Archive for the Category Switzerland


Fed policy options

The Fed has three primary ways to impact NGDP:

1.  Change the supply of base money–primarily through open market purchases (OMPs), or sales.

2.  Change the demand for base money through adjustments in interest on reserves (IOR)

3.  Change the demand for base money through adjustments in the Fed’s target (inflation, NGDP, etc.), or making it more credible though actions such as level targeting, or currency depreciation in the forex market.

Most pundits think and talk in terms of binaries, and thus underestimate the policy options available to the Fed.  Thus a pundit might say we need to ban currency and break the zero bound, because OMPs are ineffective at the zero bound—forgetting the option of impacting base money demand by adjusting the policy target.

For each of the three options, it’s useful to treat one as a given, and think about the other options in a two dimensional space.  Thus if we have a given policy target, say a 4% NGDP target path, then the Fed has two tools to get there, OMPs and adjustments in IOR.  Then you can think about how much weight the Fed should put on each tool, by considering other objectives, such as size of the balance sheet.  For any given NGDP target, the higher the IOR the larger the balance sheet, and vice versa.  If the Fed wants banks to hold lots of liquidity, they might opt for a higher IOR.  If they are worried that they’ll need to do a lot of QE to hit their target, and that this QE will be politically unpopular, they’ll go for negative IOR.  (That’s where the ECB is right now.)

But we don’t have to think of the policy target as a given.  Japan recently raised their inflation target from 0% to 1%, and then later to 2%.

Or we could assume that for some reason IOR is fixed at zero, as it was during the Fed’s first 95 years. Then the trade-off would be between steepness of target path and size of balance sheet.  The faster the desired rate of NGDP growth, the smaller the ratio of base money to GDP, and hence the smaller the central bank balance sheet.  Australia chose a high target path, and got a very small RBA balance sheet as a result.

And finally, the balance sheet itself might be a key objective.  For instance, the Swiss National Bank recently became concerned about their ballooning balance sheet.  Suppose central banks are averse to a large balance sheet.  In that case the target path and IOR become the two policy options.  The Swiss could opt for a higher rate of inflation, or they could opt for a lower rate of IOR.  In fact, they’ve opted for negative 0.75% IOR, an especially low rate.  In my view they should have changed the (effective) inflation target, by not revaluing last year.

Even within a category such as OMPs, there are several possible options.  Thus the central bank could buy Treasury bonds, or they could buy a riskier asset.  Generally speaking, the riskier the asset the more “bang for the buck”, but not as much more as you might imagine (in my view.)  Monetary policy primarily works by impacting the liability side of the Fed’s balance sheet; the asset purchases are not very important.  However when we are at the zero bound, or when the market rate equals the interest rate on reserves, it’s quite possible that the asset side becomes relatively more important.  It’s hard to say how much more, because policy at the zero bound is especially sensitive to expectations of future policy.  But if we hold the NGDP target path constant, then the specific type of assets being purchased might make some difference.

Here’s a question from Eliezer Yudkowsky:

Should market monetarists be pushing heavily to have the Fed be buying higher-priced bonds, foreign assets, or non-volatile shortable equities, instead of US Treasuries?

It seems to me intuitively that buying Treasuries with money might itself be a wobbly steering wheel, because as the Treasuries have lower yields and especially as you foolishly start to pay interest on reserves, you’re substituting two very similar assets. As the two assets get *very* similar you might be approaching a division-by-zero scenario where it takes unreasonably large amounts of money creation to change anything. And yes, there’s still an amount of money that’s enough. But maybe you would literally have to run out of short-term Treasuries to buy. Maybe you’d need to print far less money if you were buying a basket of low-volatility stocks or something. So maybe this is one of the things that market monetarists should push for, for the same reason we push for not using interest rate targeting because the meaning of the asset keeps changing? Like, if we try to create money and exchange it for Treasuries, does the meaning of that act change and diminish even as the Treasury yields get closer to zero.

If printing more of the unit of account or unit of exchange is supposed to have a mode of action that doesn’t interact with the similarity of that currency to the Treasuries that it’s replacing, then I confess that this is something I still don’t understand myself and definitely couldn’t explain to anyone else. It might need to be explained to me with some kind of concrete metaphor involving apples being traded for oranges in a village that prices everything by apples, or something. Right now, the only part I understand is the notion that people have a price/demand function for things-like-currency, which implies that if a Treasury has become a thing-like-currency, creating currency and removing Treasuries will be a wash in terms of the demand function.

I think this question needs to be broken down into pieces.  First, are we happy with the policy target?  In my view the ECB and BOJ should not be happy with their policy target, as it leads to such low NGDP growth expectations that they are forced into unpleasant decisions on IOR and/or QE.  They’d be better off with another target, say level targeting of prices, which would lead to faster expected NGDP growth and less need to do negative IOR or QE.

But let’s say the target is carved in stone, then what are the options?

I prefer starting with buying Treasuries, even if it is less effective than other assets. Recall that seignorage is basically just a form of tax revenue, which ultimately goes to the Treasury.  Unless you specifically want to build sovereign wealth fund, it’s not clear why you’d want the Fed to buy stocks.  And if you do want to build a sovereign wealth fund, it seems like it should be the Treasury’s decision.  In other words, the Treasury could borrow a trillion dollars and use it to buy index stock funds. Then the Fed would have lots more T-debt to buy.  This combined operation has the same ultimate effect as Eliezer’s proposal, but the lines of authority are clearer.

The next question is how much T-debt should the central bank buy?  I don’t really know.  I’d probably ask the Treasury how much they’d like to leave in circulation to give liquidity to the markets (which might be $5 trillion), and then stop at that red line.  At that point I’d have the Fed buy other assets, such as Treasury-backed GSE debt (i.e. MBSs), foreign bonds, AAA corporate debt, etc.  I suppose at some point you might end up buying stock, but I can’t really envision that happening.  On the other hand, a decade ago I couldn’t envision where we are right now—-6 1/2 years of nearly 4% NGDP growth and interest rates at 0.5%.  So who knows?

To summarize, I have several objections to the Fed buying stocks right now:

1.  I doubt it provides much more bang for the buck, as it’s the liability side of the Fed’s balance sheet that really matters.

2.  Even if they do need to buy more Treasury debt (relative to stocks), buying that debt is not costly, indeed the Fed usually makes a profit.

3.  Any decision to build a sovereign wealth fund should be made democratically, i.e. by the Treasury.

I could add other objections, such as that it’s “socialism”.  However I’m actually not all that worried about the Fed meddling in the management of companies.  But lots of other people would be.

Eliezer’s right that base money and T-debt are much closer substitutes at the zero bound, but I don’t see that as a problem.  So do more!

I prefer to work back from the target.  What percentage of GDP does the public want to hold in the form of base money, if the central bank is expected to hit its target?  Right now people are confusing two issues, a desire to hold base money because rates are low, and a desire to hold base money because the central bank is not expected to hit its target (as in Japan and the eurozone).  If credibility is the problem, then you need a mechanism to restore credibility.  I like my “whatever it takes” approach and/or level targeting, but other options are available.  Thus small countries like Switzerland can simply devalue their currency.

Until we get clear thinking from the central banks about the three policy levers discussed above, it’s hard to give good policy advice.  For instance, if the ECB actually has big problems hitting its inflation target at the zero bound, then the asymmetry built into their target is obviously exactly backward.  In a world where the zero bound is a big problem, the target should be “close to but not below 2%”. Right now, they have a policy target that conflicts with their operating procedure. The target reflects the assumption that it is high inflation that is difficult to control. And yet exactly the opposite seems to be true.

Then central banks need to think clearly about the inflation rate/size of balance sheet trade-off (at each IOR).  They don’t seem to know whether they are more averse to higher inflation or to a very big balance sheet, and hence end up in the worst of both worlds—missing the inflation target and thus getting an even bigger balance sheet.  Of course the lack of clear thinking might actually reflect very clear thinking by each member of the ECB, but no agreement on which of those clear paths is best.  But I think it’s worse than that, you have central bankers saying we need to raise rates so that we can cut them in the future, an EC101-type error.  So I’m not willing to give them the benefit of the doubt.

I don’t think Eliezer will be happy with this post–it’s too long to be an “elevator pitch”

Odds and ends

1.  Over at Econlog I have a post responding to Arnold Kling.

2.  Tyler Cowen has a new post discussing the ideas of Kevin Erdmann.  In my view Kevin is one of the most underrated thinkers in economics.  He’s done a long series of posts on real estate, as well as related issues such as inequality.  I differ with him on the natural rate, but only for the relatively trivial reason that I define the term differently than he does.

3.  Joseph Stiglitz recently criticized Paul Krugman’s claim that our stagnation was due to an inability to cut interest rates far below zero.  Here’s why Stiglitz think’s Krugman is wrong:

The real problem is people don’t have income, and when they don’t have income they don’t spend.

Well thanks for clearing that up! And the reason my car is going too slowly is not that I am not pushing hard enough on the gas pedal, it’s that the wheels are not rotating fast enough.  I would have loved to see Krugman’s reaction, as well as his reaction to Ralph Nader’s recent advocacy of tighter money.  I’m guessing Krugman won’t treat them with the same contempt that he views the gold bugs and inflation truthers.

4.  Timothy Lee has a great article on Bitcoin:

Bitcoin hasn’t received the kind of hype in 2015 that it has in previous years. But outside the spotlight, the Bitcoin economy has continued to grow slowly but steadily. And in the last few weeks, the value of Bitcoin has soared. One bitcoin cost $236 at the beginning of October. Now, five weeks later, it costs $426.

No one is sure why the currency has had such a dramatic surge. But it’s at least partly a sign of growing investor confidence in the growth of the underlying Bitcoin economy. Here are five charts that show Bitcoin’s progress.

He has lots of evidence that Bitcoin is making big inroads into the real economy; it’s not longer just a speculative asset. Of course lots of people told us it was a bubble a few years back, even with the price was 1/10th its current level.  I’d guess its price will continue to be wildly unstable, but I also suspect that it’s not just a flash in the pan.  Bitcoin is another example of why bubble theories are useless.  Suppose you had refrained from investing in Bitcoin based on earlier claims that it was overvalued at $30.  You would have missed out on huge potential gains.  For every bubble prediction that comes true, there is one that comes false.  Asset prices are a random walk, and bubble theories add nothing useful to that fact. When you have an asset that’s value is easy to estimate, like 3-month T-bills, its value will be pretty stable.  It’s harder to estimate the value of GE stock, so its value will be less stable.  And it’s really hard to estimate the value of a biotech start-up, or Bitcoin, so their value will be very unstable.  There will be dramatic ups and downs that look like bubbles, but that will be a cognitive illusion.

5.  Tyler also discusses a new book by Garett Jones, called Hive Mind: How Your Nation’s IQ Matters So Much More Than Your Own.  It’s one of the best non-fiction books I’ve read in quite a while (although admittedly I’m a slow reader, so I don’t read nearly as much as Tyler.)  It’s no surprise that people with IQs of 105 make more money, on average, than people with IQs of 90.  But the difference is modest.  On the other hand, countries with average IQs of 105 are dramatically richer, on average, than countries with average IQs of 90.  Of course there are lots of possible reasons for that (and exceptions to the rule), and Garett discusses a lot of interesting theories, some of which are based on behavioral economics research.  The hypothesis that interested me the most is that higher IQ people (and countries) tended to be thiftier. Interestingly, the highest IQ countries tend to be in East Asia, and the smartest country in Europe is Switzerland. The book also has lots of interesting discussion of ways to boost IQ, the Flynn effect, etc., but I’m going to skip over the difficult problem of correlation/causation, and think for a moment about how Garett’s work interacts with Thomas Piketty.

Let’s suppose Switzerland and Singapore save more because their people have high IQs.  According to Piketty, they’ll gradually get richer and richer, piling up huge current account surpluses.  Now what should a good progressive think of that fact?  If you are an “internationalist progressive”, who like all utilitarians believes the massive spending on social welfare in Western Europe should be redirected to the poor of Africa and Asia, then you’d be horrified by those two economic models, even though the conservative economic policies of Switzerland and Singapore benefited their own citizens.  If you were a “nationalistic progressive”, which of course most are, you’d favor the European welfare state, and controls on immigration, because solidarity with the poor of your own country is more important than eliminating extreme poverty in the 3rd world.  Then you might even like the Singapore/Swiss approach.  It certainly seems to have won out in northern Europe.

6.  It’s interesting to contrast Garett Jones’ book with another very interesting book that I recently read, The Moral Foundation of Economic Behavior, by David Rose.  Garett says that higher IQ leads to higher levels of trust, which is important for economic development.  David Rose also says trust is central to economic success, but focuses on cultural differences. He suggests that “guilt cultures” such as the West, have an advantage over “shame cultures” such as East Asia. That’s because people in a guilt-based society will be reluctant to cheat, even if they can get away with it.  (Obviously I’m oversimplifying the story here, he’s well aware that lots of individual people cheat in all societies, even Denmark.) The book has many other interesting ideas.  Conservatives would especially like David’s book.

7.  Timothy Lee also has a nice post on monetary policy:

The broader problem with Nader and Carson’s arguments is that the Fed doesn’t actually have that much control over interest rates.

Think of a guy driving along a winding mountain road. In one sense, he has total control over where the car goes. If he turns the steering wheel to the right, the car goes right. But that doesn’t mean he can drive the car wherever he wants. If he steers too far to the right, he’ll go through the guardrail and off the cliff. If he steers too far to the left, he’ll run into the mountain on the other side of the road.

The Fed is in a similar situation. It’s trying to steer a course between the twin evils of inflation and recession. If it keeps rates too low for too long, the economy will start to overheat, and inflation will get out of control. If the Fed raises rates too quickly, it’ll tip the economy back into recession. So it’s true that at any particular instant, the Fed can make interest rates go up and down. But the Fed doesn’t have that much leeway to raise rates if it wants to avoid hurtling over the cliff and into a big recession.

The European Central Bank did exactly that when it raised interest rates prematurely in 2011. That proved to be a huge mistake, because it tipped the eurozone economy into a double-dip recession.

Think of someone driving from Munich to Milan.  Who determines the path of the car over the Alps?  Is it the driver, or the Swiss engineer who designed the road?  Both have some influence, but the one that directly controls the steering actually has the least influence.  Ditto for the effects of the Fed and NGDP on interest rates.  Most people don’t understand that point.

8.  Lars Christensen points to a recent paper by Ryan Murphy and Taylor Leland Smith, which shows that NGDP shortfalls lead to statist policies.  I’ve always believed that to be true, but mostly based on anecdotes like the New Deal, Obama, and the Argentine government’s shift toward statism after 2002.  Now we have an empirical study, which shows how inflation hawks like Bob Murphy are inadvertently helping socialists such as Bernie Sanders.  And the results hold even if you exclude the Great Depression and the Great Recession.

9.  And last but not least, Paul Krugman hints at sinister policies that are dramatically improving the health of America’s Hispanic population, while slightly worsening the health of whites:

There’s a lot to be said, or at any rate suggested, about the politics of this disaster. But I’ll come back to that some other time. For now, the thing to understand, to say it again, is that something terrible is happening to our country “” and it’s not about Those People, it’s about the white majority.

I can’t wait to see Krugman reveal more details of the “politics” behind this outcome.  Let me guess, the GOP will come out looking bad.  (Seriously though, it is a really interesting graph, and not just because of white Americans, but also the huge gaps between say France and Sweden/Australia.  They are not what I expected, and I have no idea what causes them.)

Getting to Switzerland

Matt Yglesias has a good post on Denmark.  He points out that Denmark has far higher taxes than the US, especially on the middle class.  He also points out that Denmark has much more efficient provision of public services.

Consider health care, which is almost 18% of US GDP, and more like 10% in Western Europe.  Now suppose the US moved to complete socialized medicine, without dramatically cutting the pay of doctors and nurses. Assume we also adopted the other aspects of the Danish social welfare model. Denmark’s government currently spends about 57% of GDP.  If the US tried to deliver the same services, without reducing costs from the current level, it would cost at least 65% of GDP.  It’s not possible to raise that much money without dramatically reducing total GDP—making us much poorer.

Matt points to some other examples of waste, such as the fact that transportation projects in America are far more expensive than in Denmark (or in the rest of Europe, for that matter).  So it might require even more than 65% of GDP. Democrats don’t tend to talk about this problem, because part of it is caused by their constituencies. And we know that when push comes to shove, they care more about public employees than social welfare programs (recall the education voucher debate.)

And of course Denmark is actually more capitalist than America, a point that Yglesias overlooked.

The fact that Bernie Sanders is being fundamentally dishonest about the nature of Scandinavian “socialism” does not mean that we shouldn’t try to emulate Danish policies.  I do view their system as superior to the US, because it’s more capitalist and more utilitarian.  But that’s a low bar—why not aim higher?

Matt shows a list of the happiest countries in the world, where Denmark comes in third.  It’s kind of a bizarre list (the US is at 15, squeezed between Mexico and Brazil.) But suppose you actually believe this stuff.  It’s worth noting that the US scores higher than every single large European country (over 40 million people); higher than Germany, France, Britain, Italy, Spain, Poland, Ukraine, Russia.  That suggests to me that the US policy regime is superior to the European policy regime.  Or any other large country regime, except . . . Mexico??

And let’s go one step further.  The very highest country in the happiness rankings is Switzerland.  Soon after Matt provides this ranking, he asks:

3) How did Denmark get to be so awesome?

Taxes. Denmark does it with really high taxes.

Taxes certainly explain the social benefits Matt discusses, but what about the happiness ranking?  Since the Swiss are much richer than the Danes and also seem happier, why not emulate Switzerland?  The Swiss have the smallest government in Western Europe (as a share of GDP), indeed even smaller than in the US.  So let’s shrink our government to be more like the Swiss.

When I mention this proposal to progressives they invariably say:

“Switzerland is a small homogenous country, its model is not applicable to the US.”

I then ask; so which model should the US copy?  And they respond:

“Denmark” or “Sweden”

I usually spend the next 10 minutes rolling on the floor laughing, before pointing out that at least Switzerland has four different languages.  They also have more immigrants than other European countries.

I wish we could have an honest debate.  The Dems could say, “We want to be more like Denmark.”  The GOP could say, “We want to be more like Switzerland.”  Then show American voters the taxes paid by the middle class in both countries, and the public services provided in both countries, and let them decide.

Unfortunately, the Dems don’t actually want us to be anything like Denmark, nor does the GOP want us to be anything like Switzerland.  Hence the debate over “big government” is all a sham.

HT:  TravisV

Williamson on NeoFisherism (define “loosening”)

Stephen Williamson has a new post that interprets recent monetary history from a NeoFisherian perspective.  It concludes as follows:

What are we to conclude? Central banks are not forced to adopt ZIRP, or NIRP (negative interest rate policy). ZIRP and NIRP are choices. And, after 20 years of Japanese experience with ZIRP, and/or familiarity with standard monetary models, we should not be surprised when ZIRP produces low inflation. We should also not be surprised that NIRP produces even lower inflation. Further, experience with QE should make us question whether large scale asset purchases, given ZIRP or NIRP, will produce higher inflation. The world’s central bankers may eventually try all other possible options and be left with only two: (i) Embrace ZIRP, but recognize that this means a decrease in the inflation target – zero might be about right; (ii) Come to terms with the possibility that the Phillips curve will never re-assert itself, and there is no way to achieve a 2% inflation target other than having a nominal interest rate target well above zero, on average. To get there from here may require “tightening” in the face of low inflation.

I partly agree, but disagree on some pretty important specifics.  I thought it might be instructive to start out by rewriting this paragraph to express my own view, with as few changes as possible (in bold):

What are we to conclude? Central banks are not forced to adopt ZIRP, or NIRP (negative interest rate policy). ZIRP and NIRP are choices. And, after 20 years of Japanese experience with ZIRP, and/or familiarity with standard monetary models, we should not be surprised when ZIRP results from low inflation. We should also not be surprised that NIRP results from even lower inflation. Further, experience with QE and inflation forecasts embedded in TIPS should not make us question whether large scale asset purchases, given ZIRP or NIRP, will produce higher inflation. The world’s central bankers may eventually try all other possible options and be left with only two: (i) Embrace ZIRP, but recognize that this means a decrease in the inflation target – zero might be about right; (ii) Come to terms with the possibility that the Phillips curve will never re-assert itself, and there is no way to achieve a 2% inflation target other than eventually having a nominal interest rate target well above zero, on average. To get there from here may require “loosening” in the face of low inflation.

Why do we reach such differing conclusions?  I think it’s because I have a different understanding of recent empirical data.  For instance, Williamson’s skepticism about monetary stimulus in Japan is partly based on his assumption that the recent sales tax increase raised the Japanese price level by 3%. But there’s never a one for one pass through, as it doesn’t cover major parts of the cost of living, such as rents.  So the Japanese price level (net of taxes) has risen by considerably more than Williamson assumes (albeit still less than 2%/year).  Even more importantly, Japan had persistent deflation prior to Abenomics.  And if Williamson is going to point to special factors such as the sales tax rise, it’s also worth mentioning that his recent data for Japan (and the other countries he considers) is distorted by a large one-time fall in oil prices.  Almost all economic forecasters (and the TIPS markets) expect inflation to soon rise from the near zero levels over the past 12 months.  Abenomics drove the yen from 80 to 120 to the dollar—-is that not inflationary?

In the Swiss case Williamson mentions low rates and asset purchases, but completely misses the elephant in the room, the huge upward revaluation of the franc earlier this year, which was widely condemned by economists (and even by many Swiss).  This policy was unexpected, unneeded and undesirable.  It immediately led forecasters to downgrade their forecasts for Swiss inflation, and those bearish forecasts have turned out to be correct.  I hope that’s not the sort of “tightening” of monetary policy that Williamson believes will lead us to higher inflation rates.

Seriously, I’m confident that Williamson would agree with the conventional view that currency appreciation is deflationary. That should send out warning signals that terms like “loosening” are very tricky.  Before we use those terms, we need to be very clear what we mean.  You can achieve higher interest rates through either loosening (a crawling peg devaluation forex regime) or tightening (open market sale of bonds), it all depends how you do it.  More specifically, it depends on the broader policy context, including changes in expectations of the future path of policy.

I think he also gets the Swedish case backwards.  The Swedish Riksbank tried to raise interest rates in 2011.  Instead of producing the expected NeoFisherian result, it led to what conventional Keynesians and New Keynesians and Market Monetarists would have expected—falling inflation. It led to exactly the type of bad outcome that Lars Svensson predicted. So Svensson was right.  And contrary to Williamson, the Riksbank did not turn around and adopt Svensson’s preferred policy, which is actually the “target the forecast” approach; rather they continued to reject that approach.  They continued to set rates at a high enough level so that their own internal forecasts were of failure. Once a tight money policy drives NGDP growth lower, the Wicksellian equilibrium rate falls and policy actually tightens unless the policy rate falls as fast or faster.  That did not occur in Sweden.

Let me try to end on a positive note.  I have a new post at Econlog that took a position roughly half way between the NeoFisherians and the Keynesians.  Brad DeLong had noted that Friedman often claimed that low rates are a sign that money has been tight. I’d emphasize, “has been.”  Krugman said this was wrong, at least over the time frame contemplated by Friedman.  I disagreed, defending Friedman.  I believe that Keynesians overestimate the importance and durability of the so-called “liquidity effect” and underestimate how quickly the income and Fisher effects kick in.  At the same time, as far as I can see the NeoFisherians either ignore the liquidity effect, or misinterpret what it means.  (My confusion here depends on how literally we are to take the “tightening” claim in the quote above.)

Question for the NeoFisherians:

I often discuss the Fed announcements of January 2001, September 2007 and December 2007.  That’s because all three were big shocks to the market.  In all three cases long-term interest rates immediately reacted exactly as Irving Fisher or Milton Friedman might have expected.  In the first two cases, easier than expected policy made long-term rates (and TIPS spreads) rise.  And in the last case tighter than expected policy made long-term rates (and TIPS spreads) fall.  Please explain.

To me, that’s the Fisher effect.  But here’s the problem, the Fed produced those three results using the conventional manipulation of short-term rates.  Thus in the first two cases the Fed funds rate was cut more than expected, and vice versa in the third case. From a Keynesian perspective this is really confusing—why did long-term rates move in the “wrong way”? From the NeoFisherian perspective this is also really confusing—why did moving short-term rates one way, cause TIPS spreads (and long term rates) to move the other direction?  From a market monetarist perspective this all makes perfect sense.  (It doesn’t always play out this way, but if you look at the really big monetary shocks the liquidity effect is often swamped by the long-term effects.)

HT:  Marcus Nunes

Further thoughts on Switzerland

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.