31 Jan 2015

A *Possible* Scenario In Which the SNB Wouldn’t Want 100% of GDP in Euros

Banking, Market Monetarism, Scott Sumner 33 Comments

What is really odd in the econoblogger debate over the SNB’s recent decision to drop the Swiss franc/euro peg is that some people (including prominent monetary economists) are acting like there is not even a possible danger here. Bill Woolsey actually asked me in the comments here at Free Advice: “Is the argument here that officials in the SNB would get carpal tunnel syndrome by typing in numbers in their computer? Or are we supposed to be worried about exhaustion by those working at the SNB trading desk, purchasing all of those foreign assets?”

No, that’s not really the argument. And I find it alarming that this sarcasm is the extent of the brainstorming that really sharp guys (not being sarcastic when I say that) have put into thinking through the possible downsides of more aggressive monetary policy.

I’m not predicting this would have happened in the next 18 days, but suppose–just to show the kind of thing that perhaps the SNB officials wanted to avoid–that at some point down the road, consumer price inflation in Switzerland started rising again, and they wanted to tighten. But at the same time, the ECB was getting ready to loosen. So the officials at that point have no choice but to abandon the peg, because now it’s interfering with the domestic price inflation goals.

Oh shoot, when they drop the peg, they lose a boatload of money on their euro-denominated assets. The SNB literally goes bankrupt, in an accounting sense. Even worse, now they lack the ability to withdraw the reserves of Swiss francs from the banking system, because their mechanism is to sell off euros and buy back francs, but now the exchange rate moved way against them.

But just because the Swiss franc appreciates against the euro, doesn’t mean the Swiss franc is appreciating against goods and services. It is possible to imagine a scenario where they totally lose the ability to restrain domestic price inflation to their target goal, because they foolishly loaded up their central bank’s balance sheet with (say) 120% GDP worth of a foreign currency.

To repeat, I’m not saying the above was likely to happen anytime soon, but surely that’s the kind of thing that worried SNB officials. I don’t mind if Sumner and his crew think the benefits outweighed the possible risks, but I have yet to see any of them even acknowledge there were risks with the franc/euro peg.

33 Responses to “A *Possible* Scenario In Which the SNB Wouldn’t Want 100% of GDP in Euros”

  1. skylien says:

    Well, I am just as surprised by this like you. However it was only now when I discussed with Transformer about this that I realized fully that it is only consistent for them.

    Since Transformer and Bill Woolsey think NGDP targeting is fine (at least as second best solution) they have to think nothing bad can come from a bloated balance sheet stuffed with all kinds of assets, ranging from long term government bonds to ABS etc..

    I mean there is no difference in a currency peg, QE and NGDP targeting other than the actual goal. All mean bloat the CB balance sheet with all kinds of stuff (doesn’t really matter right?)

    I mean I don’t believe that all of them believe it is no problem because the CB could create assets like I think Transformer thinks (due to our last discussion), but here again for all:

    No, the central bank cannot create assets! It can create money, but it can’t create assets!

    • skylien says:

      Well, of course for normal people cash on hand (and therefore money) is on the asset side listed on a balance sheet. However a CB doesn’t list cash (money) on its asset side because technically it it has an infinite amount of it at its disposal. That would make the balance sheet of the CB a complete joke.

      So it cannot create other assets than money, which is what it would need to be able to counter loss on its asset side.

    • Andrew_FL says:

      As I understand the MM position, it should never actually be necessary to bloat the CB’s balance sheet under NGDP targeting. That only becomes necessary if you’re doing it wrong.

      The idea is if you tell people that by hook or by crook, this is where you are going to have NGDP at, the threat of NGDP being increased by M is met with people increasing V instead. Sort of “Don’t make me come back there” monetary policy. Only if people don’t believe you’re serious about the threat to increase M if necessary, will the strategy to achieve this goal not work.

      Of course, it strikes me that a bloated balance sheet is then prima facie evidence that your policy goal is not credible. So we’re back to the peg not being credible. Tyler Cowen and Bob seem like they’re correct. Unless of course only NGDP targeting takes away the need to bloat the balance sheet as long as your goal is credible.

      • Bob Murphy says:

        Andrew_FL wrote:

        Unless of course only NGDP targeting takes away the need to bloat the balance sheet as long as your goal is credible.

        I remind you that on December 21–and to this day in fact–Scott still maintains that the peg allowed them to reduce their balance sheet. The doubling (or whatever) of the balance sheet *after* the peg was established was due to the situation in Europe, not the peg, in Scott’s attribution of blame.

        So even if the balance sheet went up 10x after NGDP targeting, Scott would still think he was right.

        • Andrew_FL says:

          That strikes me as special pleading, too.

  2. Anonymous says:

    I am quite aware of the problem and that is why charging banks to hold franc balances at the SNB is sensible. The charge should compensate the SNB for the risk of a negative return on its asset portfolio.

    Your diagram showing a sharp increase in base money, and your account here that it would be inflationary shows a bad framing of monetary analysis. It isn’t unusual. Demand for money (or velocity) constant. And then, assuming that all money creation is permanent. And the scenario here is just difficult to grasp.

    Of course the whole problem is that there has been a surge in the demand for Swiss francs and it could easily be temporary. Maintaining monetary equilibrium (leaving aside your preferred option of a price and wage deflation) requires an temporary increase in the quantity of base money.

    This is why central banks should have assets that they can sell.

    If the demand for money is always rising at a slow, steady rate, that just isn’t an issue. But that scenario (constant velocity more or less) is not realistic.

    So, what is the likely loss on the SNB asset portfolio based upon appreciation of the SNB necessary to maintain monetary equilibrium in Switzerland?

    Would such appreciation really be consistent with a large decrease in the demand for Swiss francs?

    Can you see the contradiction in your scenario?

    Change your framing and it will all become clear.

    • Bob Murphy says:

      Anonymous wrote:

      So, what is the likely loss on the SNB asset portfolio based upon appreciation of the SNB necessary to maintain monetary equilibrium in Switzerland?
      Would such appreciation really be consistent with a large decrease in the demand for Swiss francs?
      Can you see the contradiction in your scenario?

      You’re saying it’s a contradiction to think that Swiss consumer price inflation could be higher than Swiss officials want, and that Eurozone price inflation could be higher still?

      No, that’s not a contradiction, and I even specifically spelled this part of my argument out in case someone thought it was impossible for the Swiss franc to rise against the euro at the same time that Swiss officials wanted to tighten.

      • Transformer says:

        “You’re saying it’s a contradiction to think that Swiss consumer price inflation could be higher than Swiss officials want, and that Eurozone price inflation could be higher still?”

        If you target a specific exchange rate then then of course the price level can become indeterminate for the reason you give. The can be avoided if you target the price level directly, can’t it ?

        • Bob Murphy says:

          Transformer, yes you can directly target the price level. But you can’t directly target your domestic price level and the exchange rate of your currency with a foreign currency. If you try to do both, and load up your balance sheet in the process, it might blow up in your face. Anonymous above was suggesting it was a contradiction to think that.

  3. Max says:

    What you say makes perfect sense, but it doesn’t explain the timing of the movie. Euro zone inflation is at an all time low. And after lifting the ceiling, the SNB resumed griping that the franc was overvalued! So they are confusing everyone.

  4. Transformer says:

    I’m pretty sure Nick Rowe has covered this case in a recent post. If the CB ends up with a zero balance sheet then the government has to run a surplus (tax more than is spends) to reduce the money supply and hit the inflation target.

    Of course this is not great but is it not better than years of recession due to monetary disequilibrium ?

    • baconbacon says:

      The problem here is that the potentail for asset sheet accumulation is practically infinate,while the possbility for tax surpluses isn’t even close.

    • skylien says:

      The solution is that congress has to perform monetary policy and hit the inflation target? Good luck with that!

      😉

      • Transformer says:

        But with a fed balance sheet of 4 trillion , and no sign of inflation, I think we some way from that being an issue.

        • skylien says:

          If things move in the wrong direction, they can move very fast. In my view capital-value disequilibrium is increased in the market with an ever higher CB balance sheet.

          So it is not the bigger the balance sheet the more room the CB has to act for the same volatility of market moves, no the bigger the balance sheet the more volatile the market moves will be, while volatility is not increasing linear with the balance sheet but whatever more than that…

          • Transformer says:

            So you’re saying then when the CB expands the monetary base and its balance sheet (and probably drives up asset prices) its creating a danger that one day with little warning everyone will freak out and start to offload all the currency that they hold? And even if the CBs sells all of it assets to soak up this excess currency it will not prevent hyperinflation? And even though the fiscal authorities could avert this inflation (via vacuum cleaner money) they will not do so ?

            I cannot deny the logic of such a scenario – I just find it a bit of a stretch to envisage this happening. I would rather compare this risk to the real benefits of allowing the supply of a virtually costless asset (money) to expand to meet the demand for it, the way it probably would under free market conditions.

            • skylien says:

              Basically yes. Well I am not sure if it really means hyperinflation, but at least lots of very nasty and unnecessary market swings, I mean yes at some point there would be hyperinflation inevitable, but don’t ask me how big the balance sheet needs to be or what other factors might increase/decrease this possibility.

              Whatever would happen in a free market wouldn’t distort capital-values because every bit of money given out was done from a private entity financed by its own equity, which binds them not to over-issue.

              A CB isn’t bound by that, and they more or less buy arbitrary assets to get money into the system, distorting the value of those assets, and at the same time arbitrarily setting the cost of borrowing which affects all assets, not just those bought by them… You just can’t copy the free market with a CB.

              Also I have trouble with the monetarist line “it is just meeting the demand of money”. This is meaningless. If that was true there is no reason to ever stop issuing more and more money. But this is wrong, what people demand is purchasing power, and that cannot be printed. It is not about meeting the demand of money, it is about targeting certain things like inflation, NGDP whatever. But at no point you could say, now we have met all demand for money to the full extent. (Take me for example, my demand for money relatively to other assets increased because of all those, as I believe, foolish acts of central bankers and governments. However since I know that they want to satisfy my demand with just printing it up, I moved my actual demand which is purchasing power to precious metals, I am not trusting the EUR anymore as a reliable store of value, I only use it as medium of exchange, but otherwise try to avoid it).

            • skylien says:

              Discussing economics can be so much fun, if you are just asking questions, getting them (all!) answered politely, answering questions (hopefully) politely myself. No one calls the other one an idiot or tells him how they don’t understand anything etc..

              Thanks!

            • Major.Freedom says:

              Transformer:

              “I cannot deny the logic of such a scenario – I just find it a bit of a stretch to envisage this happening. I would rather compare this risk to the real benefits of allowing the supply of a virtually costless asset (money) to expand to meet the demand for it, the way it probably would under free market conditions.”

              And that is precisely where the fundamental flaw in MM resides. The claim to knowledge that only information from a free market can actually provide. Hedging such arrogance with phrases like “probably” are clearly rhetorical devices only to mask your presumptions here.

              Fiat money production is not costless. It is not virtually costless either. Your theory prevents you from even recognizing the costs. Your claim concerning the costs is not grounded in economics, but short term political opportunism and a desire to convince those who bear the costs you do not understand, that fiat money is tantamount to a free lunch. In this way, you also seek to smear the inflation hawks and free money advocates as bah humbug curmudgeons whose motivations can only be out of spite and contempt.

              You are ignoring many costs. The biggest cost is of coursr the direct costs of maintaining the state apparatus itself, which is a minimum requirement for any central banker data entry analyst to even be in the position of clicking a few computer keys and adding zeroes to account balances. Then there are the costs of influencing the economics establishment through financing research grants to those favorable or apologetic to monetary socialism. All of the real goods and services used up in these processes are real goods and services that could have otherwise been enjoyed by participants in a free marmet., but instead are directed towards the state itself and the central bank. And this is not small potatoes. The state and central bank are very very expensive, both in nominal and real terms. You do not consider these costs because your political advocacy blinds you to them.

              Those costs alone show your claim of “virtually costless fiat money” to be a mockery of reason and economic principles. It is as if you believe promoting mafias and criminal gangs is virtually costless if all you did was mention that you are only calling for more bullets, the costs of which are in the pennies, and ignoring the costs of maintaining mafias and criminal gangs.

              But there are other costs you ignore. These are the opportunity costs that you in your scientistic bias do not consider, because you cannot observe them. These costs are all those specific goods and services could have otherwise been produced and consumed had it not been for the fiat money system redirecting real resources towards the maintenance of state power (for necessarily its own sake). It is quite possible for all those trillions of dollars in redirected wealth to have otherwise been used in the market to produce jaw dropping, game changing technological advances that NOBODY saw coming except a few intrepid entrepreneurs that had zero political pull or influence.

              There are more problems in what you wrote. Namely, your assumption that the central bank is just there to print money at “virtually no cost” to “satisfy additional demand for dollars.” Foolishness! You don’t even understand that the desire for more wealth, money included, is practically infinite. You ask anyone if they would be willing to accept double the money for the same labor, and you would always find that the “demand” for additional money is as far as you can tell, unlimited.

              What you are actually doing when you claim to know of a demand being satisfied here is nothing but a promotion of YOUR preferred limit, maximum, supply that ought to be increased to meet what is a practically unlimited demand. You believe that the practically infinite demand should be met with whatever quantity of inflation that will being about a constraint to NGDP. The demand should be satisfied you say, but tacitly only to the degree that results in NGDP rising by a “nice stable rate”. For all the additional demand, you say it should not be met with additional supply of money. YOU want to have YOUR limits imposed on everyone, and yet you claim all you want is for demand for money to be met with central bank inflation.

              The truth of course is that you don’t know what that constraint should be. It is not whatever volatile change in money growth that results in your preferred stable NGDP. It is a false characterization of free markets to presume that there would be 5% NGDP growth every year. Such pomposity! Free markets are erratic and are not “stable” in money or spending. It is a lie to claim that NGDPLT is “probably close to” a free market. Not when market forces made NGDP decline by double digit percentages in the early 1930s and 2008-2009, that the Fed “failed to reverse”!

              Stable NGDP is in fact perfectly consistent with an increasingly “sick” economy. No such sloppy rhetorical tactics as “probably” or “likely” can eradicate this.

              You are a witchdoctor telling us all to ignore the FULL costs of central banking, and presenting central banking as “virtually” a free lunch.

              I am not decieved by your madness, FYI.

              • The Pen Is Mightier says:

                *applause*

              • skylien says:

                „You are a witchdoctor telling us all to ignore the FULL costs of central banking, and presenting central banking as “virtually” a free lunch.

                I am not deceived by your madness, FYI.”

                MF, I just don’t see why this is necessary. If you call someone mad and a witchdoctor than you imply bad intentions and/or being mentally ill. Nothing of this is the case for Transformer. People just can be genuinely wrong, without being stupid, mad or evil…

              • skylien says:

                “…witchdoctor *then* you…”

              • Transformer says:

                MF,

                Sounds like you are probably not an advocate of fiat money, and likely suspect it has hidden costs.

                Do you have any examples you can share of those hidden costs ?

  5. baconbacon says:

    While I am not one of the sharps I came up with a hypothetical showing how the SNB couldn’t keep the peg if the ECB wanted to break them. http://sebwassl.blogspot.com/2015/01/a-sillyscary-thought-experiment-on.html

  6. Transformer says:

    ” It is possible to imagine a scenario where they totally lose the ability to restrain domestic price inflation to their target goal, because they foolishly loaded up their central bank’s balance sheet with (say) 120% GDP worth of a foreign currency.”

    Of course, in theory at least, they could end up with a zero balance sheet if the assets they bought to stop deflation depreciated in value by the time they had to sell them all to prevent inflation at a later date.

    But remember the overall goal of monetary policy is to stabilize thee economy by adjusting the size of the monetary base. Buying/selling assets is simply the optimal way of achieving that end. In the unlikely and unprecedented situation where the CB ended up with a zero balance sheet it would simple have to adjust the size of the base in a different way (vacuum cleaner money as Rowe calls it).

  7. Yancey Ward says:

    In the past, I have often encountered the argument, from those very same people, that counterfeiters are different from central banker in that the bankers have assets backing their currency issue. Now they argue that the it doesn’t matter if a CB is insolvent. Nice.

  8. The Pen Is Mightier says:

    I really don’t understand why macro economists believe they can completely ignore public choice theory. No central bank is going to follow some theoretically optimal target because their incentive structure isn’t aligned that way. Even Friedman (eventually) understood that his constant monetary growth rule wasn’t going to happen. NDGP targeting isn’t going to happen either. Isn’t a macro scholar’s time better spent working on free banking or investigating other alternatives to a central bank? Of course, work on the causes (whatever they are) of boom and bust are always critical. In any case, central banks (including the Fed) should be analyzed for what they are: government agencies.

    Side note:
    Sumner is a smart guy, but the FAQ page on his personal blog is just hilarious to read in light of public choice theory. Krugman and his ilk, on the other hand, live in la la land.

    • AD says:

      NGDP targeting is about a thousand times more likely to happen than free banking.

      • Major.Freedom says:

        A “permanent plateau” in the stock market was a thousand million times more likely than a second world war.

        Cool, I love making things up and pretending they are scientific too.

      • The Pen is Mightier says:

        AD,

        Please share with us precisely how you came to your probabilities.

        I can’t put specific probabilities on it, but I’d say Bitcoin made free banking a whole lot easier than NGDPLT. 🙂

    • Andrew_FL says:

      Actually, the problem with the original constant growth rate rule that forced abandoning it was that once checking accounts were allowed to bear interest, the money supply definitions previously used ceased to be operationally useful. To put it another way, the velocity of such measures suddenly became unstable.

      As Roger Garrison calls it, “The Irony of Monetarism”: “Implementing its policy recommendations, which were intended to allow the market economy to preform at its laissez-faire best, depended critically on this one little piece of intervention called Regulation Q. ”

      But I do agree that Central Banks are unlikely to abide by any particular rule consistently. One could in principle replace them with a computer but that raises it’s own questions.

  9. Pierre says:

    Hello all,

    HELP ME, I’m Swiss (and no economist).

    My understanding had been that the main problem with the “peg” was that the huge amount of Swiss francs created in order to buy euros would eventually end up spilling into the real economy (since cash and bonds have very low returns), thus creating price inflation, maybe in the form of a real estate or stock market bubble. It seemed logical that, unless the SNB reversed course and started buying back francs, some of all those francs would end up causing trouble in the real economy, at least in the long term. Did I understand something wrong? Then what?

    Please show some compassion for that Swiss (austrian-friendly) citizen whose economic understanding mostly stops at Hazlitt and Bastiat!

    (I also stumbled upon that blog post, which was not very comforting either: http://monetary-metals.com/the-swiss-franc-will-collapse/)

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