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Saturday, 17 January 2015

What does the end of the Swiss Peg tell us about central banks?

A lot of the discussion in blogs about the end of the Swiss exchange rate peg has focused on whether the original peg, which started in September 2011, was a good idea in the first place. [1] This post asks a rather different question, which has wider relevance.

First some facts, which you can skip if you have already read some of those posts. The safe haven status of the Swiss Franc meant that during the Eurozone crisis people wanted to buy the Swiss currency, and the resulting appreciation was in danger of driving some Swiss producers out of business. [2] The chart below plots competitiveness, measured as relative consumer prices, in Switzerland and in the UK. [4]

      
The appreciation problem in 2011 was real and the exchange rate cap fixed that, but to prevent the exchange rate appreciating beyond the 1.2 Swiss Francs (CHF) per Euro mark the central bank had to create lots of money to buy Euros. You can think of it as Quantitative Easing (QE) that buys foreign currency rather than domestic government debt. [3]

The interesting question is why the central bank ended the cap. Perhaps the cap was always meant to be a transitional measure, to allow firms time to adjust to a loss in competitiveness. (Here is the official explanation.) This is not that convincing. If the central bank was worried that its producers were becoming too competitive, it could have changed the cap from, say, 1.2 CHF per Euro to 1.1 CHF per Euro. Removing the cap completely would only make sense if you thought your safe haven status had reached some kind of equilibrium, and with the Greek elections and other things currently happening that seems unlikely. Even if you did think this, caution might suggest testing the market with a more appropriate cap and seeing how much defending you had to do.

As a result of ending the peg, the Swiss Franc has appreciated substantially, from 1.2 CHF per Euro to around 1 CHF per Euro, even though the central bank has lowered the interest rate on sight deposit account balances that exceed a threshold to −0.75%. There seem to be two alternative interpretations.

The first is that the central bank simply made a serious mistake. For some, the mistake was to impose the cap in the first place. If you do not take that view, and assuming the market’s immediate move is not a very temporary overreaction, the large appreciation partly undoes the benefits of the original peg. Either way, a major mistake has been made at some point. This can be added to what is now a seriously long list of recent major central bank mistakes: see in particular Sweden and the Eurozone. Does the fact that central banks in the UK and US seem rather less error prone have something to do with the greater influence of economists (inside and outside) on those banks? [5]

The second interpretation is that the open ended money creation that the policy implied just became too much for the central bank. In theory the central bank could go on creating money and buying Euros forever. As long as the exchange rate peg was reasonable this policy could be consistent with its inflation target (the target is ‘below 2%’, while actual inflation is currently negative). If it ever decided it was not and there was too much Swiss money around, the policy could be reversed by selling Euros. The central bank might make a loss when this was done, but economists generally dismiss this as a non-problem (a central bank is not like a commercial bank), just as they dismiss the same problem with conventional QE. But perhaps central banks do not see things this way (HT MT), because they worry about the political consequences of such losses. If this is the case, then this is something that economists need to respond to in one way or another.  


[1] The discussion in the media, as often with mediamacro, is obsessed with the markets. The Guardian had a link entitled “Swiss franc - what the economists say”. What you got were 6 City economists, who wrote the kind of thing City economists write. Now I’m sure the Guardian will say they needed something fast, and academics - even academic bloggers - are unreliable in that respect. But please label this properly: you are getting the reactions of City economists, whose primary concern is what this all means for the markets, and not what it means for ordinary people.

[2] Economists have a theory, Uncovered Interest Parity (UIP), which says that short term capital flows like this should not influence exchange rates, because the market will keep rates close to fundamentals. It does not work too well, partly I suspect because the market has little idea what the fundamentals are, and partly because no one in the market is prepared to take bets that last years rather than days.

[3] Switzerland has a really large current account surplus, which since 1997 has averaged 10% of GDP. The reason for this surplus is complex, but it suggests that there is scope for a gradual real exchange rate appreciation over time.

[4] Source: OECD Economic Outlook. The level is arbitrary, at 2010=100. A rise is an appreciation, which means a loss of competitiveness. The average level of this measure of Swiss competitiveness was around 96.5 from 1998 to 2004.

[5] However the suggestion by Tony Yates that every blogger should be given a job at the SNB seems to be going too far.


40 comments:

  1. There is a third explanation, which is that choosing the Euro as a peg made sense at the time but not now. The ECB is about to embark on a QE programme which will weaken the Euro. Indeed, a weaker Euro is one of the main channels through which the ECB intends to achieve its goals. So keeping the peg would have weakened the Swiss effective rate, probably leading to an even bigger need for intervention.
    Central Banks set the preservation of their independence as a very high target. So it is true that they are very averse to anything which weakens them politically, as big losses would do. The fact that the SNB announced big profits just over a week ago means the current losses are less unpalatable.But the more important point to learn and remember is that Central Banks do not feel the to keep their promises. At any moment in time, they see their obligation as doing what is right at the time. If that means making promises about future behaviour they make promises about future behaviour. And if that means breaking promises they made in the past, they can do that too. One definition of a central banker is "an hinest man sent into the market to lie for his country."

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    1. But if the problem was a weak Euro, why not just change the peg. Abandoning the peg would only make sense if you thought the safe haven problem was over, which right now seems unlikely.

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    2. es, I think so, too, Gobanian. The Swiss economic policy establishment is similar to the german one, i.e. ordoliberal. I suspect that the Swiss did expect the German resistance against QE to succeed, and they might have thought that the Eurozone depression would weaken sooner, so that the peg would have been a temporary and relatively shallow measure. But now, the necessary central bank activism to hold the peg is to become too great.

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    3. i am an american, and i would guess that europeans have a better sense for it, but i will be surprised if the ECB does even the rather modest version of QE that was done in the US. And given the lolly-gagging of the ECB, that level of stimulus would not be enough.

      That said, low gasoline prices should stimulate almost all European economies save for Norway and to a lesser extent, GB.

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  2. "The central bank might make a loss when this was done, but economists generally dismiss this as a non-problem (a central bank is not like a commercial bank), just as they dismiss the same problem with conventional QE."

    And this is exactly where those economists lose all credibility. "If the central bank A does this, it is basically inconsequential." Yeah, right.

    If the assets on a central bank's sheet are irrelevant and can sit there forever, then the central bank is handing out fresh central bank money for nothing. Not only that but because doing so is inconsequential, a central bank could buy the entire planet with freshly-printed money and, following that logic, it would have no effect whatsoever.

    Pure genious! Why u no QE Forever?! I could hand over some IOUs to the BOE and they could give me, say, 1 million.... nah.... 1 TRILLION pounds in return? Surely, how much they gave me in return for my empty promises would make no difference for the overall economy?

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    1. That market participants are happy to take CHFs (including in returns for euros) demonstrates that the SNB's balance sheet is not a problem.

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    2. "That the markets are happy to buy Lehman certificates demonstrates that mortgage-backed securities are not a problem."

      Sometimes the logic in here is just brilliant.

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    3. euros are money; sovereign promises are worth more than a promise from a company. you may worry about inflation but now.

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  3. The Swiss F / Euro peg has served its purpose for the Swiss exports to the EZ. Exports are being directed to the middle and far east now. Hence, currently the Swiss F / US Dollar rate is more important. Far east currencies also as China etc, go for the high end Swiss export goods as they get more affluent.

    IMF policies were to blame for the GFC 2008. It continues to be the global dementor with its stupid fiscal austerity mantra. The whole outfit should be shut down. It encouraged the elimination of Capital Controls and now we have Countries with overseas asset and liabilities up to five times there GDP. The ability of any sovereign currency nation to control its own economy has been badly diminished by neo-liberal "casino banking" politicians.

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    1. Although I agree with your general point about the "Washington Consensus" policies, the IMF has changed its mind about capital controls. Although it is still doing harm with Greece.

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    2. @Peter - I am not an economist, so maybe I don't have a good enough grasp of what the IMF is doing now, but it seems to me that there are two parts to the IMF. There is a research part, which writes speeches for Christine Lagarde and publishes policy papers, then there is the operating part which is neoliberal (or ordoliberal) and in practice imposes austerity. Most economics bloggers I read seem not to notice this disparity, so maybe I'm completely wrong, but ...

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    3. If I can interject, I think it is more complicated than this. I wrote something here

      http://mainlymacro.blogspot.co.uk/2012/10/heterogeneity-at-imf.html

      but I think there is much more to say.

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  4. I've also read that the swiss government and people have learnt to expect large profit payouts from the central bank. This means that taking a 'loss' is politically damaging for the SNB. The swiss seem to view their central bank as a business that needs to be profitable so they can pay fewer taxes. Is it a way to partly (pretend to?) socialise the profits from the swiss banking sector.

    If that is true, this 'swiss disease' is somewhat like the old 'dutch disease'. Including the feature of pushing up the currency over time.

    Viewing the national bank as a normal bank that needs to make profits, the Euro peg was a good way to grow foreign reserves in Euro. That profit went straight into the reservers. But now that the reserves are nicely stocked up would be time to go back on the other tack. A diversified portfolio?

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    1. Profit payouts from the central bank also make the news in Germany as well. It's a philosophical difference. Central banks in Germany and Switzerland (and other more ordoliberal countries like Finland) are not PRIMARILY macroeconomic stabilizers, but curators of the national currency. This is where much of the intra-ECB conflict comes from.

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  5. Surely the Swiss are in for a shock then, if one follows your argument to its logical conclusion? The SNB has blown 100 billion francs on its peg on a mark to market basis, and I very much doubt they are as relaxed about it as Prof W-L suggests they should be.

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  6. I find it interesting that Dean Baker disagreed with Krugman when they usually agree on most things.

    http://www.cepr.net/index.php/blogs/beat-the-press/paul-krugman-and-the-swiss-movement

    "While the general point is right, it is hard to see how this story applies to Switzerland. Switzerland did not see the same sort of downturn as the rest of the OECD in 2008. Furthermore, it has fully recovered from its downturn with a GDP that is 8 percent above its pre-recession level and an unemployment rate of 3.5 percent.

    In this context, it is actually doing what we should want Switzerland to do as a good world citizen. By allowing its currency to rise, it will make its goods and services less competitive internationally...."

    But does he assess the state of the Swiss economy correctly? W-L writes "As long as the exchange rate peg was reasonable this policy could be consistent with its inflation target (the target is ‘below 2%’, while actual inflation is currently negative). "

    If the World Trade Organization was in charge of currency disputes how would it rule in the case of the Swiss Franc versus the Euro?

    Is Dean Baker right that the Swiss are "stealing" demand from the Euro area by making their exporters more competitive? By allowing their currency to rise, the SNB will make Euro exporters more competitive.

    But it doesn't seem like they have their output gap closed if they have negative inflation with a 2 percent ceiling target. Baker says they have fully recovered from their downturn.

    My guess is that it would be more helpful to have competitive devaluations with the ECB devaluing in turn. The Swiss only need to slow the economy down if inflation is getting out of hand. Concerns about the central bank balance sheet are second order.

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    1. I also disagree with Krugman, yet, the deflation puzzle remains. Could it be that Switzerland has imported Eurozone deflation since it is surrounded by it, i.e. businesses in competition with Eurozone countries have to join the race to the bottom? In Germany, many cities at the swiss border are already looking forward to the swiss customers who are now going to buy the cheaper euro goods.

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    2. Does this event contradict the notion of monetary inefficacy at the ZLB? The voluntary nature of this massive real exchange rate appreciation seems to imply that depreciation was an effective option despite hitting the ZLB late last year.

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    3. At least, Switzerland is trying to ignore the ZLB. The target rate is at -0,75% at the moment (plus/minus 0,50%).
      http://www.snb.ch/en/iabout/stat/statpub/zidea/id/current_interest_exchange_rates

      Maybe Swiss banks still enjoy a reputation that prevents people from withdrawing their money.

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  7. I think Swiss central bank stopped the peg, because, if Swiss central bank went on selling CHF and buying Euro, there might be too much CHF in the market, which Swiss central bank could not control. It's a serious problem for the central bank.

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  8. I have many Swiss friends and go to Switzerland a lot. I envy their Franc. Switzerland is a small country and Swiss people go abroad for various reasons a lot. People who have to convert pounds no how hard Switzerland can be, but how easy it is for them in London and elsewhere. Although their secret banking practices are proper grounds for very harsh criticism, overall this is a well managed economy which can export to secure the imports it needs in spite of a strong currency. We should be careful about lecturing it.

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  9. If the ECB did decide to print money in a serious way to avoid deflation or financial crisis, which is a distinct (and welcome) possibility, the peg might become a problem. This event would also likely cause a large increase in value of the CHF.

    So this would be a reason for the peg to go. Maybe the execution was wrong. But the fast timing of the Swiss Bank may have been due to the advancing Greek election, and the possibility that this would be the spark a "crisis" that lead to rapid ECB action.

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  10. Not the Greek election so much as the legal ruling the day before the rise that the ECB could legally begin QE, as well as other factors eg the upcoming ECB meeting...

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  11. The exchange rate ceiling basically said, "we're going to be at least as inflationary as the ECB". It doesn't tell you anything about absolute inflation, only inflation relative to the euro zone. That's kind of a strange commitment to make.

    Contrary to what the SNB said, a ceiling is not a logical response to an overvalued currency. Because you're throwing money away. Why not buy as many euros as possible at the overvalued rate?

    Perhaps the SNB hoped that markets would interpret its action as simply the reversal of a policy that never made any sense, rather than as a tightening of monetary policy.

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    1. "Contrary to what the SNB said, a ceiling is not a logical response to an overvalued currency. Because you're throwing money away. Why not buy as many euros as possible at the overvalued rate?"

      Uh, that's what they were doing. They were just doing it on a continuous basis.

      max
      ['Making money for the central bank was the least of their problems.']

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    2. Strictly speaking it wasn't a ceiling, but a floor. Different from the Lamont ERM issue when he tried to protect an overvalued Pound, the SNB wanted to prevent an overvalued Franc.

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  12. "The central bank might make a loss when this was done, but economists generally dismiss this as a non-problem".

    This is not my impression. Any economist who values central bank independence, and that used to be nearly all macroeconomists, will regard this as a problem.

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  13. "The second interpretation is that the open ended money creation that the policy implied just became too much for the central bank. In theory the central bank could go on creating money and buying Euros forever. As long as the exchange rate peg was reasonable this policy could be consistent with its inflation target (the target is ‘below 2%’, while actual inflation is currently negative)."

    That's my vote. I expect they were thinking in terms of the fact that that if the EU did 500 billion or 1 trillion of QE it would entail pumping out very large numbers of CHF and then...perhaps the EU would just buy the country outright? Significant inflation? If the Greeks then decided to leave and the euro went in the toilet, they'd be sitting on a boatload of seemingly now-worthless euros.

    They want to keep inflation low, so they're just going to accept the punishment to their (very large) export sector until the situation clears up.

    max
    ['At which point they might re-institute the policy.']

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  14. And if they internally predict that Germany will be pushed to leave the Euro eventually, they need to get out ahead in time.

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  15. "Does the fact that central banks in the UK and US seem rather less error prone have something to do with the greater influence of economists (inside and outside) on those banks?"

    You're at it again. Do you think the fact that this is perhaps the world's best run economy might have something to do with the fact that such people may have had less influence over its monetary and macro-economic decisions?

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    1. I agree. I used to work for the BoE in its market operations area, in which capacity I once attended a monetary policy course at the SNB's study centre in Gerzensee. I was impressed by the straightforwardness and objectivity of the SNB's economists compared with those at the BoE. Our economists seemed to spend much time on sophistry, both to create an impression of academic "rigour", and to provide the monetary policymakers with intellectual arguments to do what they wanted to do anyway.

      I am sorry - for the SNB - to say that that experience made me an admirer of the SNB and therefore a buyer of CHF! If some parts of the Swiss economy suffer from the abandonment of the peg, the Swiss should console themselves that the view of Switzerland that prompts people like me to hold CHF is the same as that which motivates people to pay up for Swiss chocolate, watches and machine tools.

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  16. Switzerland seems anomalous. It is essentially an island right in the middle of the Euro area. It literally has Euro to Euro trade passing right through it. It could be an interesting case study if a part of a country heavily integrated economically within that country decided to go alone with its own currency.

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  17. They simply made a mistake. It is clear that they thought that the negative interest rates would be sufficient to keep the Franc near then-current levels, but they did not realize how much work the peg was doing to maintain current exchange rate. With a credible peg they were not seeing strong the inflows that they saw when they dropped the peg. (Much of the Banks huse portfolio was accumulated long ago before they instituted the peg.)

    You are correct that the SNB is very concerned about their profitability because they distribute that money to the cantons. With the peg, they were making money on dollar appreciation of that portion of their portfolio. With the appreciation of the Franc against both the dollar and the Euro they will book large losses and they will no longer be able to distribute profits to their cantons, probably for several years. Another policy error was that with a peg they should have had their assets in the pegged currency to reduce profit fluctuations. Too much of their assets were in dollars.

    The appreciation of the Franc will lead to more deflation, loss of competitiveness, and losses on the SNB books. I do not see any upside to this policy. The old policy would have imported looser ECB monetary policy which would have been good, given their negative rate of inflation. The huge 80% of GDP stock of asset they had not risky if it was in Euros because they could have unwound it easily if the Euro would have strengthened by selling Euros and buying Francs.

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    1. A comment from Krugman's first post on the swiss franc:

      The SNB promised to defend the peg to infinity. Academics wouldn't think this to be a crazy statement; they have formulas and graphs which permit unbounded amounts. But in the real world there are limits, and the SNB's promise was clearly insane. You can't accumulate an unlimited amount of foreign-currency assets, which was what the SNB was doing, because at some point the risk becomes too great.

      Here is a fail-proof way to win money at a casino (playing an even-chance game): put down 1; if you lose, play again with double the money; and if you win walk away. If you can play to infinity, you will always end up earning 1. But you can't, and so the strategy is one where you win small most of the time but lose big infrequently.

      PK's advise has never given limits. In 2008 when I was in more of an open mind than I am now, I might well have embraced his economics, but he would never give a limit. If he had just said, the government debt can go to 200% of GDP and then we'd need to stop, I would have said sure, Go to 200% and let's see what happens. But because he never did give a limit, I could only conclude he was like the foresaid gambler in the casino, whose strategy would win a small amount most of the time, but lose big every once in a while. And that, my friend, is a strategy which leads to disaster.

      So don't blame the SNB for giving up. Blame academics who think infinity is actually possible in the real world.

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  18. I agree that the problem is political, not economic, but I would be more radical: an unlimited purchase of euro would have shown that the play of the central banks, of the ECB first, is totally absurd from the point of view of the common people and their enormous power.

    By doing so the Swiss central bank has defended its independence and the credibility of the international monetary system?

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  19. This is part of OECD countries QE program, which starts from US, UK, Japan, Swiss technically used different way with pegging to Euro, now it's EU's turn to print money. It's a money printing game, everyone will have to follow, otherwise you will be the loser. When Swiss had enough, it simply ended and passed the ball to EU. At the end of the game, the debtors are the winner with gain, the creditors are the loser with loss. History will tell!

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  20. What if CHF actually increased it's value because of the increased debt (loans) in CHF?

    See: http://meaningofstuff.blogspot.ro/2015/01/debt-gives-value-to-money.html

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