanding higher risk premium for the sovereign debt issued by those
countries that are not behaving in a prudent manner. However, market discipline also seems
to have broken down in many instances. For example, right after Greece joined the Euro
Zone, the market was somehow attracted by the so called convergence play and for 8 years
from 2001-2008 it ignored the fundamentals of Greece and its Single A rating and traded
Greek sovereign debts as a Triple A credit, with a spread of as low as 8 basis points above
German Bunds in February 2005. Looking back, the rationale for this kind of convergence
play defies common sense and any analysis of fundamentals. However, the breakdown of
the market discipline had played a key role in encouraging and facilitating continued erosion
of fiscal discipline of the national authorities by conveying the wrong signals about the market
tolerance, and appetite for their sovereign debts. As an illustration, the sharp fall of interest
cost (10-year government bond yield) from over 10% in the mid 1990s to a low of 3% in the
mid-2000s had also helped lower the cost of Greek Government borrowings and created the
illusion of the affordability and sustainability of the rising pile of government debts.
There are many reasons why market forces are failing to impose discipline when national
authorities or firms fail to behave prudently. However, it is fair to say that financial innovation
in the last decade or so contributed in no small part to the breakdown of market discipline.
Coming back to the US, the proliferation of MBS and complex financial derivatives of CDOs
had, as we now know, greatly increased the leverage and thus risk of the entire financial
system. What was worse was that the structure of these financial products was so complex
and so far removed from the underlying assets that it was virtually impossible for anyone,
including the rating agencies, to fully understand the risks involved and to price such risks
appropriately. We now know that there were thousands and thousands of CDOs sold before
the Global Financial Crisis that were given Triple-A ratings simply because seriously flawed
assumptions and models were used in assessing the risk of defaults. As I mentioned earlier,
these financial derivatives had helped amplify the shocks and transmit these shocks across
the global financial system during the latest Global Financial Crisis.
An era of awakening?
While we have seen many instances where market discipline has broken down, it is hard to
believe that market discipline will break down permanently. As Europe has recently found
out, the market can suddenly awaken and begin to doubt the fiscal sustainability of some
members of the Euro Zone. This belated awakening has so far created considerable
dislocation to the banking system and capital markets. Once the market discipline begins to
kick in, the national and Pan European authorities have little choice but to push forward a
series of drastic, painful but necessary austerity measures to quickly achieve fiscal
consolidation and to restore market confidence.
Another important issue we are facing is to what extent monetary policy could be effective in
supporting and stimulating economic growth. In other words, it is by no means clear that
excessive accommodative monetary policy would be effective in boosting demand and
creating jobs in the US and elsewhere and whether such policy, if deployed for a long period
of time, would have undesirable consequences, both overseas and domestically, that would
outweigh the likely benefits it could potentially generate.
I would argue that we central bankers must be able to recognise the pitfalls of trying to
achieve goals that are beyond our reach. And I would agree with Chairman Bernanke when
he said in his recent speech at the Jackson Hole conference that "most of the economic
policies that support robust economic growth in the long run are outside the province of the
central bank". While monetary discipline, fiscal discipline and market discipline are absolutely
necessary conditions for economic stability and prosperity, they are clearly not sufficient
conditions. For the global economy to recover and to return to its long-term growth trend,
important structural imbalances in the major advanced economies have to be corrected. We
must recognise that economic growth and prosperity built on excessive debts by households,
corporates and the Governments are clearly not sustainable. We must awaken to the cruel
reality that somehow the debt overhang accumulated over the years has to be reduced and
redressed before consumers and investors can regain confidence on a brighter future.
To some of you my speech today may have sounded rather gloomy. You might have felt that
it is easy for someone from Asia, a region that is growing strongly and to some extent
suffering from overheating pressures, to lecture colleagues in Europe, which is in the midst of
a sovereign debt crisis and suffering from low growth and high unemployment, about what
are the right things to do. But it is far too easy to overlook the fact that Emerging Asia's
dynamism today is the result of very painful adjustments that took place after the widespread
devastation caused by the Asian Financial Crisis of 1997-98. You may or may not know that
Hong Kong had had a very serious housing market bubble, which collapsed in late 1997. In
the six years after that, housing prices declined by close to 70%, with unemployment rising
three times. At the same time, the economy contracted by 8.7% over 5 quarters with
deflation amounting to 15% during this period of adjustment. There was a lot of pain and
sense of gloom during this very difficult period, but Hong Kong people did not give up and
kept on trying their best to deal with the problems. After this very painful adjustment, Hong
Kong has re-emerged stronger and more resilient than ever before.
In conclusion, I wish to leave with you the following message: the breakdown of monetary,
fiscal and market disciplines has contributed to the deepness and severity of the latest crisis
in the advanced economies. In my view, there is unfortunately no easy way out or clever
solution that could avoid the need and thus the pain of structural adjustments that would
redress the imbalances built up in the last decade or two. Going forward, we must realise
that we have to restore the 3Ds or three Disciplines, without which the conditions for
sustainable economic recovery would not exist. Are we now in an era of awakening? I am not
totally sure but I think, or at least I hope, we are. If not, then market forces would eventually
push all of us into that position, except that the later the awakening occurs the heavier the
price we will have to pay.