Everything that needs to be said has already been said.
But since no one was listening, everything must be said again.

Andre Gide

Saturday, January 17, 2015

On the Instability of Unilateral Fixed Exchange Rate Regimes

Was there an easy way to bet on a CHF/EUR appreciation? Because if there was, we must all be kicking ourselves for not exploiting that trade!

The difference between winning and losing in the FX market is usually just a matter of luck. To a first approximation, floating exchange rates seem to follow a random walk (see here). But the trade I'm describing here is one I think we should have expected to pay off for reasons beyond pure luck. That is, there is a pretty sensible theory of currency crises that might have guided our investment strategy in the present context. In particular, I'm thinking of Paul Krugman's (1979) model, which he describes here.

The basic idea is as follows. Suppose that a central bank wants to peg its currency relative to some other currency. Suppose that it does so unilaterally. The success of the peg will depend critically on its perceived credibility. This credibility may depend on, among other things, the amount of foreign reserves held by our intrepid central bank. To defend the peg, the central bank must stand ready to buy its own currency on the FX market, which it does so by selling off its stock of foreign reserves.

A unilateral peg of this sort is just ripe for speculation. The two most likely outcome in this case are (1) the peg holds or (2) the peg fails (the domestic currency depreciates). The trade in this case is to go short on the pegging bank's currency and long in the foreign currency. A speculator either breaks even if (1) or wins if (2). It's a can't lose proposition (but please don't try this at home kids). Rational speculators, recognizing the opportunity, start shorting the pegged currency. If they do so en masse, our little central bank will soon run out of reserves and be forced to abandon the peg--a self-fulfilling prophecy.

I didn't spot this in the case of the SNB because, well, Switzerland is not a banana republic--the Swiss Franc is considered a safe-haven security. And the SNB was pegging because it was worried about currency appreciation--not the usual concerns about excess volatility or depreciation. Of course, there was never any danger of the SNB running out of reserves--they can print all the Francs they want! So what was the danger?

Central bankers are by nature a highly conservative bunch. They become uncomfortable with things that are unfamiliar. Like balance sheets the size of the moon, for example. With an ECB QE policy on the horizon, there was the prospect of EUR for CHF conversions proceeding at an even more rapid rate--leading to a very, very large SNB balance sheet. My claim is this: we should have guessed that the SNB would have at some point in this process lost its nerve and abandoned the peg, allowing their currency to appreciate (And if it didn't lose its nerve, the peg would have been maintained, so we would not have lost on the other likely outcome of my proposed bet). Rational speculators anticipating this should have ... oh well, forget it. (Let's try it next time and see what happens?).

As for the SNB abandoning its peg, especially the way it did, well, it just seems crazy to me. It would have made sense if one thought that EUR inflation was likely to take off. But all the worry at present is directed toward the prospect of EUR deflation. Yes, that's right, the SNB is stocking up on a currency whose purchasing power is projected to increase. And as for being concerned about EUR inflation because of QE, it seems unlikely to me that the ECB wouldn't be willing and able to defend its low inflation target.

In short, I think the SNB could have let it's balance sheet grow much larger without any significant economic repercussions. Instead, by removing the peg as they did, they suffered a huge and needless capital loss on their EUR assets. Strange move. But how can we argue against the past success of Swiss bankers?

On the plus side, I suppose we can no longer claim the Swiss to be boring

Friday, January 9, 2015

On the Want of Bold, Persistent Experimentation

How should policymakers react to an economic crisis or ongoing economic malaise--an event that has taken them by surprise and/or left them searching for answers?

Brad DeLong's prescription is to follow the example set by FDR in the 1930s: How to Fix the Economy: "Try Everything".  He favorably quotes the former president, who once proclaimed:
The country needs and ... demands bold, persistent experimentation,” he said in 1932. “Take a method and try it. If it fails, admit it frankly, and try another. But above all, try something."
In some ways, this sounds admirable. But in other ways, it sounds...well, it sounds a bit crazy. Even DeLong acknowledges this when he writes:
To be sure, Roosevelt’s New Deal policies sometimes conflicted with one another, and quite a few of them were counterproductive. But, by trying everything, and then scaling up the most successful policies, Roosevelt was ultimately able to turn the economy around. 
Hmm. Ultimately turned the economy around? I guess so...even if it did take 8 years. One has to wonder how long it would have taken if FDR had done nothing at all?  I also wonder which of the many (some declared unconstitutional) experiments ultimately turned the economy around. The bold experiment of declaring war in 1941?

One of the problems associated with macroeconomic experimentation, apart from the fact that most experiments fail, is the aura of uncertainty it engenders. The appearance of senior leaders resorting to bold and persistent experiments is unbecoming and even a little scary. What will they think of next?! Should I invest now, or should I wait?!  It does not take a rocket scientist to appreciate the effect that policy uncertainty might have on prolonging an economic slump. I'm not sure how important this force is quantitatively (because it is hard to measure) but I don't think one can easily dismiss the role it can play in an economic crisis and recovery. Certainly, there is no shortage of narratives out there that blame FDR's "bold and persistent experiments" for transforming a recession into depression (many also blame President Hoover for the same reason).

Truth be told, I doubt that DeLong actually endorses "bold, persistent experimentation" in the sense of "anything goes." The set of "bold, persistent experiments" after all is very, very large. As he suggests, we already possess a set of tools--we (think) we know the nature of promising interventions--if only those squabbling politicians would employ them! In addition, he provides a short list of  potential interventions (some of which, like QE, were actually implemented).

It seems that DeLong was motivated to write this piece mainly to criticize Martin Feldstein's needlessly inflammatory language in promoting an otherwise sensible policy proposal. I do agree with DeLong on that sentiment. But if this was the intended purpose of his article, then why invoke Hoover-FDR fables?*  And why speak favorably of the FDR-style "kitchen sink" approach to macro policy?  After all, if we don't know what we're doing, then isn't the principle of primum non nocere at least as compelling?

*Note: FDR actually criticized Hoover in 1932 for his "reckless and extravagant" fiscal policy. Consider the following data: