Bacon, Brits and the Swissy
This morning I am flying to London so I think it is an excellent opportunity to celebrate the long Danish-British trade relationship. Danes and Brits do not only share a same sense of irony and a love of beer, but also the love of Bacon. Or rather we love to produce it and the Brits love to consume it. It has been the basis of a good relation between the two nations for ages. As a consequence a shock to the bacon shock would be a demand shock to the Danish economy (under a fixed exchange rate regime), while it would be a supply shock to the British economy. In the proud tradition of Market Monetarism and in the tradition of the teaching of George Selgin we should argue that the Danish central bank (Danmarks Nationalbank) should "accommodate" shocks to the bacon prices (assuming that bacon is all we export), while the Bank of England (BoE) should let the shock to bacon prices be reflected in the price of the Brits favourite breakfast product. However, David Stinson in a response to my previous "bacon post" raised an interesting question:
"As I understand from your previous posts, your argument is that, under a fixed exchange rate, changes in export prices are demand shocks because they affect the money supply. But changes in import prices would also affect the money supply under a fixed regime. An increase in import prices would cause the money supply to fall as the central bank engages in domestic currency purchases to support the exchange rate. In that case, a fixed exchange rate would add a negative demand shock to a negative supply shock. Is that the basis for targeting only export prices?"David hits it right on the nail and his question very clearly illustrates the problem with a "normal" exchange rate peg. Lets say that the upcoming exit of BoE governor Mervyn King simply is to much to handle for the British government and the government decides to peg the pound to the tremendously stable euro (note the Danish-British irony...). Then imagine that the UK is hit by the a triple hit - the prices of bacon, butter and beer are doubled overnight to the joy of Danish exporters (This is revenge for Bombardment of Copenhagen 1807...ok, no Danes really remember that...). However, this would be a massive negative supply shock to the British economy - just try to imagine a British worker functioning without these essential products. The sharp rise in British import prices would lead to downward pressure on the pound and to avoid it becoming a much devalued pound the BoE would defend the peg against the euro by intervening in the currency market selling foreign currency and buying pounds. This is the same as a contraction in the British money supply. Hence, the response to the negative supply shock is to impose a negative demand shock. Now the British workers truly would be dissatisfied - then they have to pay more for their bacon, butter and beers and being out of a job! And the average British would likely find very little joy in the fact that real estate prices would have dropped. So David got it completely right – by pegging to export prices monetary policy will not react to supply shock and hence not distort relative prices in the in the economy. It should of course be noted that the Bank of England even in the present monetary policy set-up – inflation targeting – would react to a doubling of bacon, butter and beer prices as the increase in the three Bs would effectively shoot the aggregate supply (AS) curve to the left. This of course is a core problem with inflation targeting and a problem that caused the ECB wrongly to increase interest rates twice in 2011. Why the brilliant Swiss franc peg might not be so brilliant We now continue from the Britain and Denmark to Switzerland. Here is David’s second question:
In the case of Switzerland’s recent peg, I have been interpreting that as the central bank basically accommodating the increased external demand to hold the franc for safe haven investment purposes. I wonder if one might characterize the franc as the “export” against which the central bank is pegging, except in their case an increase in the value of the “export” would represent a negative demand shock absent pegging?This is interesting way of putting it and I am actually reminded about Robert Clower’s monetary theory (and I am sure Nick Rowe would be as well). Clower would basically start out with a Walrasian economy with no money and then introduce money as the m’th good in a Walrasian economy and setting the price of m equal to on 1. If we open the Clowerian monetary economy then we can think about the m’th good as the main export of the country. This is basically what David is saying. I, however, think that that makes things slightly too complicated. David is, however, not wrong in his analysis. But I would rather take a slightly simpler rout. What happened during 2011 was that the demand for Swiss franc increased sharply as the euro crisis was intensifying in the autumn. With the demand for Swiss francs increasing – for a given supply of Swiss franc – there will be a sharp tightening of Swiss monetary conditions, which obviously will be deflationary. The decision to introduce a one-side peg for EUR/CHF at 1.20 meant that the Swiss central bank (SNB) effectively said that if the demand for CHF increase (and lead to a strengthening of CHF below 120 against the euro) then the SNB will increase the money supply so much as to meet any increase in money demand. Market Monetarists including myself have applaud the SNB’s move to introduce the 1.20 one sided peg as it mean that the Swiss money supply becomes completely elastic and any increase in the demand for money will be meet by an increase in the money supply. This is the same thing that would happen under a nominal GDP level target. However, this does certainly not mean that Market Monetarists in general would think of this kind of peg as a good idea. Rather what Market Monetarists have applaud is that the SNB understand that if it does not accommodate the increase in money demand then it will becomes deflationary. Furthermore, Market Monetarists would point to the fact that the Swiss actions illustrate the powers of the Chuck Norris effect. There are however, a more serious problem with the Swiss peg, which should be address. It is pretty clear I think that the appreciation pressures on the Swiss economy in 2011 were caused by an increase in Swiss franc demand on the back of the euro crisis. However, there could be other causes why the Swiss franc should appreciate. Imagine for example that the global cocoa prices by dropped 50%. This would be a massive positive supply to the Swiss luxury chocolate industry as cocoa as far as I know is the main input to Swiss chocolate production. If we assume that the luxury chocolate is the only thing the Swiss are producing then this surely would lead to appreciation pressures on the Swissy. Under the present peg the SNB would respond to this positive supply shock by trying the curb the strengthening of Swiss franc by increasing the money supply. This is a real no, no. The SNB is responding to a positive supply shock by easing monetary policy. If you want property market bubbles then this is the right policy, but if you want nominal stability this is certainly not what you should do. Hence, the Swiss 1.20-peg is only a good idea as long as there are no major positive supply shocks to the Swiss economy and the only reason for Swiss franc appreciation is increase money demand. On the other there is no real reason to be concerned about negative supply under the present policy as the EUR/CHF peg is asymmetrical. The SNB will allow for any up move in EUR/CHF (an depreciation of the Swissy), but will curb any strengthening of EUR/CHF below 1.20. Looking at the Swiss economy there is actually reasons to worry about this. Unlike the US and euro zone Swiss nominal GDP has more or less returned to the pre-crisis trend and as such monetary tightening might be warranted. However, the SNB does not have an NGDP level target, but rather a inflation target and hence we are having deflation in Switzerland the SNB can rightly say that it should maintain its 1.20-peg for now. However, if the SNB had been targeting the NGDP level would the peg now looks so brilliant? So what should the SNB do? Well, I would certainly not recommend to peg the Swissy to Swiss export prices – as the Swiss exports are far to diversified to find a good real-time measure of Swiss export prices. However, why not introduce a NGDP level target? The Swiss economy is very developed and the Swiss financial markets are highly liquidity. There would certainly be no problem introducing a futures based NGDP targeting regime. However, SNB could also introduce an exchange rate based NGDP targeting regime. If NGDP is too low it would move up the one-side peg against the euro and if NGDP is too high it would move it down. I think that would work pretty well. Concluding, the 1.20 peg works well to curb a sharp rise in money demand. However, the policy carries some serious risks. However, the problem is not using the FX rate to conduct monetary policy, but rather that the SNB is targeting inflation rather than the NGDP level. So I were to make a recommendation then the SNB would make the 1.20-peg conditional on where Swiss NGDP is forecasted to be in lets say 12-18 months. That would ensure nominal stability and be the best way to avoid the development of “secondary inflation” and asset bubbles. So I am finishing of this post as we are approaching London City airport. A small airport, but centrally located in London so clearly my favourite airport when I have to fly to London. Back to Copenhagen tonight…that is the one of joys of working in the financial sector, but if I am lucky I might have time to taste a bit of bacon, butter and beer… PS sorry for the typos…no time for proofreading…and I will hopefully add a view links in a later update...