SNB decision tells us that the crisis is entering a new phase

Switzerland – homeof the secret bank vaults, which house treasures stolen from people (particularly the Jewish victims) by the Nazis during WW2 and ill-gotten cash by capitalists who wish to evade scrutiny of prudential and tax authorities of their domiciled nations. Now it is the canary, which has just sung to tell us that all the hubris about Eurozone recovery cannot cover up the reality that the crisis is not yet over and requires root and branch reform to the policy ideology that exposes the floored design of the monetary union. The – Decision – last week (January 15, 2015) by the Swiss National Bank (SNB) to both break the peg of the Swiss franc to the euro and cut its interest rate on sight deposits to -0.75 per cent signals the surrender by that nation to the reality surrounding its borders. The interest rate decision was required after it decided to scrap the exchange rate peg, given that it didn’t want a credit crunch killing the domestic economy. The appreciation of the exchange rate, which has been held artificially low by the peg, will already undermine domestic spending. The SNB said its decision as reversing its previous “exceptional and temporary measure”, which “protected the Swiss economy from serious harm” as the exchange rate became overvalued. But the decision itself was rather extraordinary given it was seemingly so surprising for most and central bankers are meant to be cautious types.

But the decision has a logic that is easily understood by those who are not trapped within the Euro Troika narrative.

What the decision means is that the exchange rate quickly appreciated from its pegged value and is looking like being stable at the new parities.

This is what happened (graphically, using daily data):

But this is a longer-term view (using monthly data) and I have expressed the currencies in reverse order in this graph so an appreciation is a fall in the graph. The reason for presenting the data in this way is because the SNB provides the raw data in two different forms and I was just saving myself time. But then, of course, once I had created the graphs I realised that typing these three lines took me more time than computing the reciprocal in Excel!

The arrow shows the appreciation that particularly against the USD but also the yen and the euro, which led the SNB to impose the peg on September 6, 2011. At the time, it was clearly a decision aimed to protect the export sector, which is the largest as a percentage of GDP in the world (around 73 per cent, compared say to South Korea (54 per cent), Germany (46 per cent), China (27 per cent), Japan (16 per cent) and the US (14 per cent).

At the time, the SNB released a press statement – Swiss National Bank sets minimum exchange rate at CHF 1.20 per euro – which said:

The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development … With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.

That means it acknowledged its currency sovereignty and its capacity to create “unlimited quantities” of it to pursue its stated goals.

As the graphs show, the decision clearly stabilised the CHF against the euro and the other leading currencies.

Of course, the operations associated with the strategy increased the SNB’s holdings of foreign currency reserves (particularly the euro). The arrow marks the announcement in September 2011.

Some might think that the SNB balance sheet looks very similar to that of the US Federal Reserve, or that of the Bank of Japan, or the Bank of England for that matter. Hasn’t QE increased the reserves of these central banks in the same way as the SNB reserves grew?

The answer is that the SNB hasn’t been engaged in QE, which we understand to be the purchase of sovereign bonds in exchange for bank reserves. Rather, the SNB has been buying the currencies of other nations in exchange for francs and so the valuation of its reserve holdings are highly exposed to movements in those currencies.

This leads to the mainstream argument that the SNB made the decision because they expect the ECB to announce the introduction of quantitative easing (QE) this week, which would lead to a huge increased demand for Swiss-currency denominated financial assets from parties who would have previously invested their surplus funds in euro-denominated assets.

The demand for Swiss francs and sale of euros that would accompany this type of portfolio shift would then have required the SNB to purchase further substantial volumes of euros to maintain the peg.

So? The SNB foreign exchange reserves would have risen accordingly and build on record levels already held by the bank. So? First, this would mean that the ECB would continue to call the shots on Swiss monetary policy, which means that Switzerland’s currency sovereignty would be compromised.

Second, the mainstream argument is that the SNB would be fearful of holding even more foreign currency reserves given they have already risen by around 800 per cent since 2009.

Why? It would expose them to paper losses on their foreign currency holdings (as the exchange rate appreciated) and to minimise those losses the SNB decided to stop building euro-denominated reserves.

I would not support that interpretation. The SNB has no need to be concerned about these paper losses given it is the currency-issuer. Unlike a private bank, the SNB could operate with permanent negative capital.

Please read my blog – The ECB cannot go broke – get over it – for more discussion on this point.

While the central bank officials would hardly acknowledge the logic in that blog in public, the fact remains that they know it is fact and would hardly have made the decision on the basis of the myth that they can go broke.

I also don’t think the recent conservative demands that the nation return to the gold standard explain the SNB decision.

I am guessing that the SNB has realised that with such a consertative fiscal position being run by the Swiss government and policy austerity surrounding its borders that deflation is inevitable and that they may as well return to a more normalised position (historically) now before the ECB changes its strategy.

On January 16, 2015, Eurostat released its latest inflation indicator for December 2014 – Annual inflation down to -0.2% in the euro area – which confirmed that Europe is now caught in a deflationary spiral, which is likely to accelerate given the cuts in oil prices. Switzerland’s annual inflation rate fell by 0.1 per cent in December 2014.

Greece is deflating quickly (-2.5 per cent) which reinforces my earlier suspicions about the claimed recovery. Please read my blog – Alleged Greek growth could be an illusion – for more discussion on this point. As an aside, the German paper, Der Spiegel quoted from my blog last week (January 13, 2015) in this article – Ist die griechische Statistik erneut geschönt?.

A deflationary environment is not consistent with a broad-based and robust recovery. It tells us that domestic demand is weak and getting weaker, notwithstanding the fact that the declining oil prices (a supply side boost) are, in part, responsible for the falling price levels.

Deflation means that debtors are now worse off in real terms and this is likely to discourage any major credit boom in the period ahead. With governments running austerity stances and net exports a zero sum game across nations, recovery in most nations required domestic demand to expand.

But with private domestic debt levels already high (as a hangover from the pre-GFC credit binge), the motivation to expand private investment by firms is unlikely to be high in a deflationary environment, especially as consumers will be putting off major purchases in anticipation that goods and services will continue to get cheaper over time.

The accompanying interest rate decision was designed to take some upward pressure of the CHF by providing a disincentive to purchase CHF-denominated financial assets.

But there is a broader point that needs to be examined which exposes the mainstream myth that investment is reliant on private saving. This myth is buttressed by a related myth that fiscal surpluses increase national saving and make more funds available for private investment.

Please read my blog – Budget surpluses are not national saving – for more discussion on this point.

The deflationary environment will further undermine the investment climate in the world. By investment I am using the economist’s definition – spending by business firms on productive capital such as equipment, buildings etc – rather than speculative spending on financial assets.

We have seen saving ratios rise again as a result of the GFC and the policy response to the rising fiscal deficits brought about by the crisis has been to invoke contractionary initiatives (austerity).

So has investment increased to eat up all those available funds in the loan markets? With all those bank reserves (liquidity) why hasn’t bank lending gone crazy?

The answers are No and What! No, investment ratios have continued to fall or flatten out at depressed levels. What – is reference to the absurdity of the argument that banks loan out reserves. Please read my blog – – for more discussion on this point.Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

The following graphs show the investment ratios (total fixed capital investment as a per cent of GDP) for the EU/Eurozone and then some selected Eurozone nations.

What these graphs tell you is how entrenched Europe is in economic stagnation despite the tepid growth in recent quarters.

Households are adopting cautious spending strategies given the high unemployment and the suppressed real income growth. Net exports will not drive widespread growth in all nations of the Eurozone, especially now that China is slowing.

Fiscal austerity is denying the public sector as a growth source.

Which leaves private investment as the saviour. But the investment ratios are showing that firms are not willing to return to pre-crisis levels of investment scaled against the size of the economy.

The decline in the PIGS (Ireland is omitted for lack of comparable data) is spectacular and the situation in Italy is deteriorating further (the data goes to the third-quarter 2014).

The situation in the US is somewhat different and the Investment ratio has slowly improved since 2010, which is consistent with the recovery that is underway in that nation. I have noted elsewhere that the US recovery was supported by an on-going fiscal deficit, a support that the mindless policy makers in Europe have denied their economies.

The SNB decision has to be seen in that light, although that doesn’t provide any inside intelligence as to what was the actual reasoning that led to that decision.

With unemployment low, it might have been that the SNB is prepared to let its export sector suffer a bit of contraction (via the exchange rate appreciation) and push the political consequences back onto the Government, which can then adjust its contractionary fiscal policy to compensate for the decline in net exports.

I suspect the SNB’s decision will cause the Swiss more angst than they might have thought. But the SNB is only one arm of economic policy and the decision will now shine a spotlight on the conservative fiscal stance that the Swiss government adopts.

I also suspect that the SNB didn’t want to be seen as moving lock-step with the ECB, which is certainly not a model on which to base monetary policy settings.

Conclusion

Time will tell what the medium-term consequences of the decision will be.

But what it tells me right now is that the crisis is entering its ‘mature’ phase where the prolonged fiscal austerity and entrenched mass unemployment throughout Europe is now causing deflationary forces to accelerate, which will further undermine the chances of recovery.

The SNB’s decision is an acknowledgement of that – they seem to have decided to cut and run and take the consequences now.

I have to attend to meetings in Colombo now!

That is enough for today!

(c) Copyright 2015 Bill Mitchell. All Rights Reserved.