The SNB has to pick its poison. It is damned for one set of reasons if it holds the currency peg, and damned for another set if it ditches the peg. Welcome to the world of horrible dilemmas facing modern central banks.
Ambrose Evans-Pritchard, 15 Jan 2015
For every credibility gap, there is a gullibility gap
The decision by the Swiss National Bank (SNB) to release the Swiss Franc from the peg it had to the Euro, and indeed the consensus reaction to that decision, should disavow the notion that the current economic situation is not one that is based on the whims of central bankers. Since the Global Recession of 2008, the major central banks of the world have been trusted with the task of ‘fixing things.’ Owing to a shared economic philosophy of intervention in markets when things don’t go according to plan, the majority of mainstream economic commentators have a tremendous amount of faith in central banks, only quibbling with them on secondary issues.
In removing the peg, the SNB effectively tightened its monetary policy, thus doing an about face in a world in which the conventional view is that there is no such thing as monetary policy which is too easy. Thus, the SNB invited upon itself a torrent of criticism. Most of the criticism revolved around two ideas, the first being that the SNB decision is simply bad for growth prospects.
The second, and more interesting point of criticism, is the perceived loss of credibility the SNB has now sustained. Given the elevated stature the central banks have attained post-2008 as the ‘saviors’ of the world, their every policy announcement, press conference and media appearance has been treated by market participants and economic reporters as though it were the Word of God being delivered by Moses from Mount Sinai. When viewed in that context, it is easy to understand the disappointment in the SNB. An institution viewed by many as infallible abruptly reversed course, essentially admitting it wasn’t as foolproof as once thought. The ultimate significance of this, however, lies in the fact that the situation the SNB got itself in was a microcosm of the situation global central banks have gotten themselves into.
Less than two weeks after the SNB relieved itself of the peg, the European Central Bank (ECB) embarked upon a period which will be similarly trying. The much awaited entrance into the QE game went relatively smoothly, but it is the Greek elections that are sure to increase the tension across the continent. Should the victorious Syriza stick to its guns, the fabric of the status quo will surely be ruptured, further calling into question the fortitude of central bankers and other bureaucrats who have thus far been able to hold things together with mere assertions. Alarmingly, it is this brand of ‘credibility’ upon which global markets rest.
The Critics of the Swiss National Bank Have It Wrong
Before delving into the wider significance of the SNB decision, the more proximate perceived consequence – a descent into recession – deserves further treatment. This view, of course, is nothing more than the old canard that deflation is bad, and thus, the instant appreciation of the Swiss Franc (CHF) is bad because will result in deflation, which in turn will lead to disaster. Below is a chart of EUR/CHF in the aftermath of the SNB announcement:
Violent as that move is, the move downward (stronger CHF) was a move in keeping with the underlying trend. Observe the following, which is a chart of EUR/CHF over the last 10 years.
EUR/CHF made its last major top in October 2007, at a price of roughly 1.682. It then spent the better part of 4 years trending lower, flirting with parity, before the SNB acted in September of 2011 to peg EUR/CHF at 1.20. The critics claim that the ending of this peg, and the resumption of the downtrend (EUR/CHF traded as low as 0.85 after the announcement), will lead to recession for the Swiss economy. If the move from 1.20 to 0.85 will usher in pain and suffering, then surely we can look to the move from 1.68 to parity for some insight as to how much damage will occur, and what the Swiss can do to brace themselves. The following is a chart of Swiss inflation during the time in question:
As one can see, the inflation rate was less than 1.5% for all but 18 months of the nearly 9 year period depicted. This is particularly worrisome for modern economists who believe that inflation rates that are ‘too low,’ as defined as being below 2%, are the starting point for economic disaster. Given the Swiss economy spent the best part of 9 years in this condition, one would expect Switzerland to be an economic wasteland by now.
The following is a look at the unemployment from 2007, through to the present:
Now Exports from the same time period:
Hardly gloom and doom, and hardly what one would expect if one accepts mainstream economic theory with respect to strong currencies and falling prices. To put it plainly, price movements are the effects of changes in real economic developments. Modern economists mistakenly treat price movements as the cause of real economic developments. It is not the change of price that should be feared or welcomed in isolation; it is whatever caused that price change that needs to be assessed to determine the positivity or negativity thereof. With respect to the Swiss economy, it is on relatively sound footing, and Swiss companies in general produce high quality products that are widely sought. The result of that is continued demand for Swiss Francs, as well as downward pressure on prices thanks to high productivity.
Unfortunately, the recognition of the unambiguously positive condition of economic stability/progress has been trumped by the modern fear of falling prices. This has led central bankers, fervent adherents of these faulty views, to prioritize the state of price trends above all else. The fact that the SNB felt it had to initiate the peg, in the face of positive real economic developments was Munchausen-like. Yet it was viewed as sound policy across the sphere of economic commenters.
If taking putting the peg on – to keep the Deflation Boogeyman at bay – was sound policy, then taking it off must be suicide. So it was reported, in the aftermath of the SNB decision. Apart from the predictable calls for Swiss recession, the belief that the SNB had completely lost its credibility was the most revealing one to me.
What the SNB essentially did was admit that it could no longer fight the trend of CHF appreciation. In order to prevent CHF from rising, it had to purchase large quantities of Euros, thereby saddling its balance sheet with assets that were more likely than not to continue depreciating.
Furthermore, the sheer size of these purchases, in comparison to the size of the Swiss economy meant that the SNB was taking great risks in creating dislocations elsewhere. The drastic reduction of interest rates triggered by the SNB actions enticed borrowing in CHF, mostly for mortgages. Both domestically, and in neighboring parts of Central and Eastern Europe, household borrowing increased, leading to a Swiss property market which is frothy, if not an outright bubble.
In ending the peg, the SNB prevented further losses to its balance sheet, and prevented the continuation of a negative process in which cheap loans foster unsustainable asset increases, which in turn begets more credit creation to sustain further asset price increases, and so forth, before an inevitable bust. That this behavior constitutes irresponsibility, and signifies a loss of creditability should give one insight into the Orwellian nature of modern economics.
Some point to the fact that the SNB made the move in a surprising fashion. To use modern econospeak, the SNB did not ‘telegraph’ their intentions beforehand, even stating that the peg was the centerpiece of its policy only days before the January 15th announcement. For market participants to take umbrage with this sort of bait and switch further underlines the importance of central bankers over the state of affairs. In other words, market participants have now elevated the central banker to deity, and without his or her guiding hand at every step of the way, the market is lost. The kicker is that most of those people will turn around and claim we have free markets.
The bottom line is that the SNB peg made no discernable economic impact that could be credited to the policy itself, rather than the intrinsic nature of the Swiss economy. Yet it was creating problems in the shape of a possible credit boom and future risks of increased prices. Modern economic dogma completely disregards any risks of central bank policy as long as it is done in the name of deflation prevention. According to most economic commentators, the ‘dilemma’ Ambrose Evans-Pritchard alludes to in the opening quote does not really exist. As long as deflation is avoided, the belief is, nothing else matters. Any problems that do occur are rationalized away, misattributed to some other reason, or simply ignored.
The myopia of deflation-phobia is so acute that Larry Fink, CEO of BlackRock, thinks that the Swiss not going into recession as a result of CHF appreciation is a risk. His rationale is that the Swiss negotiating the CHF appreciation smoothly will send the message to Germany that ‘de-pegging’ from the Euro in the shape of returning to the Deutschmark will be sound policy. The truth is that it probably is the right course of action, but the message is clear from Fink: the Status Quo must be defended.
When it comes down to it, this is the heart of the matter. The SNB and the Swiss economy in general have simultaneously shattered two, if not three tenants of status quo economic belief. The first is regarding the perniciousness of strong currencies, which I have discussed before.
The second is the more general view that central authorities can reliably and indefinitely counteract trends in real economic conditions through printing money, and can stop at any time without negative effects. Recall the EURCHF chart from the time of the SNB announcement, reproduced here:
Also, recall that the 3.5 year peg did not prevent the underlying trend from resuming. Real economic conditions always win out, regardless of the actions of central bankers. The only thing the SNB succeed in doing was change the date when the EURCHF traded down to 0.85. Instead of happening in 2012 or 2013, or some other time, it happened in 2015. But it was always going to happen. What the SNB did accomplish was enabling that move to happen in the space 30 minutes instead of 30 months. In other words, as a result of the peg, the move was far more violent and disruptive, as virtually nobody had time to adjust to the movement, a feeling that many in the financial world as well as Eastern European debtors can attest to. A much more protracted and orderly decline would have been much better.
What is truly alarming is that every major central bank across the developed world has done the same thing as the SNB did, writ large. They have not necessarily employed the same tactics as the SNB in that a currency peg was not the tool of choice. However, the major central banks of the world have all done the same thing in that they have all engaged in expansionary policy to fight real economic conditions. More specifically, they have engaged to fight the effect of weakening economies – deflation – rather than to cure the causes.
In essence, the 3.5 year period of peg-induced stasis on the EURCHF chart is analogous to the stimulus-induced stasis in low growth rates experienced by much of the developed economies. As Evans-Pritchard suggests, the dilemma for central bankers will come when they stimulate to the point where prices are too great and debt loads to excessive for the average consumer to bear. From there, the choice is either to further stimulate, risking total destruction of the currency, or the cessation of stimulus, which will see a sharp drop in growth rivaling that of the EURCHF chart after de-pegging. One thing is for certain, and it is that real economic conditions will assert themselves once again. They always do. To the extent that policymakers keep fighting the effects of these conditions rather than their causes will be the extent that they further expose the futility of their efforts, This in turn exposes the futility of the ideology it is based on, thus terminally losing the credibility they seem to hold so dear.