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?
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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
