SNB, CHF, ECB, and QE

The last two weeks have been full of monetary news with the Swiss Franc peg, and the ECB's announcement of Quantitative Easing (QE). A few thoughts.

As you have probably heard by now, the Swiss Central Bank removed the 1.20 cap vs. the euro, and the franc promptly shot up 20%.

To defend the peg, the Swiss central bank had bought close to a year's Swiss GDP of euros (short-term euro debt really) to issue similar amounts of Swiss Franc denominated debt.

This is a QE -- a big QE. Buy assets, print money (again, really interest-paying reserves). So to some extent the news items are related. And, it's pretty clear why the SNB abandoned the peg. If the ECB started essentially the opposite transaction -- buying debt and selling euros -- the SNB would soon be awash.

A few lessons:


A peg depends on credibility. The dollar is pegged to 4 quarters. The Fed is not racking up huge dollar for quarters QE, because everyone knows it will always be thus. The fact that the SNB had to buy euros at all is a great signal that everyone knew the peg was temporary. As, in fact, the SNB had made pretty clear. Sometime or other, probably when it's most important, investors thought, Swiss Francs will shoot up again. Might as well buy more of them.

An exchange rate peg is fiscal policy.  Really, the "credibility" a country needs is fiscal credibility.

The peg fell apart because the SNB was trying to do it alone. On the day of abandonment, the SNB lost about 20% of its balance sheet, since it owns Euros and owes Swiss Francs. Had things gone on any more before the plunge, they would have had to go begging to the Treasury for a recapitalization. "We just lost 20% of GDP, could you please send us some fresh government bonds to back our CHF debt issues?" That works seamlessly in economic models, but would be a political nightmare for a central bank.

So, if you want to run a peg, it should be done jointly with the Treasury. The central bank buys euros, sells francs, but immediately swaps the euro debt to the treasury for CHF debt. That at least is removes the first fragility, by taking the fiscal risk off the central bank balance sheet.

From the point of view of the nation as a whole, a strong demand for your government debt (that's what this is) is an invitation to profligacy, not a fiscal danger. That's why pegs usually break in the other direction: The central bank tries to peg a currency, let's call them pesos, against another, let's call them dollars. (Or gold.) People start to ask for dollars in exchange for pesos, the central bank starts to run out of reserves. At this point the treasury has to either tax, reduce spending, or credibly promise future taxes or spending reductions to borrow some dollars, and given them to the central bank in exchange for the bank's government debt. When that can't happen, the peg breaks. The essential problem is fiscal.

Switzerland had this in reverse: The Swiss were too darn thrifty.  Americans and Greeks know what to do if world capital markets come knocking and want to buy boatloads of your government debt. Print debt, give it to them, and send us Walmarts full of goods, or driveways full of Porsches.  Norway had a similar issue, with the world wanting to buy its oil. Norway decided not to go on a consumption binge, so their sovereign wealth fund buys equities; rights to future consumption.

Switzerland could have done the same: sell CHF bonds, use the proceeds to go on a consumption binge or buy about a year's GDP of foreign stocks. Instead, a referendum threatened a return to the gold standard.

Or, they could have said, "and by the way, we declare that we have the right to pay off our government debt in euros at 1.20, or to swap CHF debt for euro debt at that rate." Now that would have really enforced the peg. Devaluing the currency means engineering a partial default on government debt. Its fiscal policy and can't be done by the central bank alone.

QE and the ECB

Ben Bernanke famously said that QE works in practice but not in theory.  What that means, of course, is that the standard theory is wrong, and to the extent it "works" at all, it works by some other mechanism or theory. Permanent price impact by changing the private sector portfolio composition is the "theory" that Bernanke acknowledges really makes no sense. So why might a QE work?

In the US case, QE was arguably a signal of Fed intentions. Buying a trillion dollars of bonds and issuing a trillion dollars of, er... bonds (reserves are floating-rate debt) is a way for the Fed to tell markets that it will be years and years before interest rates go up. As I chat about QE with economists, this pretty much surfaces as the most plausible story for QE effects (along with, there weren't any long lasting effects.) Greenwood,  Hanson, Rudolph, and Summers make this point nicely, showing that Fed-induced changes in maturity structure have about twice the effect that Treasury selling more bonds does -- though exactly the same portfolio effect.

But what is the signal in ECB QE? Well, a decidedly different one. The signal is, I think, not about interest rates, but that the ECB will buy government debt. "What it takes" is now taken. Yes, there is this lovely pretense that national central banks buy the bonds, so the ECB doesn't hold credit risk. But if a country defaults, where is the national central bank going to come up with funds to pay the ECB?

So, when we think of what expectations people derive from ECB QE, and with that how it might or might not "work," the obvious conclusion is that the Eurobonds are now being printed. Like all bonds, they will either be repaid, inflate, or default.

Torsten Slok sends on this interesting graph. 80% of Greek debt is now in the hands of "foreign official." Now you know why nobody is worrying about "contagion" anymore. The negotiation is entirely which government will pay.