Making Sense of the Swiss Shock

Jan 17, 2015 Markus Brunnermeier , Harold James

For years, policymakers have been wondering whether the exit of a small, fiscally weak country like Greece could undermine the euro. Now, policymakers will have to deal with even bigger risks, stemming from the exit of a small, fiscally strong country that is not even a member of the European Union.

PRINCETON – Since the European sovereign-debt crisis erupted in 2009, everyone has wondered what would happen if a country left the eurozone. At first, the debate focused on crisis countries – Greece, or maybe Portugal, Spain, or Italy. Then there was a rather hypothetical discussion of what would happen if strong surplus countries – say, Finland or Germany – left.

Through it all, a consensus emerged that an exit by one country could – like the collapse of Lehman Brothers in 2008 – trigger a wider meltdown. Now, in Switzerland, we have a demonstration of just some of the risks that might emerge were a surplus country to leave the eurozone.

In September 2011, Switzerland pegged its currency to the euro to set a ceiling to the Swiss franc’s rapid appreciation in the wake of the global financial crisis that erupted in 2008. The country thus became a temporary adjunct member of the European monetary union. But, on January 15, the Swiss National Bank (SNB) suddenly and surprisingly abandoned the peg.

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Markus Brunnermeier

Writing for PS since 2015
2 Commentaries

Markus Brunnermeier is Professor of Economics and Director of the Bendheim Center for Finance at Princeton University.

Harold James

Writing for PS since 2001
177 Commentaries

Harold James is Professor of History and International Affairs at Princeton University and a senior fellow at the Center for International Governance Innovation. A specialist on German economic history and on globalization, he is a co-author of The Euro and The Battle of Ideas, and the author of The Creation and Destruction of Value: The Globalization Cycle, Krupp: A History of the Legendary German Firm, and Making the European Monetary Union.

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0 Comments on this paragraph, 16 in all 16 Comments on this article

Paul Hanly Jan 19, 2015

Don't Swiss banks fund themselves in the currency of the country in which the brnch or subsidiary operates and when they buy foreign denominated assets aren't they obliged to have risk weighted limits to their exposures to movements in exchange rates nuder a capital at risk model and doesn't that involved an overall requirement for risk weighted capital under the Basle agreements? They will undoubtedly have credit risk on loans made in CHF to people whose income is not in CHF and those borrowers if they hedged will have credit risk on their counterparties. but I think this para overstates the currency risk to commercial banks.
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Christopher williams Jan 19, 2015

It will be interesting to see how the banks that encouraged Eastern Europeans (not just in Hungary) to take Swiss franc loans react to potential defaults. While not of the same size as the US-based mortgage defaults of 2008, the danger of an untidy break-up of the Euro may become signposted by this action.
Of particular note will be the reaction to a Syriza victory in Greece; will Germany consider the danger of major defaults by Euro mortgage holders (as well as the government debt) when deciding how 'generous' the EU should be regarding keeping Greece in the Euro?
It is urgent that the current "there is no Plan B" attitude be changed to one of preparing for the worst, i.e. the exit by the most debt-ridden countries from the Euro, creating another banking crisis.
The consideration of revaluing the strong currencies of Germany, in particular, has far less risk, allowing the Euro to drop to a realistic rate for the poorer countries.
Whatever else can be done, the reduction of cash holdings is an important step, by the withdrawal of all notes above, say, 10 Euros, to avoid rewarding the speculators - and, at the same time, greatly reducing the hundreds of billions lost to tax evasion.
What Switzerland has done is given us a sharp reminder that printing more and more money is not the long-term answer; what is not clear from their extraordinary action during trading hours, is whether it is too late already?
But whatever else happens this coming week, let us hope that Plan B is not just a dream but being prepared as a matter of urgency.
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Edward C D Ingram Jan 19, 2015

It is clearly time to stop nations from buying each other's bonds etc in order to manipulate currencies.

One price cannot perform two functions. Currencies are supposed to float and create a long term balance of trade. Period.

This is all a part of my vision of a wolrd economy as well as national economies that use prices to balance supply with demand.

I predict that this will end economic crises. And much more besides.

This is just one example of how we prevent that pricing adjustment from taking place in an orderly manner.

Another example is the way we structure debt as explained here:

http://ingram-school-illustrations.blogspot.com/p/re-writes-updates-and-additional_8.html

And then the third example is the way we are creating money instead of doing so in a limited way and allowing interest rates to find their own level. Interest rates are a price too.

If a price is fixed there is not going to be a balanced economy.

If prices jump around because of the way we structure debt... if currencies are distorted in price...then the distortion breaks or continues with manipulation - there are virtually no prices and values that the world can count upon.

But we can count on getting into more crises.
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Kandaswami SUBRAMANIAN Jan 19, 2015

What Switzerland had with the EU is a morganatic arrangement and not a legal wedding! It meant that the SNB will go along with the currency peg as long it suits the country. It also implied that to maintain the pegged rate the SNB will have to buy up euro assets and store them. It is estimated by WSJ that the purchases were of the order of $2 billion per day. The arrangement will work as long as there is faith in the EU assets. The higher the rate of accretion, the lower will be the faith in the value of those assets. Under political pressure, SNB perhaps felt that it had reached a point of no return and removed the cap. This is the price the world pays for lack of global cooperation on monetary management. When the US FED introduced the QEs or decided to withdraw they did not consult countries like India which had been destabilized for some time. Mr. Bernanke said that the FED would serve the interests of the US and need not bother about countries like India. In fact, he snubbed Dr. Raghuram Rajan in a Brookings meeting where he raised this issue.. Now the western banking system has a taste of its own medicine. Let them stew in their own juice!
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Michael Public Jan 19, 2015

Pegging the franc was price fixing. All price fixing must stand up to market pressures (and market pressure can drive political pressure) or it must eventually cease. China fixing their currency only works because of the extreme political power of their government being able to override market pressures. As Switzerland is a democratic country the unpegging was inevitable.
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Procyon Mukherjee Jan 19, 2015

The Swiss voted overwhelmingly against the Gold Reserve referendum last 30th November, while the balance sheet of the Central bank rose to unprecedented levels; the bank just announced a profit in excess of CHF 34 Billion. The Central bank ownership structure does not allow the bank to operate without implicitly listening to the concerns of the Cantons, who indirectly own 40% of the equity of the bank. Given that the QE in Europe is round the corner, it was only to be expected that the peg should be removed.
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Andrew Purdy Jan 18, 2015

The SNB is just like a poker player in a game where a bigger player just raises the ante, and the little guy folds. The ECB is about to do QE, and to make it worth doing at all, the ECB has to go large. The SNB faced the prospect of printing trillions of Franks to buy up Euros in order to keep the peg. If they went down that path, they would have to face the prospect of what would happen if the ECB's gambit fails, and the Eurozone falls apart anyway in a few years? All those trillions of Swiss Franks could come rushing back to Switzerland like a tsunami if the Eurozone failed. The SNB would be gambling with possible future hyperinflation. The game was too rich for their blood. They folded.
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John Ellis Jan 18, 2015

The Swiss weren't in Eurozone.
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David Neunuebel Jan 18, 2015

You state, "... markets will now hesitate to believe central banks’ statements about future policy, and forward guidance...."

So every central bank is thrown into the ditch as untrustworthy because of this one central banks surprise. Doubtful!

True, the German and "Nixon Shock" created a severe bear market for a while and then the greatest Bull Market in history followed. When you make statements like, "Today, the global ramifications of a major central bank’s actions are much more pronounced than in 1971." without suggesting exactly what might happen and just leave it at that suggests this journalistic style is a bit yellowish.
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Nichol Brummer Jan 18, 2015

Does it make sense to compare 'currency war' with the way WWI got started, due to the comparably intransparent network of deals, alliances, levels of support between national banks? This episode seems as mysterious as the question about who started WWI still is.

Did ECB pressure force the SNB to make a dramatic panicky jump? And indeed why at all: the SNB balance sheet growth had already slowed down a lot.
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Luis Arenzana Jan 18, 2015

Swiss politicla pressure has resulted in wiping out all of the equity of their central bank in one day. The SNB reported CHF of foreign asset holdings an donly 13b of foreign liabilities. With an evergae depreication of 15% the loss on the foreign is teh size of the SNB's reported capital of CHF 73 bn. If this loss is the lesser of two evils, the SNB officilas really have a very negative view on Euro zone Government Bons credit. As in ususlaly the case they will be wrong. It is paradoxical how little Swiss bankers understand about finance tim eand time again.
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Sean Mullan Jan 18, 2015

'But domestic criticism of the SNB’s large buildup of exchange-rate reserves (euro assets) was mounting.'

–This statement is just wrong. First, Swiss conservatives put a minimum gold-holding initiative to the electorate, which the electorate rejected by a massive margin (77% no, 23% yes). You acknowledge the vote, but do not acknowledge how large its defeat was. If you know past Swiss votes, you'll know that was a MASSIVE rejection. Public pressure?!? Second, the SNB's FX holdings had barely increased at all during the past year. The largest increase was during 2012/2013, if I am not mistaken. There was no substantive movement during the past year. Third, the only discussion I had seen recently in the media (Tages-Anzeiger and NZZ Neue Zürcher Zeitung) was about adopting a currency basket over time, as the Euro had fallen so much against the USD.
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Faruk Timuroglu Jan 17, 2015

SNB isn't the only Central Bank that has large buildup of Euro assets. If Euro fails, it won't be SNB's fault. Swiss people were menaced, in a way, to reject the "gold reserves" proposal in referendum and they did. If it were accepted, SNB wouldn't be obliged to throw in the towel today and the transition could've been much smoother.
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Kurt Bayer Jan 17, 2015

The reference to "naive Hungarian homeowners" does not go far enough. In most Central and Eastern European countries banks (mainly Western) pushed hard-currency loans to private households and non-covered SMEs before and during the crisis. This now accounts to high NPLs for many banks. Maybe it was imprudent of Western banks to push (ostensibly cheaper) hard-currency loans on debtors whose experience with exchange rate risks was, to say the least, limited.
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slightly optimistic Jan 17, 2015

Is it really being argued here that the 1971 'Nixon shock' was not responsible for destroying the UN's financial discipline and the horrendous repercussions that caused?
The refusal of the US to honour its debts at that time was a huge default. Despite this relief, the build-up of borrowings continued to dangerous levels; but such default is no longer available - so quantitative easing has been used. What next?
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jagjeet sinha Jan 17, 2015

The Price of Gold in Euros perhaps the best barometer of what Syriza, Podemos, and the SNB believe is the shape of Europe to come. Dreams of Petro-Euros up in smoke before the Dollar goes back to parity and Oil goes back into the 30s. Blimey, 2014 turning out to be a Game changer as great as 1914, 1814, 1714,1614, 1514, 1414 - back to Agincourt.
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