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

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"

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.

Footnote:

* "(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