American Swiss Foundation

"The Swiss Franc Shock: Why Now and What Next?"

The below are remarks given by Daniel Oliver, Jr., President of the Committee on Monetary Research and Education (Young Leader 2014), on March 3, 2015 regarding the recent shift in the Swiss franc.

"You asked me to talk about the Swiss franc, and I know some of you keep large balances in both francs and dollars and want to know when to transfer them.  But instead of telling you what will happen to the franc, I’d rather tell you why.  As they say: give a man a fish, feed him for a day; teach a man to fish, feed him for a lifetime.  Not to mention that the secret to financial prognostication is to reveal what or when, but never both at the same time.

Like many of you I’m sure, for several years I had David McCullough’s book on John Adams on my bookshelf.  I finally despaired and watched the miniseries instead, which is surprisingly good.  Near the beginning, we see Adams wrestling with a pig in a pen outside his house, outside of Boston, a village of 16 thousand.  Before long, Adams goes to Paris, which looked about the way it does now.  Books may always be better, but the visuals reinforced the contrast between eighteenth century Boston and Paris.

I thought of this when I was told by one of my new Swiss friends that at the time Adams was in Paris, Switzerland was a collection of starving farmers whose highest ambition in life was to become a mercenary.

Yet only two centuries later these two backward countries would be the richest in the world.  Too often we forget to consider why.  It wasn’t natural resources, of which Switzerland has few. 

In my view, the only possible explanation – what these two countries had and maintained longer than others – is the spirit of federalism grounded in classical liberalism guarded by solid social institutions.

Federalism is the proposition that core principles should reside at the center, but the regulation of activity surrounding those principles should be done at the local level. 

The U.S. Constitution, for example, provides that Congress shall fix weights and measurements – a better system than having the measure of a foot reflect the physique of each passing governor.  Regulation of commerce itself – what that unit of measurement is used for – is properly left to the states.

The most important measure in commerce, of course, is value.  Value orients all investment, all trade, all consumption.  Money is supposed to be the measure of value, and this why in the U.S. Constitution the power to coin money is in the same clause as the power to fix measurements.

But, the nature of money has befuddled philosophers since time began, and how much more so politicians and bureaucrats.

Yet even if the experts cannot figure it out, the market has spoken with a unified voice: gold is the preeminent measure of value.  Through history, all economies that have had access to gold have chosen it as the measure of value, unless it is suppressed by the state through taxes or usually more draconian means. 

There is good reason.  To perfectly measure shifting value requires using as a reference point something the value of which doesn’t change – as Aristotle put it, the unmoved mover.  There is no such thing in human affairs, but gold comes closest:

Its supply is nearly constant –mining increases the supply of gold by 1.7% a year – would that the Fed could be so precise.  Gold doesn’t oxidize - it is perfectly durable.  Its extreme density makes it readily identifiable.  The fact that it is useless to industry not the liability most suppose, but rather an asset – it makes its value immune from the business cycle.

The choice of gold as the core reference point for value was decentralized.  Gold didn’t become money because the Kings of Judea so mandated.  Individual traders chose it in their own interests because those who use gold see value more clearly - they prosper against those that don’t.

For example, the United States abandoned the gold standard in 1971.  Since then, the price of oil – the most important commodity in an industrialized world – has increased in dollar terms by 26 times.  And the dollar has historically been one of the more stable currencies.

Switzerland held the line until 1999: up until then, 40% of the Swiss franc was backed by gold – and since 1971, oil in terms of Swiss francs has increased only 5 times.  The reason is that oil viewed in terms of unadulterated gold is exactly the same price as it was in 1971.  Moreover, oil was less volatile in terms of gold than in terms of dollars, which benefited the franc.

Economic agents were better served – had a clearer view of reality – by holding cash balances in Swiss francs over dollars because of its gold content.  This is why the Swiss franc has been so powerful for so long.

Yet, we are told that gold is a barbarous relic: there isn’t enough of it for a modern economy, and it’s too unwieldy.
The first objection is pure sophism – there is always enough gold at the right price.  The second problem was solved centuries ago.

Using gold coins is a pain.  A hole in your pocket in the U.S. might cost you a dollar in loose chain, in Europe, you can lose several dollars as those enormous coins roll into the hotel sofa.  Under a gold standard, it would be hundreds or thousands of dollars tumbling down your trousers, so we are told.

The problem was solved four hundred years ago when the Bank of Amsterdam opened its doors in 1609.  Its sole purpose was to make gold more liquid.  It accepted gold coin and issued paper certificates against it.   Merchants much preferred the paper gold because it lowered transaction costs, and they could always go get the gold if they wanted.  This is the origin of paper money.

Now imagine what would have happened if the Bank of Amsterdam suddenly were to announce that half the gold reserve had been stolen.  The value of its notes would immediately decline by half. 

Let us consider this little parable in the context of the Swiss National Bank’s decision in 1999 to sell half of its gold reserves – the element that kept prices stable, one of the foundations of Switzerland’s economic success – and distribute the proceeds to the government to be consumed.

Would you believe it if I told you that within three years of removing half the gold collateral, the franc declined by half in terms of gold?

And what replaced gold on the balance sheet? 90% of it is now comprised of foreign currencies, roughly half of which is in AAA-rated bonds, the rest in lower grade bonds and even equities!  Like all investors, the SNB is reaching for yield.

But why?  The function of money is to be a stable reference point for value.  Stability should be the central goal, not profit.

The SNB’s vice-chairman Jean-Pierre Danthine revealed the reason in his tirade against the recent gold initiative.  If it passed, he warned: “because gold pays no interest or dividends, the SNB’s ability to generate profits and distribute them to the Confederation and the Cantons would be impaired.”

The politicians had so much fun spending the gold, they want more free money.  The SNB is being run like a hedge fund only worse – the gains go to the state, but the losses will accrue to those holding Swiss francs – gains socialized, losses privatized.

And there will be losses – massive losses.  The central banks of the world have engineered the final bubble of our age – the government bond bubble.  Unlike the 2008 meltdown, the bubbly assets don’t sit on commercial banks some of which can be cut loose to save the ship, they sit directly on the central banks’ balance sheets.   When these bonds devalue, either through default or inflation, so will currencies.

When the global monetary experiments fail, it’s not just that the franc will fall in value as against real goods, volatility will increase.  This is fantastic for currency traders, who are able to front run order flow, but a disaster for real businesses and, therefore, the economy. 

Under the principles of classical liberalism, government set the rules – it didn’t participate in the game.  Both the Swiss and Americans have forgotten this founding principle in the monetary domain.  The inevitable result brings to mind the wisdom of an early saint who said:  “If they would not gain knowledge by being taught, they shall gain it by being afflicted.”

With that theoretical background, let me shift briefly to the practical.

I had lunch with a Swiss lawyer friend when I was in Zurich.  He complained that during the financial crisis, his clients started calling up and asking why his billing rates had increased 30%.  Of course, his rates were constant in francs, it’s just that his clients were in other currency zones. 

He could, of course, charge in the currency of his clients, but his business and personal costs are in franc terms.  He was in favor of the 1.20 euro-peg because it stabilized his cashflow.

He was buying lunch – armed with dollars, I couldn’t possibly afford it – so I had to agree.  His reasoning, though, forms the nexus of an unholy alliance that has developed between organized labor and exporters determined to keep the franc weak.

Let us examine the peg policy from the principles we have discussed.  In 2008, even though half the SNB’s gold had been sold, the gold backing had risen back to 30%.   This is why the franc started shooting higher.   The gold part of the Swiss franc was sending a message to my friend – his clients’ money was no good.

The SNB tried to hide this message by diluting the gold content of franc.  Even worse, by overpaying for euros, the SNB began transferring Swiss savings to the buyers of Swiss goods so that they could continue buying products they can’t afford.  Eventually, the transfer of wealth was too great, and the peg had to be abandoned.

Any new peg will meet the same fate, at least until the franc is seen by the market to be as impaired as the euro.  Will this then be called success??

Only an autarky is immune from the economic performance of its neighbors.  The stark fact that Switzerland is going to have to face is that when the euro fails, and Europeans are revealed to be as broke as everyone already knows they are, they won’t be able to spend eight weeks skiing every year.

It’s an unpleasant message to be sure, but the clearer and sooner it is received, the sooner Switzerland can adjust and the more losses it can avoid: now may not be the best time to build that new gondola.

Let me conclude on a happier note: while money is meant to be the measure of value, because of state meddling, often it isn’t.  The real wealth that both Switzerland and America have is not the paper assets of an impaired banking system, but their culture and knowledge.

There are depressingly few places in world where packages can be left on the front steps and still be there an hour later.  Or where workers actually show up for work, and don’t steal everything in sight, and want to work.  Or where failure of bona effort is not shameful.  Or where brides to officials and payments to organized crime are not regular business expenses.  Or where judicial redresses against the state can succeed.

These are the cultural assets that made us wealthy.  Even when the money dies, which it will, if we can keep our institutions intact and the spirit of federalism alive, the processes that made us wealthy will remain."

Contributed by Daniel Oliver, Jr.

AMERICAN SWISS FOUNDATION, 317 Madison Avenue, Suite 2320, New York, NY 10017