The financial furor over the Swiss National Bank’s abrupt abandonment of fixing the value of the Swiss franc relative to the euro largely has died. The hedge funds whose managers made spectacularly wrong bets are being wound down.
Swiss companies are girding for hard times. The global economy grinds on, and Europe’s attention has shifted back to Greece.
But the Swiss revaluation raises longer-term questions about prudent central banking policies and about the choices we face in our nation — and in Minnesota. So, continuing from last week’s column, let’s examine some of these issues.
The first is whether the Swiss made the right decision. They did have alternatives.
Remember that the problem they faced was one of the franc gaining too much value, not losing value. Losing value is much more common, especially in developing countries. If a country’s currency loses value relative to the dollar or euro, its central bank has to stand ready to sell a dollar or euro at the official rate to anyone wishing to get rid of the local currency. This can go on only as long as it has dollars or euros to sell. When it runs out, the bank is in a foreign exchange crisis.
Switzerland didn’t face that problem. Instead of offering to sell euros to buy up francs, it had to offer francs to buy any euros offered. Because the Swiss National Bank can create new francs at will, it would never run out. So it certainly would have been feasible to simply keep doing what it had been for three years.
Some economists, including Nobel laureate Paul Krugman, think it should have done exactly that. Given Switzerland’s dependence on foreign trade, abandoning the peg on which the franc’s value was based would be a harsh blow to domestic manufacturers and thus to employment. The Swiss economy might have fallen into recession. Consumer inflation had not yet broken out, despite all the new francs the Swiss National Bank had created over three years.
Other credit control measures, such as requiring banks to pay interest to keep reserves with the Swiss National Bank, could have offset some inflationary pressure. And removing the peg hurts the credibility of the Swiss National Bank in any future policies it announces. So, the argument goes, it should have stayed the course.
Perhaps. But there was a growing bubble in real estate and stock prices. And central banks get into trouble when they cling too strongly to policies that events show to be unrealistic. Better to throw in the towel while still on your feet, rather than when knocked out in crisis.
Besides, abandoning the 1.2 francs-per-euro peg does not mean that the franc must float freely. The Swiss National Bank can intervene tactically to prevent wild swings. But it need not be tied to a stipulated rate such as 1.2 francs/euro that makes it a target for speculators.
That is a second important issue, the relative importance of “speculation” as opposed to “investment” in foreign exchange markets.
People might want to exchange euros for francs because they want to buy some product that Switzerland exports. Or they simply might want to keep money in a safer currency and banking system over the medium term. It is this second factor that seemed to be driving the marked increase in demand for francs since 2010.
But there is a third factor: buying the franc in the hope that its value will increase in the short term, when it can be resold for a profit. Or, using derivatives such as options or swaps, staking a bet that its value will fall. If you can borrow 49 euros for every one of your own that you commit, it doesn’t take much of an exchange-rate change to earn a good return on a correct bet.
Some people buying francs were “innocent” households or businesses seeking only to protect themselves from the risk of owning euros in the face of a European Central Bank that might create many more, thus diminishing its value.
However, many other buyers were hedge funds or trading desks of large commercial banks that were using forward or futures contracts, swaps or options, to take a stake in some expected movement of the franc/euro rate. As was demonstrated in the European currency crisis of 1992, when George Soros “broke the Bank of England” by betting that the United Kingdom would have to devalue the pound, determined speculators can become the tail-wagging, very large currency-trade dogs. The SNB remains a small institution compared with the ECB, Bank of England or the U.S. Federal Reserve, and it might have been the better part of valor to abandon the peg rather than get into a battle of wills with determined speculators.
When it did, several hedge funds went broke to the tune of hundreds of millions each, and the trading departments of some large banks lost similar amounts. That this happened when the SNB let the value of the franc rise means that the losers had taken positions betting on it to fall.
Everyone taking such a position had to have a counterparty making the opposite bet, although the degree of leverage is not necessarily the same on both sides. But, in any event, the whole fiasco again raises the often dodged issue of how much speculation is beneficial to society in financial markets.
There is another issue here with more concrete implications for many Minnesotans. Any Swiss product offered for sale elsewhere in Europe at the same franc price as a year ago now costs 25 percent more to the buyer with euros. That clearly means the Swiss will sell less. That is bad for Swiss business profits and for employment.
But it isn’t an isolated case. Take $10 worth of Minnesota soybeans. They cost 20 percent more to a European buyer than a year ago. They cost 16 percent more to a Japanese buyer. The same is true for a Minnesota-made heart valve or pacemaker. From the other side, a German-made car at the same euro price costs 16 percent less in dollars than just six months ago. These are big price swings, and they affect the quantities sold. Exports will fall and imports rise.
Just as the harmful effects on exports and employment were an important factor for the SNB, so similar effects on the U.S. economy must be to the Federal Reserve. One difference is that trade is much smaller relative to the U.S. economy than it is to Switzerland. But a “stronger” dollar does have negative effects.
The problem is that, just as for the SNB, the Fed can only cap the value of the dollar by increasing its supply. And, over the long run, that has implications for inflation, either of consumer prices or in the prices of assets such as stocks, housing and farmland. Keeping the dollar from pricing U.S. farm and manufactured products out of world markets also would continue to suppress the interest rates available to savers. So the choices for the Fed are not easy, just as they were not for the Swiss National Bank.