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Wednesday, January 21, 2015

What Are Government Promises Worth - Gold, The SNB, And Sovereign Debt (Part 1)

The shock decision by the Swiss National Bank (SNB) to drop its policy of capping the strength of the Swiss franc came as a shock to most, and proved to be financially painful for some. Certain policies, such as gold or currency pegs, are inherently unsustainable, and the only question is the timing of the end of the policy. But in the case of the SNB's policy, it appeared financially sustainable, as they have unlimited capacity to create francs. This creates an uncomfortable parallel with government bonds - they are typically viewed as default risk-free since the government can create money at no cost.

Due to its length, I have split this article into three parts. The first part discusses currency and gold pegs, and the second will discuss inflation and nominal GDP targets, and the third and final part discusses the promise to pay back government debt.

Let's Be Honest - People Are Not Honest

I have seen a certain amount of moaning about the fact that SNB officials made reassuring statements about their policy just before they pulled the plug on it. That is a fairly silly complaint; as soon as a policy change is hinted at, the markets would immediately move to price it in. If the SNB had attempted to keep the floor in place at the same level after announcing the policy was going to be dismantled in a few days, they would have face a massive wave of orders to buy francs. They could have doubled their position size in days.

More generally, I would not view governments as being more untrustworthy than any other body that has to make decisions that are unpopular. Corporate officers reassure employees that all is fine while they are making up lists of who will be released during a lay-off. And unlike corporations, governments in developed countries face voters periodically; they have to adjust policies as the winds blow.

In general, we always have to keep in mind that all government promises are conditional upon those promises being consistent with what policymakers view as the national interest. Any analysis of markets that are affected by government promises - in particular, government bonds and currencies - need to track how costly those promises are to keep.

Gold Parities - Inherently Unsustainable

Chart: Gold And The Closure Of The Gold Window
In a gold or currency peg, a government promises to keep the price of an external asset (gold or foreign currency) at a fixed price versus the local currency. To back this promise up, it is usually possible to redeem the local currency in exchange for the external asset. (The details vary by case; for example, under the Bretton Woods system, only foreign governments could exchange U.S. dollars for gold.) For simplicity, I will discuss a gold peg herein; the mechanics of an exchange rate peg are fundamentally similar, but the details of implementation are often more complex.

Why do gold pegs fail? The amount of government money is typically larger than what is implied by the amount of gold outstanding. For example, assume that the monetary base was twice what is "covered" by gold. If there is a rush to redeem money, it would only take redemption of half of the monetary base to liquidate the government's total gold holdings. The remaining money would be left "uncovered" completely. This creates a self-fulfilling run on gold; governments historically either suspended gold redemption or changed the gold parity (the rate at which gold is bought or sold). If other countries have fixed pegs to gold, this creates a devaluation in the currency.

Currency pegs are incompatible with fractional reserve banking; since the government only covers a portion of the monetary base, and bank deposits ("bank money") is a multiple of the monetary base, a run on "bank money" is always possible. This is why one should generally expect currency pegs to fail at some point.

A gold parity or a peg to a foreign currency is a promise that cannot always be kept, as governments cannot create gold or foreign currencies out of thin air (excluding industrial counterfeiting operations). If you want to analyse a government with such a promise outstanding, you cannot look at the government's intentions; you have to monitor whether it has the capacity to keep its promise (like any other creditor).

Gold Parities Too Easily Broken

I have read many texts advocating a return to the Gold Standard that were written over the past couple of decades. What strikes me is the general lack of analysis of what happens after the return to a gold peg.

Firstly, a gold peg constrains government policy (which is why libertarians generally approve of gold pegs, although some prefer other rules-based policy, such as a Taylor rule). Since there is a broad consensus amongst non-Austrian economists that gold pegs are a bad idea, successor governments will be advised to break the peg upon almost any difficulty. Meanwhile, investors now have access to a long history of gold pegs, and they know that governments easily dismantle them. Look at how often JGB bears have tested their theories about the "unsustainability" of Japanese finances; a gold peg would be under continuous waves of speculative assault.

Meanwhile, there is almost no political cost to dismantling the peg. Although gold is a commodity that cannot be created without cost, it is hard to ascribe a value to it. The fact that people can calmly discuss price targets that are multiples of the current market price indicate that it is a speculative vehicle, not a consumer good that can be traded off versus other goods and services. Since most citizens want to use money and not gold, they do not care if the gold parity changes. It does not affect their life whether the price of gold is $22/oz, $35/oz, or freely floating. The only reason people cared during the Gold Standard era about gold parity changes was that it would affect the exchange rate; but if other countries are not on gold, it does not matter what a country with a stand-alone peg to gold does with its parity.

A gold peg is pre-destined to fail. Why would politicians waste political capital on such a doomed enterprise?

(Note that currency pegs are typically more costly to break. This is because people have a foolish tendency to borrow in foreign currencies if they believe the exchange rate will be stable.)

The SNB "One-Sided Peg"

Swiss Franc - Euro Cross Rate
The Swiss National Bank's policy of preventing the Swiss franc from strengthening below 1.20 francs per euro was interesting in that it was financially sustainable. (Reminder: a lower number for the euro/franc exchange rate means a stronger franc versus the euro.) This case is interesting, as it is a "one-sided peg"; since it can always issue currency at zero real cost, it should be able to keep its currency from strengthening.

Even so, the Swiss decided to drop their policy. I assume that the real reasoning behind the decision has yet been made public, but the following arguments seem to be behind the decision.
  • The SNB has (minority) private shareholders, as well as the Cantons. Policies have to be understood by those backers, who are unlikely to understand how central banks differ from commercial banks.
  • The SNB had taken losses on their gold holdings in 2014, causing them to be skittish about further losses.
  • The size of the SNB's balance sheet was "too large", and it was exposed to "large financial losses" from an exchange rate move. Since it was only going to lose money if it dropped its policy (but see below), the policy change was self-defeating on this metric.
  • The policy entailing purchasing euro government bonds in large quantities. The SNB could have been worried about credit losses on those bonds. I think such fears have a very rational basis.
  • The SNB had some undefined fear about what would happen during a policy of ECB quantitative easing. This fear seems to be somewhat akin to being worried about witchcraft, so I cannot hope to explain it.
  • Euro area policy makers objected to the policy, since it kept the euro "too strong" versus the franc. As I quickly noted in an earlier post (my only discussion of the Swiss peg), a one-sided peg can only work if the policymakers on the other side of the peg do not object.
The issue of coordination between both sides of a currency peg seems to be an important factor behind their survival. The Danish peg to the euro, which is a "two-sided" peg, is helped by the fact that the ECB is obligated by treaty to intervene to prop up the Danish krone versus the euro. However, the euro area can probably only offer that guarantee because of the small size of the Danish economy. That said, the Danish central bank had to cut rates Monday to -0.20% in order to reduce the pressure on the krone to strengthen versus the euro. I have not looked at the details, and so I do not have an idea whether that peg will buckle in the same way the Swiss franc peg did.

Preliminary Conclusions

We have yet another example that attempts to regulate the external values of currencies will eventually fail. Currency pegs only appear to make sense in transitional eras, such as helping pin down the valuation of a newly issued currency. But there needs to be some form of "exit strategy", such as a policy of periodically adjusting and widening trading bands.

There is an interesting split amongst economists around the idea of free-floating versus regulated currencies.
  • Within mainstream economics, North American economists tend to favour floating exchange rates, while the Europeans tend to be the source of support for exchange rate controls. (This generalisation is purely my impression; I have never seen a formal survey of such a breakdown.) This reflects the fact that the European countries have locked themselves into a number of fixed exchange rate regimes over the decades. Economists in the United Kingdom may have made a transition towards the North American stance after the ERM debacle.
  • Within (broadly-defined) "post-Keynesian" economics. the self-identified "post-Keynesians" ("narrow tent post-Keynesians"*) are often critical of freely-floating currencies, whereas Modern Monetary Theory is strongly in favour of free floats. This creates an analytical and policy division within the broad "post-Keynesian" school of thought.
  • Austrians favour gold pegs (which implicitly create fixed currency pegs), while more mainstream libertarians may prefer rules-based domestic monetary policy (for example, Friedman's monetary base growth rule) with a freely floating currency.

Looking further, this SNB policy roller coaster acts as an example that even "financially sustainable" policies can be discontinued.  Can we extrapolate this to other government policies that otherwise appear "sustainable" - such as inflation targets and the redemption of government debt?

In the second part of this article (to be published later this week), I will discuss the implications for those other types of government promises.


* "(Broad tent) post-Keynesian" economics consists of a number of schools of thought. Unfortunately, the nomenclature is complicated as one of those component schools of thought is "(narrow tent) post-Keynesianism". Many within the "narrow tent" refer to themselves as "post-Keynesian", and would deny that schools of thought like Modern Monetary Theory are "post-Keynesian". Since there is no other acceptable label - since "Keynesian economics" refers to something else - I use "post-Keynesian" to refer to the broad school of thought. (I like to identify myself as a "crypto-Keynesian", but that is probably just me.) And to top it off, when many refer to "Keynesian" economists, they mean people like Paul Krugman, who is actually a "New Keynesian." As one might guess, "New Keynesian" economics is a completely different school of thought which does not fit within "(broad tent) post-Keynesian" economics. I hope that has cleared everything up.

(c) Brian Romanchuk 2015


  1. Who are these "narrow tent Post-Keynesians"?

  2. P (Paul?) Davidson is the best known "narrow tent" post-Keynesian, but I should not put words into his mouth. I believe my summary is correct, but I cannot say for sure who said what. I just got my hands on Lavoie's text ("PK economics, new foundations") which better describes this controversy. I may discuss this later when I review that text.

  3. I am grasping for logic to understand the Swiss action. Here is one scenario from my imagination:

    This scenario follows the concept of a company town where the company owns all the business in the town and runs the local economy on company script. This scenario gives the company complete control over interactions with any outside economy.

    Imagine the SNB as the manager of a company economy. The size of the company is the area within the Swiss Franc currency area.

    Essentially every worker in this economy works for the SNB because only currency issued by SNB is used. The SNB realizes profit when the economy trades with other currencies because any currency received (such as the EURO) was a trade that cost the SNB nothing. The SNN prints Swiss Francs (at near zero cost to the SNB) and gets currency in return that has real value, even if the value may soon decline due to inflation.

    As you say, why should the SNB stop if this imagined theory is valid?

    I will imagine reasons:

    1. The SNB is stumped by the need to distribute the real value represented by it's expanding EURO inventory.

    2. The SNB feels guilty about it's wealth acquired by printing Swiss Franc's. Better to let those workers earning the wealth have the benefit.

    3. The SNB feels guilty about a perceived internal wealth transfer within the Swiss Franc area. Existing holders of Swiss Francs are penalized by the (former) low Swiss Franc purchasing power while the working population had higher wages and more jobs due to the artificially supported weak Swiss Franc value.

    Perhaps a wild vision but it seems possible.

    1. Yes, it does not make a whole lot of sense. But they are organised in a similar form as a commercial bank (with non-government shareholders), and so they may look at their books in the same way as a commercial bank.

  4. I think assuming the SNB is acting from a position of wisdom is flawed. If you look at the National Bank Act, you can see it is neo-liberal through and through.

    Given the other side of the government sector is infected with the same beliefs I think we can appeal to the "cock up rather than conspiracy" approach.

    In other words they really believe they are doing the right thing selling their dominant export sector down the river.

    1. Since I do not follow them very closely, I felt it was prudent to be polite and write on the assumption that they know what they are doing. I had been pretty harsh on European policy makers in my review of Martin Wolf's book, so I decided to call a truce for,a week or two.


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