The gold referendum is in Switzerland but with the fast rise of right wing extremism across Europe, others might feel inspired by their nostalgia of an imagined past to pursue this uniquely ill advised policy. Before they do, I take this opportunity to discuss this rule, what makes it ridiculous and what some of its potential effects might be. It could be a pretty big deal.
Switzerland’s People’s Party has managed to trigger a referendum scheduled to take place this Sunday requiring the Swiss National Bank (the country’s Central Bank) to repatriate all it’s gold from those untrustworthy English and Canadian central banks and force it to hold a specific share of its foreign reserves, 20%, in gold forever, forbidding it from ever selling it.
The convivial way to describe this level of ignorance is probably not the tone that I want to promote on this platform. So I’ll just reiterate that it is ignorant and try to make it obvious. A more detailed discussion is provided by Willem Buiter’s on his website, which I strongly recommend.
Don’t I look pretty Covered in Gold?
To make it plain, it is the equivalent of “blinging” yourself up ahead of going to work. You don’t need the gold any more than cash, you are not going to sell it in exchange for food either so if you bring it along, it is just as a symbol of status. After thinking about it, an image is better than a thousand words. This is what the rule makes me think of.
Don’t get me wrong, I’m not saying that gold is not a good investment. It can be, like anything else. However, it is just an asset. Of course, it has uniquely behavioral properties as a store of value in times of crisis, or when growth accelerates quickly. But those are not the reasons those people want to do it. No, they are doing it because they think that Gold is the only appropriate store of value.
Also, I’m not trying to single out the Swiss as being specifically ridiculous, vane or ignorant. If there’s one people who knows its finance, it’s the Swiss. I am however saying that on average, we have all been socialized to believe gold has some intrinsic value, which we often forget is just social/status. While the people who have studied this know better, the people who are proposing this have a specific instance of pride in their ignorance of this topic and just want the irrational comfort shiny metal.
Also, as I discuss, this is probably the sort of thing that is not going to cost Switzerland much.
Balance of Payments: Forex Reserves, CA and FA
Looking at Switzerland’s balance of payments (data from the SNB (FXR, CA, FA), we see it runs a CA surplus (money comes in through the sale of goods and services and dividends on investments abroad), a FA deficit (money goes out to invest abroad) and that the SNB has been accumulating foreign exchange reserves since the beginning of the financial crisis.
This is the result of the SNB purchasing EUR-denominated assets since the beginning of the crisis in order to ensure that CHF does not become too expensive vis-a-vis EUR, ie that it does not fall below 1.2 as it did in 2011. The motivation for this intervention is to ensure that the crisis in Europe does not cause such an influx of investment into Switzerland that the currency appreciates beyond a level that is harmful to the competitiveness of exporters.
Note how collapse of the value in the Summer of 2011 coincides with a stagnation of current account surpluses and a temporary increase in financial account surpluses and a decrease in the size of reserves of SNB. This is consistent, a priori, with the explanation of the intervention of the SNB. Note also that since 2012 the SNB has not really increased its reserves much, which coincides with the stabilisation of expectations regarding the future viability of Europe. The ECB drops the first hints of OMT in July and the SNB’s reserves go from growing at an average of 4% a month to growing at 0.2% a month.
As a result of this historical context and recent policy interventions, Switzerland enjoys one of the best balance sheet positions in the world, as measured by the Net International Investment Position.
Impact of the New Rule: EUR-CHF stability, Competitiveness, Prices and Bubbles
The first question on anyone’s mind is: will this affect the ability of the SNB to enforce the cap on the value of the Swiss Franc?
Since the Euro-Zone (EZ) crisis started, investors have been keen to take refuge in Switzerland and as a result have flooded to the country. Consequently they rushed to sell Euros and buy the Swiss Francs necessary to hide away. Due to fears that such a move would lead to an unstoppable appreciation, the SNB decided to start buying Euro assets to balance the the exchange rate movements and maintain the international competitiveness of Swiss products. It turns what was becoming a positive financial account and a potentially negative Net International Investment Position (NIIP) and a current account deficit, into a financial account deficit, a rising NIIP and a CA surplus.
So, is the new rule a problem? Only in-so-far as it limits the SNB’s ability to target the EZ. This is what the chairman of the SNB warned against at the beginning of the week. If this limitation is too extensive, then the result will be that the Swiss Franc will appreciate and exports lose competitiveness and possibly run a current account deficit. At that stage, cash would become abundant, market interest rates would tend to fall, borrowing would increase and consumption would tend to increase, with inflation rising and reinforcing the current account deficit bias. It’s just the way that gold-standard countries work and this would effectively bring Switzerland more in line with that exchange rate regime than anything else. Now notice that the debt would have to be private, because Switzerland has a balanced budget rule.
At that stage what does the SNB do? Probably increase the reserve ratios for private banks to force them to lend less to consumers, if it is worried about consumption bubbles. It can increase interest rates without attracting even more foreign investment, so reserve ratios are pretty much all it has left. But really, it will depend on the extent to which the rule limits it’s ability to impact the value of the Swiss Franc vis-a-vis the Euro and on the exchange rate elasticity of the Current Account balance.
Difficulties in Implementation
The country could also just simply struggle to implement the policy. It requires the satisfaction of a ratio, and like the monkey with the cup, these people want the actual physical thing. Gold contracts won’t do. So the SNB would only be able to increase its balance sheet at a pace 5 times that of annual gold production. The policy may simply force the SNB to stop growing its balance sheet. Similarly,
What happens if CA Deficits Emerge?
Another concern emerges if foreigners eventually stop dropping their cash on Switzerland. Then, the price of cash rises and people can’t pay the interest rates on the loans they took, leading the consumption bubble to burst. In principle, it’s welcome to Greece all over again. However, even this is unlikely when we consider that Switzerland is a net international creditor, it’s NIIP is positive, which should cushion the pain.
SNB Concentrating Risk
Finally, the rule forces the SNB to disproportionately concentrate itself in the gold market, which exposes Switzerland to the idiosyncrasies prevailing there and the volatility of that market. Note also that if gold appreciates, the value of foreign exchange reserves increases, which either forces the sale of gold or the purchase of other assets.
Just inflating the bubble, nothing to see here…
Interestingly, this rule will reinforce the 6000 year bubble in gold, adding to the demand for the commodity as long as the Swiss economy remains competitive. Interestingly, if the SNB ever decides to change the policy, it will end up selling gold at a lower value.
Conclusion – The mistakes you can make when you are a rich country
But this is all a very far possibility with many ifs and buts, first among which is the outcome of the referendum.
It’s a silly policy, but ultimately I don’t actually expect it to hurt Switzerland that much. Let them do it if it makes them happy. Let them nail themselves on a cross of gold (really the only decoration they can do given that they’ve also banned the construction of minarets). Hopefully their stubbornness won’t be quite as painful as this, but I can’t avoid but beig reminded of this moment from the first season of Game of Thrones.
They are rich enough they can probably afford this mistake if it does turn out to be a mistake. The question is for how much longer if they start to line out policies like this one after another. We’ll see…
PS: On Sunday, November 30th 2014, 78% of the Swiss electorate voted against the proposal described in this post. On the same day, the electorate also “rejected a proposal to cut net immigration to no more than 0.2% of the population”.