The recent Swiss devaluation has led to some interesting reactions in the blogosphere. But one angle that I haven’t seen discussed is the relationship of the Swiss action and bubble theory. I’m a believer in the EMH and hence skeptical of the idea of bubbles, a least as the term is usually interpreted. But I’m in the minority, the vast majority of people think bubbles exist. And if they do, then the recent move of the Swiss franc to near parity with the euro was surely a major bubble–as the currency appeared to be at a level that was unsustainable in the long run.
If the Swiss franc is wildly overvalued, then what should the Swiss do? Because I don’t believe governments can identify bubbles, I’d be inclined to say they should do nothing. But most people think bubbles are identifiable–indeed that’s a sine qua non for the existence of bubbles. In that case the policy implications are clear–the Swiss government should buy massive quantities of foreign exchange, and then sell off the assets at a future date when the real exchange rate is at a more “reasonable” level. The very rich Swiss would become even richer. And because governments last indefinitely they can afford to wait out market irrationality, no matter how long it takes to dissipate. BTW, this action need not involve monetary policy at all.
Now suppose Switzerland faces the threat of deflation, either due to an overvalued currency, or some other problem like currency hoarding. What should the Swiss government do? They should sell massive quantities of SF, until deflation is no longer expected. BTW, this action need not involve the foreign exchange market at all.
As a practical matter the two actions I just describe will often be combined. The Swiss will sell massive quantities of SF, and buy lots of foreign assets. This would be appropriate if they think that Switzerland faces a threat of deflation and its currency is hugely overvalued.
Given my belief in the EMH, you might ask why I endorsed the Swiss intervention. I don’t care at all about the overvaluation of the SF, my support was solely based on the assumption that the Swiss do face an actual risk of deflation. I would also have supported a policy of price level targeting, or NGDP targeting. I don’t much care if the Swiss end up winning or losing their bet on the SF. The EMH says it’s a coin toss, and Switzerland’s a very rich country. If they plan this game frequently, they’ll win as many as they lose. Or if I’m wrong about the EMH, they’ll win way more than they lose.
Tyler Cowen had this to say about the action:
I am not unhappy but I am nervous. Keep in mind the Swiss tried such pegs before, in 1973 and 1978, and neither lasted. At some point limiting the appreciation of the Swiss franc implied more domestic price inflation than they were willing to tolerate (seven percent, in one instance, twelve percent in another). You can argue about whether they should be, or should have been, nervous about seven percent price inflation but the point is that they were and indeed they might be again.
Fast forward to 2011. It’s the Swiss saying “we can create money more decisively and more quickly than the speculators can bet against us, and keep it up.” If the flight to safety continues, the Swiss can reap seigniorage by creating money but also there may be spillover into price inflation. You can fix a nominal exchange rate but the market sets the real exchange rate through price movements and so Swiss exports could end up growing more expensive anyway, through the price adjustment channel. If you’re holding and trading euros, and the Swiss central bank keeps churning francs into your hand at a good rate, at some point you will consider buying a chalet in Schwyz.
If the speculators sense less than a perfectly credible commitment from the central bank, they will continue to bet on franc appreciation. In other words, the Swiss are putting their central bank credibility on the line, at least in one direction. And even if they stay credible, they may not much lower their real exchange rate over a somewhat longer run, so why should they be fully committed to credibility?
I think I understand Tyler’s argument, but am not sure quite what to make of it. It might help to slightly change the policy, and then see how it affects things. Suppose the SNB says they will buy foreign exchange in order to drive down the value of the SF until inflation expectations rise to 2%. In that case, it wouldn’t be much of a problem if inflation started rising, the SNB could simply abandon the program and declare “mission accomplished.” This suggests that the real problem is a specific commitment to peg the SF at 1.20. The SNB might have to abandon the peg if inflation started moving in a direction that conflicted with their macro policy goals.
In another post Tyler Cowen makes this comment:
And here is Scott on the Swiss unlimited pledge, a real test of credibility theories.
Just as with QE2, it’s not clear what is being tested. QE2 was certainly credible—markets reacted powerfully to the news. But the policy didn’t pan out as the had hoped. And the Swiss announcement yesterday was certainly credible. If it wasn’t markets would not have reacted so strongly. It’s important not to confuse credibility and fidelity. For instance a Don Juan may be credible, but not faithful.
It might be instructive to compare the ways in which QE2 might fail, with the ways in which the SNB policy might fail. QE2 might have failed because it was not credible, because it didn’t increase NGDP expectations. In fact, it did not fail for that different reason. The real problem was that Fed didn’t commit to enough QE to hit a particular NGDP target, they committed to $600 billion in QE2. Both the Fed and the markets initially thought that would be enough to significantly boost NGDP growth. If it did (which is unclear) all it did was to prevent an even steeper slowdown than what actually occurred. On the other hand if the Fed had promised to do whatever it takes in the form of QE, and if it was believed, it might have failed because it later reneged on that promise. The Don Juan problem. That’s a problem some people worry about, but not me. Central banks aren’t Don Juans. They don’t have fidelity problems, they have commitment problems.
In my view people are making too much of an issue of the risk that the SNB may not end up adhering to the 1.20 currency peg. The SNB frequently intervenes in the forex market, as described in this recent post. During recent years there were several interventions that seemed to achieve the SNB’s objectives, and then were abandoned when no longer needed. Mission accomplished. The macro aggregates in Switzerland are about where the SNB wants them, but there is concern about future trends. Thus they are taking a pre-emptive action.
This recent action may be abandoned because the SNB’s macroeconomic goals are achieved. But I don’t see how that would be a source of embarrassment for the Swiss. It’s inflation and NGDP that matter, not the exchange rate–which is merely a means to an end.
Here’s Matt Yglesias:
I continue to be fascinated by the fact that lots of issues in monetary policy that are controversial when you talk about “monetary policy” become uncontroversial when the subject switches to exchange rates. Everybody knows that currency depreciation expands aggregate demand. This is what the Swiss are talking about. This is what Americans are talking about when they complain about Chinese “currency manipulation.” And everyone agrees that a determined central bank can achieve whatever exchange rate goals it sets. So despite the apparent disagreement over whether or not a determined central bank can boost aggregate demand, everyone in fact seems to agree that it can””but only if we agree to talk about exchange rates rather than “aggregate demand.”
I’d hope “everyone agrees.” But here’s Paul Krugman (from last year):
Oh, and about the exchange rate: there’s this persistent delusion that central banks can easily prevent their currencies from appreciating. As a corrective, look at Switzerland, where the central bank has intervened on a truly massive scale in an attempt to keep the franc from rising against the euro “” and failed:
PS. The other quasi-monetarists have had excellent posts on the Swiss move (Beckworth, Hendrickson, Glasner, Nunes, etc.) I’m still jet lagged and struggling to catch up with all the news I missed, and what other bloggers have been saying.
Tags: QE 2