This article appeared in the Deseret News on Aug. 23, 2011
Switzerland is having currency problems. This may come as a surprise to many people, since unlike a number of other countries that are in the news these days, the Swiss have been financially responsible. However, as government debt problems have roiled many nations in Europe and the US has struggled with its own government debt ceiling, many investors have turned to Switzerland as a relatively safe investment haven.
The problem with this from the Swiss point of view is what it has done to the exchange rate. Because investors want Swiss financial assets, the demand for Swiss francs on the world market has expanded dramatically. The result has been a surge in the value of the franc over other currencies. A franc is worth 50% more euro today that it was two years ago, and is worth almost 60% more dollars than it was in December of 2008.
For Swiss tourists and importers this is a huge gain; their relative wealth has surged with the exchange rate and foreign goods look much less expensive than the used to. For Swiss firms this is a disaster; for their customers the prices of their goods have risen right along with the value of the franc. As a consequence, sales and orders have dropped off dramatically.
As a result, Swiss policy makers have begun making public statement about a possible pegging of the franc to the euro. This would require a big increase in the Swiss money supply, but it would bring the exchange rate back down.
This is one recent illustration of the importance that exchange rates play in our modern economy. They are particularly important for smaller countries like Switzerland. Countries have a variety of options when it comes to exchange rate policy. All of these, however, are simply variations on two opposites. Countries can choose to fix their exchange rate to another currency or to a commodity (historically, gold) or they can let the value of their currency float on the market.
Since the early 1970s, the Swiss franc has been a floating currency along with the other major "vehicle" world currencies, the US dollar, the euro, the British pound and the Japanese yen. A floating exchange rate gives the central bank issuing the currency complete control over its own money supply. The bank may create more money when it feels the economy needs a stimulus, or create less money if they feel inflation is beginning to become a problem. However, the central bank cannot control the exchange rate in this case. Exchange rates in this case are set in the foreign currency market by the interaction of supply and demand for the domestic currency and the central bank buys and sells in this market only rarely. Indeed, most central banks with floating currencies lack the foreign currency reserves needed to manipulate the exchange rate.
Some countries rigidly peg the value of their currency to another. Hong Kong, for example, pegs the value of the Hong Kong Dollar to the U.S. dollar at a rate of 7.8 HKD per USD. When a country pegs it ends up in the exact opposite position as above. The central bank can choose any value it wants for the exchange rate, but it loses control over its own money supply. It is forced to create an exact amount of new money each year that will keep the exchange rate fixed. If demand for the currency suddenly surges, the bank must create enough money to meet this demand. Central banks that peg the value of their currencies are forced to constantly buy and sell in the foreign exchange market to keep the price constant. When demand for their currency rises, they sell it and buy foreign currencies. When demand falls they buy their own currency and sell foreign reserves.
Most international financial crises over the past several decades have arisen because of central banks attempting to manipulate their money supplies while maintaining a fixed exchange rate. The collapse of the European Exchange Rate Mechanism in 1992, the Mexican peso crisis of 1994 and the Argentina currency board collapse in 2002 are three memorable examples. All were ultimately caused by countries attempting to hold exchange rates fixed, while at the same time engaging in independent monetary policies.
Could we see a similar currency crisis in the near future? Not with the U.S. dollar which freely floats. We could certainly see the value of the dollar drop if supplies expand or demand for the dollar drops, but we are unlikely to see the catastrophic overnight drops associated with a full-blown currency crisis. Europe, on the other hand, does have a fixed exchange rate system in that many different countries all use the same currency. Given the fiscal problems in Greece, Ireland, Portugal, Spain, and other countries in the Euro area, a currency crisis associate with a country dropping out of the euro pact is a real possibility.
Switzerland is having currency problems. This may come as a surprise to many people, since unlike a number of other countries that are in the news these days, the Swiss have been financially responsible. However, as government debt problems have roiled many nations in Europe and the US has struggled with its own government debt ceiling, many investors have turned to Switzerland as a relatively safe investment haven.
The problem with this from the Swiss point of view is what it has done to the exchange rate. Because investors want Swiss financial assets, the demand for Swiss francs on the world market has expanded dramatically. The result has been a surge in the value of the franc over other currencies. A franc is worth 50% more euro today that it was two years ago, and is worth almost 60% more dollars than it was in December of 2008.
For Swiss tourists and importers this is a huge gain; their relative wealth has surged with the exchange rate and foreign goods look much less expensive than the used to. For Swiss firms this is a disaster; for their customers the prices of their goods have risen right along with the value of the franc. As a consequence, sales and orders have dropped off dramatically.
As a result, Swiss policy makers have begun making public statement about a possible pegging of the franc to the euro. This would require a big increase in the Swiss money supply, but it would bring the exchange rate back down.
This is one recent illustration of the importance that exchange rates play in our modern economy. They are particularly important for smaller countries like Switzerland. Countries have a variety of options when it comes to exchange rate policy. All of these, however, are simply variations on two opposites. Countries can choose to fix their exchange rate to another currency or to a commodity (historically, gold) or they can let the value of their currency float on the market.
Since the early 1970s, the Swiss franc has been a floating currency along with the other major "vehicle" world currencies, the US dollar, the euro, the British pound and the Japanese yen. A floating exchange rate gives the central bank issuing the currency complete control over its own money supply. The bank may create more money when it feels the economy needs a stimulus, or create less money if they feel inflation is beginning to become a problem. However, the central bank cannot control the exchange rate in this case. Exchange rates in this case are set in the foreign currency market by the interaction of supply and demand for the domestic currency and the central bank buys and sells in this market only rarely. Indeed, most central banks with floating currencies lack the foreign currency reserves needed to manipulate the exchange rate.
Some countries rigidly peg the value of their currency to another. Hong Kong, for example, pegs the value of the Hong Kong Dollar to the U.S. dollar at a rate of 7.8 HKD per USD. When a country pegs it ends up in the exact opposite position as above. The central bank can choose any value it wants for the exchange rate, but it loses control over its own money supply. It is forced to create an exact amount of new money each year that will keep the exchange rate fixed. If demand for the currency suddenly surges, the bank must create enough money to meet this demand. Central banks that peg the value of their currencies are forced to constantly buy and sell in the foreign exchange market to keep the price constant. When demand for their currency rises, they sell it and buy foreign currencies. When demand falls they buy their own currency and sell foreign reserves.
Most international financial crises over the past several decades have arisen because of central banks attempting to manipulate their money supplies while maintaining a fixed exchange rate. The collapse of the European Exchange Rate Mechanism in 1992, the Mexican peso crisis of 1994 and the Argentina currency board collapse in 2002 are three memorable examples. All were ultimately caused by countries attempting to hold exchange rates fixed, while at the same time engaging in independent monetary policies.
Could we see a similar currency crisis in the near future? Not with the U.S. dollar which freely floats. We could certainly see the value of the dollar drop if supplies expand or demand for the dollar drops, but we are unlikely to see the catastrophic overnight drops associated with a full-blown currency crisis. Europe, on the other hand, does have a fixed exchange rate system in that many different countries all use the same currency. Given the fiscal problems in Greece, Ireland, Portugal, Spain, and other countries in the Euro area, a currency crisis associate with a country dropping out of the euro pact is a real possibility.
