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Last year I did a post criticizing this statement by Paul Krugman:

Oh, and about the exchange rate: there’s this persistent delusion that central banks can easily prevent their currencies from appreciating. As a corrective, look at Switzerland, where the central bank has intervened on a truly massive scale in an attempt to keep the franc from rising against the euro “” and failed:

I argued Krugman was wrong, that the Swiss national Bank was able to depreciate the franc whenever they wanted to. That was July 2011. Soon after the SNB again faced an attack from speculators. This time they decided to depreciate the franc and then cap it at 1.2 SF/euro. And as Evan Soltas showed in this post, it worked.

The SNB made a bold surprise promise: we will not let the swiss franc appreciate any more; we will hold the exchange rate at 1.2 CHF to 1 euro. And, in short, it worked. The appreciation of the swiss franc came to an immediate halt. The CHF-EUR exchange rate stabilized at 1.2. Even during this current turmoil in the Eurozone — which one might think would lead the currency to appreciate as capital flowed into Switzerland’s financial safe haven assets — the Swiss central bank has kept the exchange rate steady, fulfilling its promise. . . . Switzerland has the ability to stabilize its currency from upward pressure because its monetary policy tool is unlimited — it could always print out more swiss franc to satisfy market demand. This is, in other words, the opposite of trying to prop up a currency, which strains the foreign currency reserves of the central bank. The result is that the Swiss intervention is entirely credible. Its credibility is so powerful, in fact, that the SNB has stopped having to buy up foreign currencies with new swiss franc, which it did in earnest to prove its commitment in 2011, increasing its foreign exchange reserves by 177 billion from July to September. It hasn’t had to defend at all the value of its currency against appreciation since September, despite what should be enormous pressures. (See here and here for the data.) That is truly remarkable, when you zoom out for the macroeconomic big picture. That is the power of credible monetary promises. And we can do the same thing with the price level path, of course, managing correctly the striking strength of market expectations. All it takes is the appropriate use of the expectational channel; re-establish 5 percent annual NGDP growth as did the SNB for its currency, and then the market will do the rest for you.

It’s easy to say “I told you so,” but what Evan is doing here is far more interesting. He isn’t just disproving Krugman’s liquidity trap hypothesis; he’s showing that Krugman is wrong in a very interesting way. Krugman saw the huge SNB purchases during the period of policy failure as a sign that the effort required to achieve policy success would be even more monumental. What Soltas shows is that exactly the opposite is true. As soon as the SNB set a firm exchange rate target, they no longer had to buy foreign exchange to defend the target. Why invest in Switzerland at zero interest if you aren’t going to at least get some currency appreciation? The bloated Swiss monetary base wasn’t stimulus that failed; it was stimulus that was never seriously attempted.

Then Evan makes the very astute observation that the same logic applies to US monetary policy, where NGDP level targeting would be equivalent to the pegged Swiss franc. Krugman sees the large increase in the US monetary base during recent years as monetary stimulus that failed. In fact, it’s just the Fed accommodating the high demand for base money when tight money and ultra-low NGDP growth drove nominal rates to zero. Evan is right that with much faster expected NGDP growth there would actually be less demand for base money in the US. How much QE would it take to get back to the old NGDP trend line? Roughly negative $1.6 trillion.

Update: Evan has a new post that provides more information on just how effective the expectations channel has been in Switzerland. BTW, I deleted the previous lame attempt at humor in the postscript. It occurred to me that Evan is just a high school student, and doesn’t need me generating problems for him in the future.

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This entry was posted on May 31st, 2012 and is filed under Monetary Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



