Summary: Why should we care about the problems of the Swiss National Bank and their currency management policy? Because they grapple with two of our time’s great economic policy issues — both important to us: the strength of a nation’s currency and the credibility of its central bank. We should watch and learn from their experience. {1st of 2 posts today.}
This is a follow-up to yesterday’s post Today began the next phase of the great monetary experiment, as reality plays a trump card. Readers said that was too technical; today’s post explains the issues more clearly.
“My power proceeds from my reputation.”
— Napoleon’s diary entry on 30 December 1802. It could equally as well have been written by the Wizard of Oz. Reputation (credibility) is among the most fleeting kinds of power.
Don’t the Swiss want a strong currency?
.
Nobody running a major nation wants a strong currency (details here). There are people who do want a macho currency policy, and even some who want a gold-based currency (a bad idea for reasons described here). They loudly warn of doom about modern fiat currencies, as they have for generations. They are kept away from the national controls in America and elsewhere.
The people running the most economically successful nations (e.g., Germany, China) do the opposite; they manage down the value of their currencies in order to maintain competitiveness of their exports. Switzerland shows the problems caused by a too-strong currency.
Today the 1% in many nations have fears about their money. Some seem reasonable — fears of Europe and China’s rich about social, political, and economic instability. Some seem daft, such as fears that Obama will redistribute their wealth and the UN will steal their golfs. Whether smart or foolish, rich people have confidence in Switzerland because of its centuries of stability This makes it a magnet for scared money; these inflows push up the value of the Swiss Franc (CHF).
It’s like the crowd on boat rushing to one side, tilting it dangerously. The SNB must respond, as this depresses their exports — which are over half of Swiss GDP.
Unfortunately there are no easy and painless and reliable methods to depress the value of a currency (it’s a trilemma; you can have any 2 but not all 3). The Swiss tried relying on their credibility — 1.2 Swiss Franc to the Euro and no farther! — and massive money printing (with which they bought many kinds of assets, including $26 billion in US stocks).
Yesterday they abandoned their Plan A (drawing a “line in the sand” above which the CHF would not rise), accepted the inevitable increase in the CHF’s value, and went to Plan B. They hope to slow or prevent the CHF from rising more, and minimize the damage from its rise.
About credibility.
“The biggest bubble out there is central bank credibility. … When that bubble pops, all hell will break loose again, and there you really just want to be in cash.”
— Gerard Minack (former chief strategist at Morgan Stanley), Financial Review, 12 January 2015.
Credibility has become a key tool in both geopolitics and economics, offering an easy cheap method to influence events. Beyond the obvious — credibility can increase one’s ability to influence others — it’s become a chimera, a largely imaginary concept sought at great expense by people who’ve lost touch with the real world. I could explain it, but why bother? The next generation will laugh that we took it seriously.
The great economist Alan S. Blinder (Wikipedia entry) explains how this works in “Central Bank Credibility: Why Do We Care? How Do We Build It?“, NBER Working Paper, June 1999 — “Central bank credibility plays a pivotal role in much of the modern literature on monetary policy, yet it is difficult to measure or even assess objectively. ” Excerpt:
Over the last 15-20 years, the concept of credibility has become a central concern of the scholarly literature on monetary policy. A search of the 11 economics journals archived in JSTOR reveals that 140 different articles used the word “credibility” in conjunction with either monetary policy or central banking over the 10-year period 1983-1992.
By contrast, a search of the preceding 10 years turns up just 40 references, 23 of which are in the 1980s. This heightened interest in the credibility of monetary policy pronouncements is, in part, tied to the rational expectations revolution: Under certain assumptions, including rational expectations, a completely credible central bank can engineer a disinflation without suffering any adverse effects on employment. But central bank credibility is relevant even if expectations are less than fully rational. As long as expectations matter–and how can they not? — a central bank’s credibility should influence how its monetary policy actions affect forward-looking variables like long-term interest rates and other asset prices.
After generations of brooding about their credibility, our leaders lie, cheat, and steal to bolster their credibility (Nixon’s posturing like a madman showed the absurdity of this when taken to a logical conclusion). But a miracle occurred: since the 2008 crash we have come to believe central bankers’ claims of having almost omnipotent economic power. We believe in the Green Lantern theory of finance: central bankers can do almost anything if they have sufficient willpower. Credibility — the power of their words — has become a deus ex machina.
Now markets move on the basis of even central bankers’ casual musings. Investors interpret fundamental data primarily in terms of its effect on thinking of central bankers. Our confidence in them provides the foundation for today’s equity prices and the astonishingly low (some record low) interest rates around the world.
Dreamtimes end because reality is always trump. The re-valuation of the Swiss Franc despite promises by the Swiss National Bank shows their impotence before powerful economic forces. What happens if we see more CB promises broken and a loss of confidence in their power? It will not be pretty.
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(a) Forex is the frontier of economics, where all the strands meet in ball of unimaginable complexity. Amidst the noise and guessing about the SNB’s motives, I recommend reading the following (esp Baker and the FT):
- “Regime Change in Switzerland“, Paul Krugman, NYT, 16 January 2015
- A rebuttal to Krugman by Dean Baker (co-director of the Center for Economic and Policy Research), 16 January 2015
- “If it walks like a duck and quacks like a duck…“, Scott Sumner (Prof Economics, Bentley U), 16 January 2015
- “Why did the Swiss break the peg of the franc?“, Tyler Cowen (Prof Economics, George Mason U), 16 January 2015
- “Why did SNB really drop its peg? A look at the charts“, Financial Times, 16 January 2015 — “Because otherwise it would have started to look more like an FX hedge fund than a central bank.”
(b) Looking into the future:
- Japan leads us into a new future, taking the next step in the great monetary experiment, 21 March 2014
- Listen to the slowing US economy, hear echoes of Japan, 24 September 2014
- 3 graphs tell the story about the US economy, hidden amidst the noise of the jobs report, 6 October 2014
- Look at the economy. Fight the illusion of normality. Feel the weirdness., 8 October 2014
- Here’s help to see the truth through the narratives in the news: looking at the jobs numbers, 9 December 2014
- What does the data tell us about the US economy in 2015?, 6 January 2015
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.
William Butler Yeats, The Second Coming (published in 1920)
John,
That’s a wonderful quote, but fortunately does not apply to us.
Finance provides a way for nations to relate and compete without bloodshed. Periods when trade rules our affairs are golden ages. The Pax Romana, the Pax Britannica, the Pax Americana.
I come from a different perspective. The markets are made up of millions of individual actors. When markets move radically, as we have seen in commodities and currencies, some of those individual actors are blown away, as happened yesterday in the currency market. Once that happens the center of the scene moves from trade to lawyers and things become very sticky. Enough breaks and there’s an avalanche with systemic effects. Not saying we’re there, but the risk that we will get there continues to increase. I don’t see any Ben Bernankes out there capable of saving the current global system if 2008 repeats. Another round will take much more radical surgery to eliminate the excesses in the debt markets and there is certainly no will among the lead actors to pursue the together that would be required.
John,
“Once that happens the center of the scene moves from trade to lawyers and things become very sticky. ”
Examples? We have had scores (probably hundreds) of large moves in western financial markets during the past 20 years. I can’t think of any where lawyers became “the center of the scene.”
In the narrow category of attempts to corner markets lawyers take stage AFTER the markets have cleared. For example, the 1976 Maine Potato futures bust by Simplot and Taggers, and the late 1976 Hunt silver bust.
The oil industry in the mid-1980s and much of the real estate industry in the late 80s after the S&L crisis. Since then central bankers have been relatively good at papering over crises. In the post-Lehman cycle bad deals got refinanced rather than liquidated in great part because the Fed gave the banks license to do so both directly through regulatory fiat and indirectly through holding down interest rates.
John,
“When markets move radically, as we have seen in commodities … the center of the scene moves from trade to lawyers and things become very sticky. ” … The oil industry in the mid-1980s and much of the real estate industry in the late 80s after the S&L crisis.”
In American almost every event generates litigation, but it seldom becomes a central feature. I don’t recall litigation being central to the outcomes of the early 1980s oil price decline. The S&L crisis did not result from a move in markets, but rather had several causes. It was primarily a regulatory failure (see Michael Lewis’ Liar’s Poker for the details entertainingly told).
From Liar’s Poker about the S&L executives who were clients of Solomon Brothers:
SNB giving up on pegg could be the sign of incoming Greek wealth hiding in Swiss banks again after the parliamentary election was anounced in Greece.
This is only a speculation, but i find it credible because wealthy will threaten voters with crash in Greece if they go for Syriza. Nothing new.
This is also the way for them to protect against Grexit even tough Syriza recently started to cathegorically deny any thinking about Grexit or even to use it as bargaining chip. Syriza only wants to declare bailout void and ask for debt restructure.
But Germans and rest of the wealthy and bankers do not Syriza’s win, so they talk about Grexit even tough that is not what Syriza wants. But Syriza plans to raise taxes on wealthy.
So, wealthy Greeks will buy francs in order to protect from possible Grexit and more importantly, to threaten the voters.
This capital inflight can crush SNBs promise, Swiss has small economy comparing to wealth of Greeks.
Jordan,
While that might be a factor, it’s probably a small one.
Swiss GDP is 680 euro, almost 4x Greece’s 182 euro. It’s financial system is far deeper. The Swiss money supply (M3) is roughly a trillion euros.
And, more importantly, Greece’s wealthy never kept all their wealth in Greece. And capital flight removed much of what was there during Greece in 2010 – 2012. It was a big story back then.
Some focused on the SNB buying euros to weaken the franc. Few saw that buying euros also supported that currency deflecting consequenses of ECB money printing. Back when the peg occurred I wonder if the Swiss got a tap on the shoulder by Brussels that time had come for the SNB to be a good neighbor and buy euros. The Mercantile trade promotion motivation is still valid after all. What has changed is the risk of holding euros. The Probability of a Grexit has gone up considerably in the past months. The Swiss are not renowned for being bag holders.
Peter,
Forex is the frontier of finance, where all the strands meet in unimaginable complexity. Amidst the noise and guessing about motives, I recommend reading the following (esp Baker and the FT):
I wonder if FM would dilate on why he thinks the European Union decided on a single currency for all member nations. A single unified currency can work in a unified economic alliance, like the United States, as long as there exists some central governing authority (in our case the federal government) to bail out the member governments when they get into dire fiscal straits, and to provide services in return for that government (federal highway funds to individual states, federal grants for state colleges and K-12 schools, and so on).
The European Union has no central governing authority that can act this way to disburse funds as the federal government can in America. This means that a unified European currency makes it impossible for each individual European economy to adjust in the case of trade imbalances. Clearly this makes the EU impractical from an economic standpoint.
I can see the manifold advantages of an economic cooperative like the European Union. I cannot see why a unified currency was considered necessary to implement such an economic union. In particular I cannot fathom why the planners in Brussels ever thought a European Union with a single unified currency was economically practical for survivable in the long term, given that a unified currency makes impossible any of the EU member states to devalue their currencies in response to changes in their individual economies.
Without currency devaluation, the only alternative becomes the long-discredited Hoover-style liquidationism of fiscal austerity. We saw how badly that worked from 1930-1933. Why would anyone expect it to work any better today?
Thomas,
The reasoning was discussed at great length, and has been tried many times before: a common currency was to integrate their economies as a step towards political union. The project was and remains highly popular, although specific steps have and are controversial.
Even today in America, 140 years after full integration, the Union remains highly popular yet key aspects of it remain controversial in some circles.
This process of currency union before political union was considered risky or daft by many economists. I discussed all this before the crash:
Can the European Monetary Union survive the next recession?
11 JULY 2008
http://fabiusmaximus.com/2008/07/11/euro/
Another interesting take on why the Swiss Bank dropped the currency peg. It was about to get overrun by a larger bank: http://www.forbes.com/sites/francescoppola/2015/01/17/oh-switzerland-what-have-you-done/
This seems plausible, though I don’t have enough expertise to be sure. I do know that we definitely live in interesting times.
Whistling,
I do not believe there is much debate why the SNB took this action. They were unhappy with the rapid growth of their balance sheet required to maintain the peg. The imminent QE by the ECB would almost certainly require an acceleration in that growth.
The debate about wisdom of the SNB’s decision has just began. That might take years to be resolved. It might never get resolved.
“The debate about wisdom of the SNB’s decision has just began. That might take years to be resolved. It might never get resolved.”
Indeed.