CARRY traders are squeezed, the odd foreign exchange broker goes to the wall, central Europeans who borrowed in Swiss francs to buy homes are hurt. So what, you say.

After the initial shock waves from last week’s removal of the cap on the Swiss franc against the euro have died down, is there any reason why things should not return to normal? Well, sadly, there is. Far from being a storm in a tea cup, the ramifications of this abortive experiment in currency management will be long lasting, not least because it serves as a reminder of the overwhelming importance of the political context in central banking.

For economists, the size of central bank balance sheets is of little or no importance. Even at about 85pc of gross domestic product, they tend to argue, the Swiss National Bank’s balance sheet poses no threat of inflation. Indeed, there is no economic reason why the balance sheet should not be expanded ad infinitum. Nor need it matter the SNB has accumulated such a large position in a weak currency, the euro, which its own move has further eroded and which is probably about to become weaker still on the back of a move to quantitative easing.

Never mind the potential losses, runs the argument — they are probably insignificant when compared with the net present value of seigniorage, the future profits on the issue of non-interest bearing debt. Note, too, a related peculiarity of central banks, which is that they are able to operate without difficulty when technically insolvent because they can print money to meet their liabilities as they fall due.

While the yellow metal is often thought of as a hedge against inflation, it is more of a hedge against central bank incompetence and monetary dysfunction, which includes deflation. There is no opportunity cost in holding gold when interest rates are below zero. And sure enough, the price of the precious metal has been creeping up

The snag lies with those awkward folk, the domestic voters. In Switzerland, many tend to be conservative, with a small ‘c’ — witness the recent, albeit unsuccessful, attempt via a referendum to have the Swiss National Bank increase the proportion of gold in its reserves. Part of their current concern is if the central bank makes losses on its reserves it may not pay dividends to shareholders including the Swiss cantons, cantonal banks and private investors. Even in countries where dividends are simply paid to finance ministries, there are people who worry about the damage to the credibility of the central bank and its ability to curb inflation if there is a deficiency of assets against liabilities. If that leads to political pressure for central banks to be recapitalised, their independence from the politicians is suddenly up for renegotiation.

After the sharp appreciation of the franc Switzerland will now face bigger losses on its official reserves together with problems of competitiveness. It risks importing a deflationary slump. The SNB has a credibility problem, having made strong pronouncements about the solidity of the peg to the euro just days before the removal of the cap. The initial wild surge in the franc suggests that it underestimated how a shortage of market making capacity would crucify those using the Swiss currency to finance carry trades. A reduction in the interest rate on sight deposits to minus 0.75pc was not enough to cushion the blow.

For their part, investors have been warned. So many leveraged positions in the markets are predicated on predictable central bank behaviour and believable central bank assurances about their future actions. A curious feature of market behaviour since the financial crisis is precisely the way investors have put so much faith in central bankers — and that politicians have not stirred up more on the issue of central bank independence.

The episode also underlines the increased intensity of deflationary pressure in Europe. A minus 0.75pc deposit rate makes cash look attractive. It also makes a case for gold. While the yellow metal is often thought of as a hedge against inflation, it is more of a hedge against central bank incompetence and monetary dysfunction, which includes deflation. There is no opportunity cost in holding gold when interest rates are below zero. And sure enough, the price of the precious metal has been creeping up.

With further deflationary pressure and more competitive devaluation, negative interest rates will spread across a growing number of countries where inflationary prospects are minimal. The growing band of investors who confront these dismal negative rates have good reason to ensure that gold makes a comeback.

The writer is an FT columnist

Published in Dawn, Economic & Business, January 26th , 2015

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