The Swiss Central Bank Conundrum: Fighting Fire with Kerosene
2014-05-11
crisismaven
When the Swiss Franc started appreciating against the Euro (or was it the Euro depreciating against the CHF?) the Swiss National Bank vowed to fight tooth and nail to keep the Swiss Franc at a 1.20 parity “at all cost”.
Time to wonder how such a “fight” is fought, whether it can be successful and what are the consequences.
The currency “stabilisation” choices a central bank has
A central bank is the master of its own currency, i.e. the currency it is meant to issue.
In today’s world of unbacked (“fiat”) currencies even the Swiss Central Bank has no real restriction as to how many units of its currency it can create. It can virtually create infinitesimal amounts of it.
And indeed the Zimbabwean central bank did so until recently. In Germany the Reichsbank tried to do just that back in 1923. (Actually “money shortages” got so bad even individual cities began printing their own money.)
Both Germany and Zimbabwe “succeeded” up to a point and that point is where the currency loses all value. It then becomes unusable in any transaction and ends up as wallpaper.
There is an interesting asymmetry in this game of pegging one’s currency at a certain parity to another currency or a basket of currencies though: It means any central bank can depreciate its own currency as much as it pleases and almost as fast as it pleases but, however, could it do the opposite as well?
What decreases a price? If either supply increases or demand decreases.
The Swiss central bank’s problem was that the CHF demand increased as people were starting to buy Swiss Francs and/or Swiss Franc denominated paper as an inflation hedge in their flight from the Euro.
So the Swiss feared their country’s exporters were losing their edge if they would sell in Swiss Francs to e.g. the Euro zone.
Should a central bank set prices for individual goods?
To begin with, this strikes CrisisMaven as mighty odd. Since childhood he was under the impression that he who sells can dictate his asking price, whether that means to sell too dear or too cheap, no matter, absent price regulations any seller can dictate his asking price. (Whether he is successful with his price setting is an entirely different matter. The market will tell him if it by and large is ready to accept the price. This is called the law of supply and demand.)
But maybe these poor Swiss exporters have lost their pencil or chalk to change the prices on their price lists and therefore the Swiss National Bank needs to help them out in fixing the overall price of their currency?
Again this strikes CrisisMaven as odd – if every exporter has a different internal cost structure how can he be helped by having his prices his price for him by a third party in a sweeping fashion?
Well maybe these national bankers went to university and there were so brain-washed that they forgot the most basic workings of an enterprise or a whole economy.
Let CrisisMaven explain then (if any Swiss banker likes to ask in a comment: I can translate it to Swiss German for you if you ask nicely):
If a currency appreciates do the exported goods from that country automatically become more expensive? The answer is, however counterintuitively, a resounding: NO!
Changing foreign exchange rates do not affect an economy in uniform fashion!
And why not? Well, because the writer of his own price list can always change the sales prices.
Oh, but would he then not lose out?
Again the answer is … no, or at least not necessarily.
As CrisisMaven has explained in “Economic Fallacy I: Harmful Currency Undervaluation?” … a rising currency exchange rate, a currency appreciation always works in two ways:
While exports would become more expensive if, and only if, the exporters would not lower their prices to reflect the currency windfall profits they thus reap, immediately and to the same extentimports would become cheaper and thus might offset the rise in export prices within the national economy denominated in that national currency.
It’s not just that country’s travelers (“tourists”) abroad who now spend a cheaper holiday, no, it’s the whole economy that profits if you will.
So, all other things being equal, the exporter who uses imported intermediate goods and parts or imported raw materials to produce his exported goods profits from these cheaper imports and thus can afford, without negative effect to his bottom line, to reduce the price of his exports in tune with these reduced import costs.
Of course, how much the price of the end product can come down depends on how large the percentage of imported parts and materials is in the first place.
Let’s assume the exported good was 100% assembled from imported goods only (that were priced in the one foreign currency the central bank wants to target) and let’s assume the cost of labour etc. to assemble them to make the exported good were minimal, then it follows with mathematical precision that the exporter could afford, without losing a “cent” to reduce the price of his exports just as much as his currency had recently appreciated or, in other words, keep the price stable in the eyes of his foreign customers, i.e. the importers in that foreign country against whose currency the exporter’s currency had appreciated.
More or less no harm done.
Well, there are, as in all things economic, some side effects:
Each importer or exporter has a different cost structure that cannot be addressed by setting the foreign exchange rate
Since the imported raw materials now appear cheaper, the exporters (and indeed other industries that cater to the national market only) may be induced to increase their purchases abroad at the cost of buying “locally” and thus it would seem some of their compatriots might lose out.
But the opposite is also true – whenever something changes in an economy, and an economy always, always evolves, someone stands to gain and someone stands to lose. Such is life, actually. That certainly is no good cause to change something at the “one size fits all” global level of currency exchange rates. That would be as incompetent as making everyone wear the same jacket when winter temperatures fall. (Although, seeing how the European Union goes about standardising light bulbs and vacuum cleaners, maybe these are all pages from the same book.)
So to sum it up: when the currency exchange rate of the Swiss Franc was X at one time did anyone need to tell exporters or importers what prices to charge resp. to accept? Then why, when these prices changed (to level Y), why would one need to tell them to keep their prices stable (in their national currency) by manipulating the currency’s external value?
I have never read an answer to the question nor have I actually seen the question really asked in any clarity. But for a subject that warrants something like a yearly Nobel Prize one wonders why questions that a five-year old could understand are never asked nor answered by the respective academic professions.
So if the Swiss central bank tries to achieve something on a national scale that a) cannot be achieved and b) that individual agents (e.g. exporters) could much more easily achieve by adjusting their own prices, then what does the Swiss currency intervention actually achieve, if anything?
Well, it achieves a result that I doubt the Swiss really like: it makes every Swiss inhabitantpoorer !
And that mechanism is so simple, not only the five-year old but equally the Nobel Prize surrogate winner (the economics’ prize was not founded by old Nobel) can understand:
When you buy foreign currency by selling your own currency, you lower your own currency’s price. You also increase the foreign currency’s price (all other things being equal). That is what the intervention is for.
However, this is only the result of and at day one.
All foreign exchange rate manipulation leads to losses of overall welfare
After you bought that foreign currency you now hold these reserves for better or worse.
Three ways this can play out:
- Nothing happens, i.e. the relative price levels of your own currency and that reserve currency you just put into your “vaults” stay the same. If that were the price you aimed for, you could call it mission accomplished – now you enjoy that (lower) conversion rate that you thought was so crucial to your country’s exporters’ fate.
- The foreign currency you just bought appreciates. Now what happens? As your own central bank is judged by the assets it holds, your national currency tends to appreciate too. So you need to start selling more of your own currency, buying more foreign currency. If you buy the same currency you just bought in the first round, its price will likely even increase further. You see where we are going with this? Sheer stupidity. You cannot, not in the long run and not with the necessary precision, devalue your currency by intervening in the foreign currency markets in this way!
- Last possible case: your newly won assets, that foreign currency depreciates (against all or most other currencies of note). Now what happens: while the exchange rate between that individual currency and your national currency may stay roughly the same, your currency devalues on a more global scale. If you still want to uphold that “fixed” exchange rate the only two real choices that you are left with now are: buy more of that foreign currency you just pegged your own currency to or sell the currency you once bought to get rid of that peg you tied yourself to and stop the decline.
Unfortunately in each of these cases you are in a rut:
If you sell off the once-treasured foreign currency reserves, you inadvertently lower the value of the still remaining reserves in this currency that you might still. (And as a central bank you cannot get rid of all foreign reserves as you need them to supply your importers with foreign cash!) As discussed earlier, these reserves define the value of your own currency (absent any real asset backing such as gold). So you are now racing against time, but in the end you may very well end up worse than not buying this currency at all.
Or you instead buy more of the depreciating “reserve” currency. Inevitably, like grabbing a falling knife, you are now diluting the value of your national currency further as you “print” more of your own currency (or empty your coffers until you either still have to start printing or else selling off other foreign currency reserves).
To sum it up: you cannot beat the market in foreign exchange (in the long run). Yes, sometimes that strategy may seem successful, but not so: it was simply “working” by accident because other factors may have come to your aid. But even so, had you left the levers of manipulating the exchange rates well alone, these beneficial effects likely would have worked even more in your favour. You just can’t see this (absent a sound theoretical framework as given above) because you cannot experiment on such a scale and you don’t have two separate universes that you could access to try it out.
So all that the Swiss central bank could have achieved (in the long run and depending on to what excess it may by then have intervened) is creating a monster that will eventually come back to haunt the Swiss and their economy as a whole, and not just the exporters.
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