The Swiss central bank’s abrupt abandonment of its 3-year-old policy of fixing the value of the Swiss franc relative to the euro has gotten a lot of attention. It also has created a lot of confusion. That is understandable, since the terminology that the international media use to describe exchange rate issues is imprecise and inconsistent.
But the economics involved is interesting, and aspects can be seen in our nation’s trade and currency policies. So it is useful to go over it one more time, simply.
Start with the problems Swiss National Bank faced and what it was trying to accomplish.
Switzerland is a well-governed nation with a reputation for prudent fiscal management, a respected currency and a competent central bank. It has often been an island of financial stability in unsettled economic times.
That stability includes the Swiss franc, which has an enviable record in terms of unchanging domestic buying power. The franc is managed by the Swiss National Bank. Like the U.S. Federal Reserve, this is nominally a private institution. But rather than being “owned” by its member commercial banks, as is the Fed, SNB stock belongs mostly to individuals and to the governments of Switzerland’s regions, or cantons. This is an important detail overlooked by many commentators and apparently by many currency speculators.
One must also know that, as a nation of only 8 million people entirely surrounded by the 500 million people in the European Union, trade is highly important to Switzerland. In 2013, Swiss exports equaled 72 percent of the country’s GDP and imports about 60 percent. The corresponding figures for our nation are 12 percent and 17 percent.
Whenever trade is important to a nation, the value of that nation’s currency relative to the currencies of its major trading partners is a crucial variable. From 1999, when the euro was introduced, through 2007, when the most recent global financial debacle began to unfold, it usually took about 1.55 Swiss francs to buy one euro. (The highest was SF 1.67 per euro and the lowest SF 1.46.) This exchange rate also was consistent with the franc’s earlier value relative to a weighted average of the individual national European currencies that preceded the euro. In other words, Swiss exporters and importers had operated in a situation of exchange-rate stability over a long period.
That ended in 2008 as the financial crisis engulfed the EU along with the rest of the world. In times of turmoil, owners of money invariably seek safety. The Swiss franc and Swiss banks had a reputation for safety and stability. People and financial firms around the world increasingly sought to exchange euros, rubles and other currencies for francs.
Note that this embodied an enormous “fallacy of composition” in economic terms. Switzerland and its currency can serve as a safe refuge for a hundred or a thousand or perhaps even a million anxious investors. But it cannot serve as a refuge for hundreds of millions of people and firms seeking safety. It is simply too small.
As more and more sought to trade euros for francs, the value of the franc rose — it took more and more euros to buy one franc. Put the other way, fewer and fewer francs were required to buy one euro.
In the tragically misleading terminology of international finance, the Swiss franc became “stronger” relative to the euro and most other currencies. To the ignorant, having a “strong currency” is always good and a “weak” one always bad. But an exchange rate is just a price, little different than the price of beef. Is a high or rising price for beef good or bad? That depends on whether you are raising cattle or buying groceries.
A “strong” currency makes imports cheaper. This is a boon for consumers and local retailers and keeps inflation down. But it makes exports more expensive and thus punishes any company that sells abroad or faces any competition from imports. A strong currency thus is negative for output and employment. That is true for an autonomous nation such as the United States, which is less heavily dependent on trade, and it is much more true for Switzerland, where trade is five times as high as a fraction of output.
So it is understandable that as the franc steadily gained value from 2008 into 2011, Swiss policy-makers were increasingly alarmed. A franc that bought 20 percent more euros than only a couple of years earlier meant that Swiss exports had increased in price by the same proportion. Recession and high unemployment was a threat.
With floating exchange rates, nations of comparable size, and trade as the principal component of international financial flows, a market would adjust. Falling exports and rising imports would have ended the increase in the franc’s value.
But such market reactions were meaningless compared to the torrent of money flowing into Switzerland as “investment.” So a severe recession loomed.
The SNB stepped in and announced that it was pegging the franc at the rate of SF 1.2 for one euro. But announcing a policy is not sufficient. To make it work, the SNB had to create as many new francs as required to offer 1.2 of them to anyone who presented one euro. They had to drastically increase Switzerland’s money supply. And they did.
Their action was described as putting a cap on the value of the franc. A franc would never be worth more than 0.83 euros. But it was also putting a floor under the value of the euro, that one would never sell for fewer than 1.2 francs. It was a policy of keeping the Swiss currency “weaker” than it would be if the Swiss central bank did not intervene.
The SNB did note that the peg was a temporary measure that would be removed at some time. It was never presented as a permanent, or even long-term, “fixing” of the exchange rate. But the assumption on all sides — central banks, investors and speculators — was that the peg would be discarded when the upward pressure on the value of the franc ebbed away, not when it intensified.
For three years, this temporary peg was “successful,” in that it prevented any further gain in the value of the franc. This kept Swiss exports competitive in Europe and other export markets and thus kept Switzerland out of recession.
The trouble was that as the European Union slipped closer and closer to deflation, the European Central Bank faced the need to dramatically increase the supply of euros. Consumer-level inflation in Switzerland remained subdued, but the dramatic increase in the supply of francs needed to cap the currency’s value already was contributing to a bubble in real estate and other Swiss asset values.
The EU and the ECB had no animus against Switzerland. But if the ECB was going to flood the European economy with new euros, there was little way that the relatively tiny SNB could counteract this. Switzerland stood directly in the path of an enormous stray monetary bullet. Its governors decided that prudence was the better part of valor and that the central bank should step out of the line of fire by abruptly revoking the peg they had established in 2011. This happened last week.
I think they were right, in terms of choosing the least bad of several very dismal alternatives. But some economists, including Nobel winners like Paul Krugman, believe that they erred. And their action inflicted multibillion-euro losses on some investors and on many foreign exchange traders. But the pros and cons of their decisions have implications beyond Europe; they will impact Minnesota manufacturers, miners and farmers. I’ll explain how in next week’s column.