Saturday, January 17, 2015

A silly/scary thought experiment on the Swiss Franc

The ECB is generally expected to launch a QE program sometime next week (late Jan 2015), last week the SNB dropped its price ceiling relative to the Euro.  What would happen if the SNB had retained the peg and the ECB started a large QE program?

1.  QE should devalue the Euro
2.  The Franc then rises vs the Euro
3.  The SNB steps in and prints Francs to buy Euros and maintain the peg.

Simple, right?  But we totally skipped WHAT the ECB is buying.  What if they decided to pursue QE by purchasing Francs?  What kind of mad world do we live in if that happens?

1.  ECB prints Euros to buy Francs
2.  Francs rise double fast (purchases increase the number of Euros AND decrease the number of Francs availible)
3.  SNB steps in, prints 2X (more than 1X as many, not necessarily 2X) as many Francs to maintain peg.
4.  SNB purchases pull Euros out of the market sterilizing their QE.
5.  ECB prints Euros and buys Francs
Repeat steps 2-5

If both banks honor their commitments and react reasonably quickly to price changes we would (expect) to see the Franc hit 1.20 and stick like glue.  With both sides having infinite ammunition in this fight there is no logical end in sight.  What should happen to those currencies compared to other currencies?  Other than some froth early on I think you can make a case for nothing (I think you could also make a case for nothing followed by complete collapse).  No new Euros will functionally hit the market before being snapped up by the Swiss and no new Francs will enter flows, they will be stocked up by the ECB. 

Is the effect really neutral though?  I think perhaps not.  In the end the banks will lose some control over their own currency and gain some control over the other parties currency.  If these two entities were of equal size then the effects would be a wash, but because the ECB represents a much more massive economic conglomerate than Switzerland the relative number of Francs it would have to put on the market to alter the value of the Swiss currency is much smaller.  In this game of chicken the Swiss would be giving up sovereignty (conservatively) ten times as quickly as the ECB would be. 

Don't believe me?  Imagine the ECB initiates QE equal to 100% of Swiss GDP (lets pretend everything ends up 1:1 nicely for simplicity) by buying Francs- the SNB expands its balance sheet by 100% of GDP by purchasing Euros to sterilize this action.  Now the ECB turns around and uses those Francs to buy US dollars.  What happens to the value of the Franc with around 800 billion newly minted ones hitting the market and 800 billion dollars getting soaked up?  Unless the Swiss want massive inflation (not 2-5% inflation but double and maybe triple digit inflation) they have to dump some of their holdings- which are overwhelmingly Euro denominated- to soak up those Francs and the Euro should depreciate vs the Franc (and also vs the Dollar). 

There is a lie floating around the ether that a CB can control its own currency with enough gumption.  That may be true (its probably not) but it immediately becomes false when a country pegs to another currency, and becomes false and really dangerous when it comes to pegging vs a much larger currency. 

If we combine this post with one from earlier today we have a rational explanation for the Swiss abandoning the peg.  That little (ie 20-30 billion francs) increase in late 2014 in SNB holdings indicate that the Swiss had not convinced the market of its commitment to maintain the peg.  To match a big QE program from the ECB the Swiss would be giving up substantial autonomy for future moves.  Even if the ECB wasn't specifically buying up Francs it would still be the major buyer of paper when Francs were flooding the market.  Either directly or indirectly the ECB would be major players in the Franc's future. 


  1. Baconbacon, I don't understand your argument. Your argument is (approximately) that if the ECB and SNB both stocked up on each other's currency, and then the ECB sold its SF for USD, then the SNB is screwed (massive SF inflation). I am not seeing this at all. As the value of the SF falls relative the the USD, it also falls relative to the Euro, if I can assume all else remains equal. What shall the poor SNB do? Let me think... can anyone think of anything?

    How about ... it could sell its massive holdings of EUR and buy back SF?? It would make a fantastic profit (as the SF has become cheaper in EUR terms), while successfully managing aggregate demand in the Swiss economy (avoiding the inflationary collapse you imagine).

    What am I missing?

    The idea of "competitive devaluation" never made any sense to me. This is not a "beggar thy neighbor" situation. If everyone tries to devalue relative to everyone else, then we get widespread monetary expansion, which is just the thing we need to fight the real problem, which is insufficient aggregate demand. The so-called "currency wars" would be a *good* thing, if they were actually to happen.


    Kenneth Duda
    Menlo Park, CA

    1. Ken, if the two monetary zones are of a similar size there is no issue, but when one is 10 times bigger than the other there is a problem. Lets say the peg was 1:1, and the ECB decided it wanted to print 1 trillion Euros, the SMB to stop appreciation would have to print 1 trillion Francs (give or take) to buy those Euros. But if the ECB dumping 1 trillion Francs onto the market and buying dollars doesn't have a 1:1 effect inflation wise as the SNB dumping 1 trillion Euros. Last remember that the SNB has a peg AND a desired inflation rate. The odds of the SNB being able to buy up exactly the right amount of Francs to maintain the peg also being the right amount of Francs to keep within their inflation range is low because of the vast size differences.

    2. To "competitive devaluation"- Lets say only two monetary zones exist- the ECB and the SNB. When the ECB loosens buy buying Francs, and then the SNB loosens buy selling Francs and buying Euros, none of those units of currency actually end up interacting with the material market. There is no reason to believe that the price of oil, gold wheat or whatever will shift because these banks are trading assets. Not it is a bigger leap to move out to our current environment, but I am working on a post about that.

  2. sorry, that came off snarkier than intended.