These are exciting times in European central banking. Last Thursday the Swiss National Bank suddenly terminated its successful peg to the euro. This week the European Central Bank is expected to announce its programme of quantitative easing. The SNB has embraced the risk of deflation from which the ECB wishes to escape.
The SNB's decision was motivated, at least in part, by aversion to being caught up in the ECB's QE programme. For Mario Draghi, the ECB president, the Swiss bank's decision is even helpful, since it weakens the euro. For many in northern Europe, however, the Swiss decision will be painful. It will remind them that they no longer enjoy the pleasures (and pains) of a strong currency. The Swiss can readily stop shadowing the euro; the Germans have been imprisoned in it.
The surprise decision created turmoil. By yesterday, the Swiss franc had appreciated by 18 per cent against the euro, the currency of its principal trading partner. With core inflation near zero, deflation in Switzerland seems inevitable. So does a recession.
Why end a policy that had delivered such enviable stability? The obvious answer is that the SNB feared huge inflation if it remained pegged to the euro, particularly after QE began – and bigger losses on foreign currency assets the later the peg was dropped. Neither fear is compelling, as Willem Buiter, Citigroup chief economist, argues. It is possible to hold down the value of a currency one creates oneself forever. It is true that the SNB's balance sheet is already large, at about 85 per cent of gross domestic product. But it had stabilised, and as Buiter notes: "There is no technical limit on the size of the central bank's balance sheet, in absolute terms or relative to GDP."
Furthermore, the Swiss could have curbed inflationary dangers without abandoning the peg, for instance by increasing reserve requirements on banks. A sovereign wealth fund could have been set up to manage huge holdings of foreign assets.
Even if a peg to the euro was no longer thought to be desirable, it could have been given up without going cold turkey. The government could instead have pegged the franc to a basket of currencies, which would have anchored its purchasing power while allowing it to move more freely against the euro.
Alternatively, it could have allowed the franc to move within a predetermined range, denying speculators a one-way bet on the value of the currency.
More interesting would have been a decision to go further in the direction of negative interest rates than the minus 0.75 per cent now imposed.
To make such a move stick, the authorities would have had to place limits on withdrawals from bank accounts or move entirely to electronic money, to prevent people from protecting their purchasing power by moving into cash. Needless to say, such radical ideas would horrify the prudent burghers of Switzerland.
QE is going to horrify the burghers of Germany, too. But it must now happen since it is the only way still available for the ECB to meet its definition of price stability. Its credibility is at stake. So, too, is the euro zone's economy. Everything is fine in Germany. But Germany is not the euro zone. Everything is less fine elsewhere.
The euro zone is in a slump, afflicted by the “chronic demand deficiency syndrome” that is the world economy’s biggest current weakness. Core inflation is 0.7 per cent, far below the ECB target of “below but close to” to 2 per cent. Five-year inflation expectations have fallen to 1.6 per cent. Nominal demand was a mere 2 per cent higher in the second quarter of 2014 than in the first quarter of 2008, while real demand was 5 per cent lower.
The question about the forthcoming QE programme is not whether it is needed but whether it will work. The doubts are less technical than political. True, yields on government bonds are already low. Nonetheless, QE should encourage investors to switch out of government bonds into other assets, including foreign ones – as Reza Moghadam, former head of the International Monetary Fund's European department has powerfully argued.
The political problem is more serious. It seems QE will be implemented in the teeth of opposition – not just from German members of the ECB governing council, who are entitled to their objections, but also from the German political establishment. This raises questions about the sincerity of the latter’s commitment to the independence of the ECB.
The difficulty is not that, to avoid the bogey of debt mutualisation, purchased bonds will end up on the balance sheets of national central banks. That fudge might even be an advantage to the more indebted countries. If the profits were divided in proportion to equity in the ECB, Germany would benefit from the higher interest rates paid on, say, Italian debt. By insisting instead on strict national responsibility, Germany will hurt itself.
The difficulty is rather that German opposition may fatally undermine the credibility of Draghi’s insistence that the ECB will keep inflation on target.
Similarly, the resolute opposition of the German establishment to fiscal deficits even when the yield on its own 30-year bonds is 1.1 per cent – virtually free money – hampers the use of fiscal policy throughout the euro zone. The emphasis on the wickedness of debt, regardless of what it costs, is pathological. No other adjective will do.
It is all up to the ECB. It may well fail, not because it is too independent but because it is not independent enough. Similarly, the euro zone may fail, not because of irresponsible profligacy but rather because of pathological frugality. In the end, the ECB must try to do its job. If Germany cannot stand that, it may need to consider its own Swiss exit. – Copyright The Financial Times Limited 2015