CHF and Irreversible policies

This is a coming together of two (or maybe three) blog posts that I wrote last week. First, on Thursday, I wrote about irreversible policies and the kind of lasting damage they cause. Essentially I had written that any policy needs to be “reversible” in that it should be easy to undo in case it is causing damage.

On Friday, and on Sunday, I wrote about the move in the Swiss Franc that caused havoc in the financial markets worldwide. Traders worldwide did not expect the Swiss National Bank to undo the cap the way it did on Thursday, and as the market found its level, traders lost heavily. Some FX houses which had not taken enough collateral from its clients also ended up going under.

Now, as Adithya remarks in the comments, a central bank ought to be reliable and predictable in its responses, and be able to build trust in the traders. Thus, Adithya argues that the sudden removal of the cap by the Swiss National Bank was a bad move.

However, putting together the blog posts referenced above, the problem is that the cap on the Swiss Franc in the first place was itself bad policy. It was bad policy in that barring certain circumstances (such as the natural weakening of the Franc against the Euro), it could never be undone without creating lasting damage in the financial markets.

Assuming that the policy had to be reversed one day or another (some people have argued that the SNB should have never reversed the cap, thus practically forever pegging the CHF to the Euro. But the SNB, as a central bank, cannot be faulted for wanting to control its own monetary policy), the sad fact of the markets is that whenever the cap was going to be removed, or the SNB announced that the cap was going to be removed, the markets would react in an extreme fashion. Unless the Franc naturally depreciated against the Euro (in which case the cap could have been quietly done away with) it was guaranteed that reversing the policy was a bad move.

It is hard to believe that the SNB was unaware of this irreversibility when it made the policy back in September 2011. The only defence that one can think of is that the SNB effectively overestimated the performance of the Eurozone, and consequently the Euro, in the time between 2011 and now. As this estimate came to be unfounded, it was forced to inflict pain.

The policy lesson from this is that when you are forming policy, you need to account for all possibilities, and make sure that the policy needs to be reversible with a high degree of confidence. This, you may note, is a stronger condition compared to what I had proposed in my blogpost on Thursday.

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