Tuesday, October 20, 2015

Swiss Deflation

The Wall Street Journal Monday Oct 19 offers a reflection on deflation in Switzerland.

"It’s as close to an economic consensus as you can get: Deflation is bad for an economy, and central bankers should avoid it at all costs."

I differ, as does Milton Friedman's "Optimum quantity of money." And my "who's afraid of a little deflation" in... The Wall Street Journal.

"Then there’s Switzerland, whose steady growth and rock-bottom unemployment is chipping away at that wisdom."

"At a time of lively global debate about low inflation and its ill effects, tiny Switzerland—with an economy 4% the size of the U.S.—offers a fascinating counterpoint, with some even pointing to what they call 'good deflation.' ”

Indeed. The 1970s had stagflation. Now we have the opposite, "good deflation."  The Phillips curve lives on in "consensus."

Switzerland also is a good case for just how powerless central banks are to do much about it.

I don't think there really is such a thing as monetary policy any more. Money and government bonds are perfect substitutes. At that point, central bank interest rate setting is the same thing as if the Treasury simply decreed the rate it will pay on government debt. When (if) the Fed raises interest on reserves, and Treasury interest goes up similarly, it will be just as if the Treasury announced it will pay 1% on short term debt. (p. 77-78 of Monetary Policy with Interest on Reserves or p. 6-7 ungated here makes this point with equations.)

But you have to be careful when you set a price. If you set the wrong price, you are either overwhelmed or starved with demand.

That's how I read recent events: The Fed talks about raising rates, a sea of foreign capital starts to want to buy US debt at that higher rate. The treasury is not offering an elastic supply -- they're setting both price and quantity. So with the interest rate fixed, the dollar goes up. Then the Fed has to back down. The Fed can't raise rates if it wants to.

Switzerland also taught that lesson when its central bank tried to peg to the Euro and was overwhelmed.


  1. Not sure I understand your penultimate paragraph - surely whenever a central bank raises interest rates, that leads to an appreciation of the domestic currency? That hasn't stopped central banks raising interest rates before (though if the currency is especially sensitive to the Fed Funds rate at the moment then that would presumably mean that the pace of tightening would be slower than it would otherwise be).

  2. Valter Buffo, Recce'd, MilanoOctober 20, 2015 at 10:06 AM

    Again: I think the quantity of debt does matter (as the quantity of money matters). Further: maybe Treasuries and money are perfect substitutes; certainly, private debt and money are not. Finally: the Fed backed down for a number of reasons, maybe including dollar strenght, but notice that the dollar index is now lower than last January (and , incidentally, below its 200-day MA since early October). I would guess the dollar was not the top priority.

  3. Japan, a much more diverse and large economy than the boutique nation of Switzerland, obtained a much less positive result with sustained deflation.

    Besides, the purpose of macroeconomic policy is to maximize output, not to obtain 0% inflation.

    Several times in his career, Milton Friedman chided central banks for being too tight, even when inflation was in the 3% range. What he believed in theory, and what he believed in practice....

    1. Japan has a 3.4% unemployment rate. Just how low do you want it to go? Two decades of slow growth are not a monetary problem.

    2. It is a monetary problem because the financialization caused by OMO's and QE is reducing real GDP. The financial sector could be smaller if the BOJ used other tools to stimulate which would free up resources for the rest of the economy.

  4. Who decided this: "Besides, the purpose of macroeconomic policy is to maximize output" ? And also, how we measure if we are at maximum output ?

  5. Swiss GDP per capita growth has been close to zero over the last few years. Isn't that what we care about ? Swiss total GDP can grow because of movement of workers from Europe. Since Switzerland is small, those numbers are easy to skew.

    1. according to my numbers, the real grwoth on average was around 1% which is pretty nice taking the whole EURO crisis in account

  6. Mr. Robazzi: well, the thrust of your question is correct in one sense. There are many people who believe the purpose of macroeconomic policy is to obtain absolutely 0% inflation, however you measure inflation.

    Me? I like prosperity. Bring on Full Tilt Boogie Boom Times in Fat City and I will be happy.

    Side note to John Cochrane: If the NeoFisherians are right, and inflation can be quelled by 0% interest rates, then the goal of macroeconomic policy should be 0% unemployment.

    Why have any unemployment?

    1. Mr. Cole, you do realize that the purpose of the Soviet system also was to obtain "maximum output", don't you? Oh, and also zero unemployment.

  7. If there is non-satiation in liquidity (people always prefer a more liquid to a less liquid asset, other things equal), then Friedman's Optimum Quantity of Money implies that the central bank owns all the assets in the economy. And if the central bank is in turn owned by the government, that means the government indirectly owns all the assets in the economy, through its holding company the central bank. Currency is shares in the government holding company, and bank deposits become ETFs in those shares, with 100% reserves.

    Marx should have read Friedman.

  8. Bonds and money are interchangeable but that doesn't mean money policy doesn't exist. If the central bank expands money to people directly without purchasing bonds spending would pick up because people in general have a much higher opportunity cost of foregone consumption than current bondholders who mainly are interested in investing.

    1. How does the central bank expand money to the public?
      - provide credit to households? Essentially this is central bank substituting for bank credit. The technical problem is households do not hold checking accounts with central banks or what will happen is lending to banks with onward lending to households. The other alternative is hh issue liabilities bought by central banks (mortgage securities).
      - currency drops from helicopters. Households get something with apparently no future obligation to repay. But this is government spending or fiscal policy in all but name. The growth in output will be a function of the marginal propensity to consume/save this fiscal spend.

      Either way it creates spending power now for an obligation in the future (repayment or tax) and the only difference is the correspondence between who spends now and who pays later tighter in the former case.
      Central banks buying bonds just changes the duration of assets held by the "market"- they get a current account deposit (in their banks who in turn get one at the Fed) for a term bond. You should see that largely as a mechanism to manage term risk premium or in an extreme case as the Fed acting as a dealer holding inventory when the dealer system is capital (or credit or risk) constrained. It is not tantamount to credit creation.

    2. The fed can issue money directly to public by providing depository accounts. At the same time the pmt system which is systemic is risk free.

      I dont see how a heli drop done without the treasury, bond issuance or taxation can be classified as fiscal. OMO's should also be called fiscal then I suppose. A hel-e is only a change of counterparties.

    3. CMA

      Thanks for your response. It makes sense for me to state my basic premise from which my conclusions follow; so if they are wrong I am unjustified in drawing the conclusions I do.
      Premise 1: A central bank is another bank; albeit higher in hierarchy, but still a bank that issues liabilities and holds assets. It is high on the totem pole only because the government guarantees its solvency.
      Premise 2: It runs a balance sheet or that the value of its assets equal that of its liabilities. Mark to market is less relevant than credit losses; or it can book all values at cost until it sells and recognizes these gains or losses.
      Premise 3: OMO is a mechanism by which it controls the supply of reserves. It always leads to the contraction or expansion of its balance sheet as it either sells or buys treasuries and credits bank accounts (both sides of its balance sheet).

      In this world a helicopter drop increases Fed liabilities with no corresponding increase in assets. The most logical way for it to balance is if government issues securities/deposits the Fed can hold. In its absence when households redeem their balances with the Fed, what will they get? A mechanism by which this might happen is the following:
      - households deposit checks on Fed with banks
      - banks now have increased reserves with Fed
      - banks reduce their cumulative reserves by buying some other asset from the Fed (or the Fed initiates it if reserves are seen as large by some form of OMO) and they need anither financial asset to affect this. An asset my guess is, that represents a government liability. Otherwise the Fed has a large negative net worth that will eventually have to be filled by a government injection (budgetary deficit) or it will be recognized as a fiscal policy action then.

      I am obviously missing something if I am unable to square this circle based on my premise. Thanks.

    4. I don't think a helicopter drop of currency is really a creation of a central bank debt. Sure, the bills say "Federal Reserve Note," but what happen when you go to the central bank and try to redeem currency? They could give you other cash, but those also say "Federal Reserve Note."

      It's only really redeemable in the larger economy, by buying goods and services. Or it can be used to pay debt, resulting in a decrease in total systemic debt without change in overall money supply.

    5. Steve

      Thanks I can see that. It will land up being like a permanent QE (and excess reserves in banks because that is where it will land up anyway) that is never wound down. I did not think of it that way. Thanks.

  9. This comment is simplistic as I try to understand what has gone wrong in the "received" wisdom that deflation leads to fall in economic activity (or at least stagnation).
    The causal reasoning seems to be the following:
    - consumption is delayed if "expected" inflation is going to be negative. Waiting delivers larger marginal utility.
    - investments are delayed especially credit financed ones because debt value is pegged. This credit dynamic may also affect consumption if it is credit based say durables.
    - if relative price falls in your country and exchange rates do not react, there might be a case for some increase in trade surplus. If exchange rates rise, this is negated.

    I will leave out all government actions because they are partly policy driven and aim to counteract some of these dynamics.

    That is the simple theory as I understand it. So what is happening in Switzerland:
    - we know inflation has been negative, but is that seen as a one-off or have expectations been revised downwards. If it is the latter, consumption should fall at least for a small part of the consumption basket

    - investments can be driven by domestic market considerations (inventory and goods sold locally) or could be destined for international markets. If the goods exported are relatively price insensitive, investment demand may not be impacted by domestic deflation expectations

    The conundrum is best answered by looking at the dynamics at a slightly lower level of granularity. This is the equivalent of motherhood and apple pie, so pardon my stating the obvious.

    If John was bringing attention to the simple "deflation is always bad" mantra, this is a useful data point. There are circumstances where deflation and poor economic outcomes have gone hand in hand; but may be there are other coincidental variables too.

  10. "I don't think there really is such a thing as monetary policy any more. Money and government bonds are perfect substitutes. At that point, central bank interest rate setting is the same thing as if the Treasury simply decreed the rate it will pay on government debt. When (if) the Fed raises interest on reserves, and Treasury interest goes up similarly, it will be just as if the Treasury announced it will pay 1% on short term debt.

    But you have to be careful when you set a price. If you set the wrong price, you are either overwhelmed or starved with demand."

    You're actually coming very close to the Woodfordian/Wicksellian consensus here.

    This has nothing to do with the current environment where money and bonds are perfect substitutes. Even before the crisis, targeting a Federal Funds rate was equivalent to setting a price for US treasuries. If you set the wrong price (i.e. set the rate away from the "natural rate"), then you would create problems. In the standard model, this ultimately shows up in prices, as either inflation or deflation. But given price stickiness, it first shows up in real interest rates and real exchange rates, and therefore real variables like employment and output.

    But I don't know why this means monetary policy doesn't exist. In fact, your statement about the Fed implies it *does* exist. People expected tightening, so the real exchange rate went up, in other words expectations of monetary policy affects real variables. Now in this case the real effect wasn't what the Fed wanted, so it backed down. But that doesn't mean monetary policy doesn't exist, any more than if you stomp on the brake, and then notice you're slowing too much, you lift your foot back up.

    It does mean monetary policy can't have long-run effects. If the adjustment process is non-instantaneous (which is what sticky prices are all about) then monetary policy will have real effects *in the short run*. But in the long-run, prolonged deviations from the natural rate will cause problems of some sort or other. Ideally we'll never do that, because under the inflation-targeting view, you always want to set the interest rate at the "natural" level anyway.

  11. On the parallel discussion on objective of economic policy, we could view the economic system as just a system for arranging exchanges. If you indeed think it can be nudged along by economic policy you want to make sure that the resources the system has (labor, resources, physical capital) is
    - utilized fully.
    - and if there are alternative ways of utilizing it, it be done as efficiently as possible.

    Growth reflects our ability to become more efficient and so growth is good all else equal and is the best target. Inflation is an intermediate variable - it is useful in that it affects growth; so the choice is not really either /or to my simple way of thinking.
    I am aware of the objections to "growth is good" and "let's aim for efficiency" objectives, but remember that is why we impose some constraints that account for accepted objections to a solution that only maximizes the objectives.
    So should we aim for 0% unemployment? We should but we then create a system that is less flexible in its ability to react to shocks. Is it then 5% or 3.4%? The answer to that is way above my pay grade.

  12. Dr Cochrane,
    Money and debt are sometimes good substitutes, until they are not. Money always trades at par with no deliverable, while debt is a mark-to-market instrument deliverable in money.

    In order for debt to form, there needs to be a saving counterparty -- an asset and a liability. Therefore, the upper limit of debt formation is determined by marginal savings. Money has no such constraint, and has no corresponding balance sheet entry -- therefore, we have no upper limit to prospective money.

    Ergo, monetary policy is always effective. You're simply confused about policy and outcomes.

    Switzerland is clearly running a tight money policy (and tight fiscal policy with 25% public debt to gdp). Tight money produces low interest rates, high private debt, and low inflation.

    The Swiss are, in fact, running highly effective monetary policies. They just might know something about banking, you see.


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