Monday, January 19, 2015

Monetary Inanity (Part Infinity)

For those who have been living under a rock the last week or so, the Swiss franc went off like a rocket when the SNB (the Swiss National Bank, Switzerland's central bank) decided to end a currency peg against the euro.

And as usual, when something like this happens, there's lots of rather poorly informed commentary making the rounds out there.  Judging from their writing, I think that financial writers must not make very much money, so it is probably understandable that most of them don't have much of a grasp of monetary matters or any real incentive to learn, especially as concerns exchange rates and central banking.  But at least some of these guys should know better, especially the ones talking about deflation.

So, once again, I'll do what I can to try and correct the internet...

First of all, the story really shouldn't be about the franc, it should be about the euro.  As far as I can tell, there isn't much wrong with the Swiss economy, and (aside from this sort of incident) their monetary system is probably the best run in...well...more or less everywhere.  Switzerland has achieved arguably the nearest approach of any modern country to monetary and economic Nirvana, which is to say, extreme boringness.  Sorry, I meant stability.  Which goes a long way towards understanding why this all happened -- especially in light of the fact that poor Switzerland is surrounded by Euro-country, which has not been managed nearly so well.

In a nutshell, with the Euro on the ropes and the European economy in the doldrums, wealthy Europeans have suddenly decided that what they really, really want is some Swiss francs in a nice, safe Swiss bank account.  This has, of course, driven demand for the franc to the stratosphere, Switzerland being a rather small country with only so many francs to go around, and Europe being rather full of fearful aristocrats with wealth to protect at this unhappy juncture.

Which is to say, it is all being driven by events that have almost nothing at all to do with the Swiss economy per se, by bad policy the Swiss had absolutely nothing to do with, yet is no doubt rather disruptive to the Swiss.  You might call it something of a 'monetary externality.'  Yet it is the job of the SNB to deal with monetary matters, and when this came up on their radar, they apparently decided that it was important to try to shield the Swiss economy from the disruption.  Understandable, but as it turned out, a rather bad idea.

A peg works by (or, rather, a peg is enforced by) the central bank undertaking activities to bring supply and demand for the two currencies in line so that the exchange rate is stabilized at a certain ratio.  If demand for one currency or the other gets too far out of line, the bank intervenes as necessary to bring them back within the bounds it has set.

In practice, this almost always means that the bank prints reams and reams of its own currency (figuratively, of course -- banking these days is done with digits) and uses it to buy assets which are sold in the other currency.  This creates demand for the foreign currency in the course of the transaction, and satiates demand for their own currency without increasing 'price' (the exchange rate) by increasing its supply.  Theoretically, it could go the other way around, (selling foreign assets to soak up your own currency, while reducing demand for the foreign one) except that the bank enforcing the peg is usually trying to bring down the value of its own currency, not up.  They don't usually do this kind of thing to prop up their exchange rate, (except maybe in really screwed up situations.  But that is not Switzerland.) 

In the process, the central bank's balance sheet 'expands' (which means it buys up more and more assets, and issues out more and more money, which it counts as a liability) and the economy is stuffed with more and more of this created money.  Usually, the Swiss are quite circumspect about this kind of thing (unlike most places), but I suppose they thought it was worth it in light of the magnitude of the disruption they were experiencing, which they probably thought would be temporary.

I think this is one of those things that, looking back, 'seemed like a good idea at the time.'  (Famous last words, right?)  The problem with a currency peg is that it forces the country creating the peg to more or less adopt the monetary policy of the country they are pegging their currency to -- for better or worse, i.e., with all that that entails.  So, if Europe inflates, Switzerland has to as well -- whether Switzerland would like to or not -- if it wants to keep the peg.  In effect, the announcement of the peg was the SNB unilaterally joining the euro.  So -- the response of Switzerland to Europe's monetary woes...was for Switzerland to adopt their monetary policies?

What could possibly go wrong?  (More famous last words...)

What probably triggered the SNB's 'immune response' was the sheer volume of transactions it was undertaking to maintain the peg.  Whenever a central bank does something like this, it is going toe-to-toe with an entire world of currency speculators and the like, having to match them transaction for transaction to keep the price where it wants.  This is a tall order, especially for a small country, and it wouldn't be the first time that a central bank failed (for a fascinating story of how George Soros ended a BOE currency peg and made a billion dollars in one day, see here). 

By pegging the franc, the SNB created for Switzerland the same, central problem that is internal to the euro itself -- bad policies, brought about externally, that nobody can get out of when they need to.  Except that the SNB saw the light, and could, and did.  And the market jacked up the exchange rate in response.  Not really that big of a deal.

Yet you see people talking about deflation.  The 'trigger' here that has set people off seems to be negative interest rates and falling prices in response to the movement (and the massive demand for Swiss bank deposits, no doubt).  Sorry folks, yes, those are symptoms, but Switzerland is really, really not what deflation looks like.

If you want to see what deflation looks like, watch the run on George Bailey's bank in It's a Wonderful Life.  Deflation looks like Wall Street in 1929, bankers jumping out of windows, mass asset seizure and liquidation by creditors, etc.  In contrast, depositors are lining up to stuff money into Swiss banks, Swiss financial stock prices were up on the news, the Swiss economy is the rock of Europe, and those poor, poor Davos billionaires are coughing up more money to conspire in comfort in Swiss resorts.  They're grumbling I'm sure, but they're coughing.

Really folks, nothing to see here.  Move along.  The situations being created by falling oil prices -- instability in Russia, Venezuela, and the like -- seem much more interesting to me.  Yet here again, these places engage in the same kinds of efforts, artificially pushing exchange rates around.  Especially in these places, this looks really destructive to me.  Probably the best thing for Russia and Venezuela would be a weaker currency, as it would make their manufacturing sectors more competitive, which might actually develop and eventually lead them to not be highly commodity-price sensitive, fragile, one-dimensional economies.  Concerns about short term stability are preventing conditions that would eventually lead to longer-term stability through economic diversification.

Likewise, the Swiss are fairly well poised to take advantage of a higher exchange rate, given their well-developed financial sector.  Maybe these guys should just listen to the market and let things unfold.  Surely there are better ways to handle these things than mass, indiscriminate, across-the-board interventionism.

But what do I know?  Maybe that's why I don't run a country.

1 comment:

  1. I agree about the Swiss. They made the right move.

    However, I want to comment on the idea of weakening one's own currency in the hope of increasing exports.

    Let's suppose that I own an American company that makes widgets. I need to take in enough dollars for each widget to cover the cost of the wages, supplies, utilities, interest, and taxes I paid in the process of making that widget, and hope to have some left over as profit.

    Now suppose I want to sell widgets in Europe. I'd have to price them in Euros, and after each sale, convert the Euros to dollars. I want the Euro price to provide enough dollars to cover all those costs I mentioned above, and leave a profit.

    Now suppose that some other manufacture (Chinese?) also sells an equivalent product in Europe. The going price for their widgets, converted to dollars, won't cover my costs. If I sell at the going price, I'll take a loss.

    So, let's suppose that I prevail on the Fed to cheapen the dollar (even more than it already is). Now a Euro buys more dollars than it did before. Selling at the same Euro price as my competitor brings in enough dollars to cover my costs and leave a profit.

    Eureka! The magic of devaluation has brought me a profit. What happened to the loss? It hasn't gone away. It's just been spread around. Every dollar in circulation now has less purchasing power than it did before. My loss has been socialized.

    What's worse, no matter how beneficial to me the devaluation is, it doesn't last. If I have to import some raw materials for my widgets, I now have to pay more dollars for them. My workers will soon be demanding a "cost of living increase." Once the dust settles and equilibrium is reached, I'll be right back where I started, unable to sell in Europe at the price my competitor asks.

    In a global economy, cheapening the currency is only a temporary fix. Eventually nominal costs rise to the point that they're back to the real costs I couldn't avoid in the first place.

    ReplyDelete

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