In memory of Dr. Andreas Höfert

The 1.20 floor: the can, the will, the shall

In Switzerland, the EURCHF floor is a hot topic. In September 2011, when the Swiss National Bank (SNB) installed it after the Swiss franc briefly reached parity with the euro, consensus on the move prevailed. Recently, this consensus is crumbling, as several personalities questioned the policy.

The debate often mixes positive, normative and even political elements. Doing this clouds the discussion. In fact, there are three independent questions we need to ask. Can the SNB hold the 1.20? Does the SNB have the will to do so? And perhaps most importantly, should the SNB intervene at all?

Some argue that the SNB cannot defend the floor, since it is a small central bank and the markets are so big. Recall how the Bank of England lost its battle in September 1992, and then had to leave the European Monetary System. This “can” argument has a major flaw. True enough, a central bank cannot defend its currency against depreciation, as it has only finite foreign exchange reserves to intervene. However, it can defend its currency against appreciation, because it has an infinite quantity of its own money.

But won’t a central bank end up in bankruptcy by massively increasing its balance sheet? A central bank is not like any other bank. Therefore in my view, the only time a central bank is really bankrupt is when the public has lost any confidence in the currency. This means the country ends up in hyperinflation. Switzerland is currently far from such a scenario. Rather, consumer prices are now shrinking, and we expect them to rise again only late in 2012.

More importantly, the argument of a possible bankruptcy of a central bank and a remote prospect of hyperinflation should in fact weaken the currency directly. Hence, instead of asking whether a central bank can always weaken its currency, we should ask whether it has the will to do so.

The communication of the SNB is quite clear. SNB President Thomas Jordan leaves no room for second-guessing when he says that the central bank will defend its minimum exchange rate “with the utmost determination even under the most difficult conditions.”

Abandoning the floor now would completely jeopardize the SNB’s credibility. If the SNB surprised markets by halting its defense of the floor, it is pretty clear that the Swiss franc would appreciate strongly. If the SNB then tried to install a new floor, it would be questioned as severely as that at 1.20. So as long as there is consensus in Switzerland that the SNB should defend the floor at 1.20, it can and it will.

Now the most important question: Should the SNB lay a floor at all? The answer to this is political, not economic. Economics is a science of choices. It is a dismal science, because each choice bears a cost. In the case of defending the Swiss franc floor, the immediate costs are carried by Swiss consumers, who pay higher prices for imported goods than they would without the floor. Moreover, this monetary policy by the SNB creates potential for inflation later on. Finally, the current extremely low yield environment could fuel real estate bubbles. This has to be balanced with the benefits of defending Switzerland’s exporters and industrial base. With a Swiss franc at parity to the euro, Switzerland would be in a rather deep recession, with a long-run risk of de-industrialization.

Thus, on the last question economists can only point out the consequences of choices. The choice remains in the political sphere, in Switzerland ultimately with the people.