Tuesday, January 20, 2015

The Swiss Declare War

Well, that is what one might conclude after the events of the last week.  As is well-known, the Swiss National Bank decided to remove the peg/floor in the exchange rate for the Franc against the Euro.  This move was made suddenly, with no announcement or even a hint beforehand.

There is so much wailing and gnashing of teeth in the financial media.  There is much I might say about this event; I will use the writing of two of the more prolific economic financial writers of today to help me on my way.  Both John Mauldin and Ambrose Evans-Pritchard (with two pieces, here and here) have written about this event; they each offer comments worth addressing – comments that help give context to some of my thoughts.  (Forgive me as I will write in the language of the macro-economist; using their own words, the failure of their logic can be demonstrated.)

Ambrose offers his analysis:

The Swiss National Bank has lost control.

Think about this…while the SNB allowed the ECB to dictate monetary policy for the Franc, the SNB had control; now that the SNB has decided an independent policy, it doesn’t have control.  What?  This passes for logic?

John Mauldin regularly writes about currency wars (describing the Swissie as “The First Casualty of the Currency Wars”), as if a currency war is something new to this generation.  It isn’t.  As long as money can be manipulated by fiat, there have been currency wars; as long as mercantilism has been official economic policy, there have been currency wars.

He offers the standard eulogy to the death of a weak currency:

Every bank and business that held non-Swiss-franc debt or investments took an immediate 15–20%+ haircut on its holdings. Swiss investors lost at least 10% on investments in their own stock market and more on shares they held in other stock markets.

In Swiss Franc terms, this is true.  However, 100% of the holders of Swiss Francs saw a tremendous gain on their holdings – of course, not in Swiss Franc terms, but relative to the wealth of everyone not holding Swiss Francs.  Denominated in dollars, Euros, Yen, Pounds, and even gold, the Swiss are much wealthier today than a week ago.  This is a great trade-off.

It gets even better, although you wouldn’t know it to read Mauldin:

Forty percent of Swiss exports go to the Eurozone, and the Swiss franc is now over 30% higher than it was five years ago – with almost half that movement coming in one day. Those exporters just got hammered.

Ambrose chimes in:

…the howls of protest this morning from the Swiss export sector. Nick Hayek, head of Swatch Group, said the collapse of the floor would cause havoc. "Words fail me. Today's SNB action is a tsunami; for the export industry and for tourism, and for the entire country," he said.

This is the tired old “a cheap currency is good for exports” line.  It might be good for specific companies (and one or two CEOs can always be trotted out to express this view).  But what about the other side?  Only a small portion of all goods and services produced in Switzerland are exported (net exports of about 5% of GDP).  Meanwhile, 100% of all goods and services consumed by people in Switzerland are either produced in Switzerland or imported; well, at least I am pretty sure about this.  Therefore, for a small percentage of the population (those producing for export), one could argue (although even here I disagree) that a cheaper currency is helpful; for the entire population, a stronger currency is beneficial.

From Ambrose:

The franc surged 30pc against the euro in early trading after the Swiss National Bank stunned traders by scrapping its three-year currency floor and freeing the exchange rate…

So a Swiss resident could buy 30% more goods from Europe for the same amount of Francs, and the same amount of goods from Switzerland.  They can buy more stuff for the same Franc, yet somehow this makes the Swiss poorer?

And why do I disagree on the export side?  In order to produce, one must consume.  Where do Swiss exporters buy the goods and raw materials necessary to produce?  While Switzerland is a net exporter, it imports CHF 15B / month while exporting CHF 17.5B / month.  Someone has to pay for those imports before they can export.

Once a manufacturer consumes existing inventory, it now must go to market and compete against those able to buy with other currencies.  Better to compete with a stronger currency, I think.

If you don’t believe me, try this: Mauldin cites his good friend, Charles Gave:

They [the SNB] didn’t mind pegging the Swiss franc to the Deutsche mark, but it is becoming more and more obvious that the euro is more a lira than a mark.

But the Swiss, not being as smart as the Italians, do not believe in devaluations. You see, in Switzerland they have never believed in the ‘euthanasia of the rentier’, nor have they believed in the Keynesian multiplier of government spending, nor have they accepted that the permanent growth of government spending as a proportion of gross domestic product is a social necessity.

Of course, the Swiss are paying a huge price for their lack of enlightenment. For example, since the move to floating exchange rates in 1971, the Swiss franc has risen from CHF4.3 to the US dollar to CHF0.85 and appreciated from CHF10.5 to the British pound to CHF1.5. Naturally, such a protracted revaluation has destroyed the Swiss industrial base and greatly benefited British producers [not!]. Since 1971, the bilateral ratio of industrial production has gone from 100 to 175...in favor of Switzerland.

The last time I looked, the Swiss population had the highest standard of living in the world – another disastrous long-term consequence of not having properly trained economists of the true faith.

The same could be said for Germany and (until very recently) Japan – in both cases a stronger currency and a net-export economy was not mutually exclusive.

It seems the Swiss only went dopey when they announced the peg (well, also maybe when they de-linked the Swissie from gold).

Mauldin goes on to bemoan the plight of the borrowers – debt becomes more difficult to service if the currency becomes stronger.  As if protecting those who choose to consume more than they produce is the only sound economic theory around.

Ambrose feels sorry for the poor central banker:

The SNB has to pick its poison. It is damned for one set of reasons if it holds the currency peg, and damned for another set if it ditches the peg. Welcome to the world of horrible dilemmas facing modern central banks.

Poor babies.  I have a solution!  Money and credit could just be left to markets; what about that idea?

On a slightly different topic, but equally important: Mauldin also introduces the reality of the default already taking place in the United States, and which could also be deployed everywhere (citing Will Denyer):

The US has just provided a remarkable example of the third option at work. Last year, the US Treasury paid a record amount of interest, roughly US$430bn. But over the same period the Fed remitted almost US$100bn to the Treasury, thanks to a balance sheet bloated by QE operations.

As long as central banks do not reduce their balance sheets of government securities, and as long as they return interest to the treasury, it is easy to state that the national government has defaulted on that portion of the debt held by the central bank.  What is it called if the borrower never has to repay the debt and doesn’t have to pay the interest?  Default is pretty descriptive.

This is the path possible for Europe, if a change or two is adopted:

But what about the eurozone, where many governments are involved? Normally, any profits made by the ECB are pooled and distributed to member countries in proportion to the central bank’s capital subscription weightings, which are based on population and gross domestic product.

What would make a big difference is if the ECB made an exception to its normal profitsharing practices, and said that all profits on Portuguese bonds will go back to the Portuguese government, all profits on Italian bonds go back to the Italian government, and so on….

There you have it – your cake and a full belly.  When does the game have to come to an end?  I don’t know, but as more and more assets are demanded by the non-productive (those living off of the largesse of central-bank financed government) and there are too many non-productive feeding off of too few productive, it will.

Mauldin does properly see the end game, at least for Europe:

Unless and until its members create a fiscal union and come up with some formula to mutualize their debt, the Eurozone will remain imbalanced and will become increasingly likely to break up.

I am betting on “break up.”  I just don’t know exactly when.

And what about the end game elsewhere?  Take a cue from this comment regarding the SNB:

Jeremy Cook, from World First, said the retreat was a “total capitulation” in the face of forces that are too big even for a central bank with plenty of firepower. “Nobody wins when you stand in the way of a freight train, except for the train.”

One by one, this will be true for each central bank.

The traumatic day in Switzerland has exposed limits of central bank power. It is a foretaste of how difficult it is becoming for countries to resist the tidal force of devaluation policies and currency warfare as deflationary forces sweep the world. The monetary hegemons are left having to pick their poisons.

Or have their poisons picked for them.

End the Fed.


  1. I was hoping you would write about this development. And a fine job, too!

  2. Spot on. Thanks for the reality check.