Credibility and the Central Bank Balance Sheet

Scott Sumner has been making the argument lately that a central bank with credibility can limit the growth of its balance sheet more effectively than a central bank that is not credible. The context for Scott’s claim is the chronic complaint by QE opponents that the Fed, by doing QE, has dangerously increased the size of its balance sheet, thereby creating an unacceptable risk of future inflation. Scott contends that if the Fed had been more credibly committed to its inflation target of 2%, the Fed would not have needed to create so many dollars in a futile effort to meet its inflation target. In other words, more credibility would mean a smaller balance sheet. That was a clever jujitsu move on Scott’s part, but does his argument really have a basis in economic logic?

The key point here is that the size of a bank’s balance sheet depends on the public’s demand to hold the liabilities of the bank. So for Scott to be right, credibility has to reduce the amount of base money issued by the central bank that the public wants to hold. So, if by credibility we mean the confidence with which the public expects the Fed to meet its announced inflation target, then, when the Fed is undershooting its inflation target so that enhanced credibility would be associated with a rise in expected inflation, enhancing credibility would indeed imply a reduction in the Fed’s balance sheet. However, if the Fed were overshooting its inflation target, enhancing credibility would imply an increase in the Fed’s balance sheet.

The credibility issue has become especially acute after the Swiss National Bank abandoned its peg to the euro last Thursday. To support the peg the Swiss National Bank was committed to buy euros without limit at a price of 1.2 swiss francs per euro, causing the balance sheet of the SNB to expand greatly. The main liability component of a central bank’s balance sheet is the monetary base; the Swiss monetary base has grown from 80bn francs when the peg was adopted in September 2011 to about 400bn francs at present. However, the Swiss monetary base has been in the neighborhood of 400bn francs for over a year, so even assuming that a new wave of demand for swiss francs, based on expectations of a falling euro and capital flight from Russia, had — or was about to — come crashing down on Switzerland, there is no reason to think that the peg had suddenly became unsustainable. Moreover, insofar as the bank was motivated by fears of euro depreciation, the bank could have seamlessly switched from a euro to a dollar peg, which might still be a face-saving way for the bank to reverse course.

So here’s the question: given that there was an international increase in the demand for Swiss francs, if the SNB wanted to limit the increase in the size of its balance sheet, associated with an increase in the international demand for francs, did dropping the euro peg imply a smaller balance sheet than the balance sheet it would have had with the peg maintained? Well, the answer is: it depends. By fooling the markets, and allowing the franc to appreciate by 20% over night, the bank avoided the increased demand for francs that would have occurred had the markets expected the peg to be dropped. So the SNB was able to achieve an unexpected increase in the value of the Swiss franc without encouraging an increase in the demand for francs based on expectations of future appreciation, and to that extent, the SNB was able to reduce the size of its balance sheet.

But another question immediately arises. Now that the franc has appreciated by about 20% after the euro peg was dropped, what will happen to the demand for Swiss francs? The speculative demand for francs based on expected future appreciation has probably been reduced by the sudden appreciation of the franc. However, Switzerland is now facing internal deflation, even if there is no further franc appreciation in foreign exchange markets, as the domestic Swiss price level adjusts to the new higher value of the franc. Oncoming Swiss deflation will increase the expected return to Swiss residents from holding francs while simultaneously reducing the expected return on physical capital in Switzerland, so a substantial shift out of real Swiss assets into cash is likely. Such a shift started immediately last week in the first two days after the peg was dropped, the Swiss stock market falling by about 10 percent, though Swiss equities did make up some of their losses in Monday’s trading. Given an increased Swiss demand to hold francs, the SNB will either have to increase the amount of base money, thereby increasing the size of its balance sheet, or it will have to allow the increased demand for francs to add to deflationary pressure, thereby causing further franc appreciation in the forex markets, attracting further inflows of foreign cash to acquire francs. If the SNB was uncomfortable with the euro peg, the SNB is likely to find out very soon that life without the euro peg or a substitute dollar peg is going to be even more unpleasant.

If your lot in life is to supply the internationally desirable currency of a small open economy – in other words if you are the Swiss National Bank – it is the height of folly to believe that you can place some arbitrary limit on the size of your balance sheet. The size of your balance sheet will ultimately be determined one way or another by the international demand to hold your currency. If you are unwilling to let your balance sheet expand in nominal terms by supplying the amount of cash foreigners demand as they try to exchange their currency for yours, you will only force up the value of your currency, which will make holding your currency even more attractive, at least until the currency appreciation and deflation that you have inflicted on your own economy cause your economy to go down in flames.

As an extended historical postscript, let me just mention the piece that Markus Brunnermeier and Harold James wrote for Project Syndicate, in which they astutely diagnose the political pressures that may have forced the SNB to abandon the euro peg.

The SNB was not forced to act by a speculative run. No financial crisis forced its hand, and, in theory, the SNB’s directorate could have held the exchange rate and bought foreign assets indefinitely. But domestic criticism of the SNB’s large buildup of exchange-rate reserves (euro assets) was mounting.

In particular, Swiss conservatives disliked the risk to which the SNB was exposed. Fearing that eurozone government bonds were unsafe, they agitated to require the SNB to acquire gold reserves instead, even forcing a referendum on the matter. Though the initiative to require a fixed share of gold reserves failed, the prospect of large-scale quantitative easing by the European Central Bank, together with the euro’s recent slide against the dollar, intensified the political pressure to abandon the peg.

Whereas economists have modeled financial attacks well, there has been little study of just when political pressure becomes unbearable and a central bank gives in. The SNB, for example, had proclaimed loyalty to the peg just days before ending it. As a result, markets will now hesitate to believe central banks’ statements about future policy, and forward guidance (a major post-crisis instrument) will be much more difficult.

There is historical precedent for the victory of political pressure, and for the recent Swiss action. In the late 1960s, the Bundesbank had to buy dollar assets in order to stop the Deutsche mark from rising, and to preserve the integrity of its fixed exchange rate. The discussion in Germany focused on the risks to the Bundesbank’s balance sheet, as well as on the inflationary pressures that came from the currency peg. Some German conservatives at the time would have liked to buy gold, but the Bundesbank had promised the Fed that it would not put the dollar under downward pressure by selling its reserves for gold.

In 1969, Germany unilaterally revalued the Deutsche mark. But that was not enough to stop inflows of foreign currency, and the Bundesbank was obliged to continue to intervene. It continued to reduce its interest rate, but the inflows persisted. In May 1971, the German government – against the wishes of the Bundesbank – abandoned the dollar peg altogether and floated the currency.


This seems basically right to me, but I would point out a key difference between the 1971 episode and last week’s debacle. In 1971, the US was mired in the Vietnam War and an unstable domestic situation; to many observers, the US seemed to be in danger of a political crisis. US inflation was running at 4% a year, and its economy, just emerging from a recession, seemed in danger of stagnating. Germany, accumulating huge reserves of dollars, correctly viewed its own inflation rate of 4% as being imported from America. Totally dependent on the US for defense against the Soviet threat, Germany was in no position to demand that the US redeem its dollar obligations in gold. Given the deep German aversion to inflation, it was indeed politically impossible for the German government not to use its only available means of reducing inflation: allowing the deutschmark to appreciate against the dollar. It is much harder to identify any economic disadvantage that Switzerland has been suffering since it adopted the euro peg in 2011 that is in any way comparable to the pain of the 4% inflation that Germany had to tolerate in 1971 as a result of its dollar peg.

17 Responses to “Credibility and the Central Bank Balance Sheet”

  1. 1 Diego Espinosa January 19, 2015 at 9:02 pm

    The Brunnemeier article brings forward a topic that rarely gets mentioned. I’m sure you know the history better, but I cannot think of a currency peg/board entered into by a country’s central bank rather than the government. Examples abound: the Euro, Argentina’s convertability, the UK’s participation in ERM. In the U.S., central bankers take pains to remind people that the currency is the province of Treasury and not the Fed.

    What are the implications of a central bank deciding on a currency arrangement independent of the government? The SNB case provides the answer: you can take the decision out of politics, but you can’t take politics out of the decision.

  2. 2 Bill Woolsey January 20, 2015 at 4:03 am

    Isn’t the key difference between Germany in the late sixties and Switzerland today that Germany was importing inflation from the US and didn’t want it, so an appreciation of the DM would reduce inflation in Germany despite U.S. inflation. But for Switzerland today, the Eurozone today, the problem is that the Eurozone is suffering deflation (or at least disinflation from a low inflation rate) as is Switzerland. And so, what Switzerland should have don is depreciate its currency against the Euro so that it could maintain its inflation target despite deflation in the Euro zone.

  3. 3 Max January 20, 2015 at 4:26 am

    It shouldn’t be a burden to have a popular currency, since normally central banking is a profitable business. It’s like Apple complaining that the iPhone is too popular. The solution to such a “problem” is simple: raise the price. In the case of central banking, the price of money, so to speak, is the interest spread between base money and safe overnight loans. Ideally this spread would be completely independent of monetary policy, but due to paper money not earning interest, the two issues are mixed together.

  4. 4 Peter K. January 20, 2015 at 9:59 am

    Would this make you happy? Or conflicted?

    Ralph Hawtrey
    by Scott Sumner

    You may wonder why I chose to name my chair at Mercatus the “Ralph Hawtrey Chair of Monetary Policy.” Here are a few reasons:

    1. He was an early supporter of NGDP targeting, or something relatively close.

    2. He was an outstanding monetary economist.

    3. He was a moderate with pragmatic views.

    4. He had a sticky wage/monetary shock view of the cycle, and his views on the Great Depression were very close to mine (gold hoarding and artificial attempts to raise wages.)

    5. He believed in monetary offset of fiscal stimulus.

    6. He is well liked by people who disagree with each other on other issues, including David Glasner and George Selgin. David dedicated his blog to Hawtrey.

    Over at Econlog I have a much longer post with some quotes to back up these claims.”

  5. 5 W. Peden January 20, 2015 at 3:42 pm


    Interest rates are the price of loanable funds. The price level (in the broadest possible sense for a given currency zone) is the price of money.

  6. 6 Frank Restly January 20, 2015 at 5:58 pm

    “If you are unwilling to let your balance sheet expand in nominal terms by supplying the amount of cash foreigners demand as they try to exchange their currency for yours, you will only force up the value of your currency, which will make holding your currency even more attractive, at least until the currency appreciation and deflation that you have inflicted on your own economy cause your economy to go down in flames.”

    Hyperbole much? The central bank may try to force up the value of it’s currency relative to the value of another, but whether that results in deflation depends on what is happening in the market for goods. Whether that causes an economy to “go down in flames” depends on a lot of other factors.

  7. 7 Mark Weber January 20, 2015 at 10:54 pm

    Ordinary Swiss citizens are saving in tax free obligatory pension funds with legal restrictions on how much equity they can hold (about 40-50%). There are more than 500 bn swiss francs in these pension funds invested. By binding the franc definitively to the euro (with a snb balance sheet much bigger than gdp it would get more and more difficult to get out of the peg) there would have indeed been economic disadvantages for Swiss citizens. In the short run there would have been advantages for export oriented industries although in the long run they would have paid with higher capital costs.

    Sadly nowadays when politicians and economists talk about “the economy” they only think of short term profits of listed companies…

  8. 8 Benjamin Cole January 21, 2015 at 7:01 am

    1. Okay, so a central bank has a large balance sheet. So what?
    2. Other than convention, couldn’t Switzerland declare a tax holiday and then monetize revenues (that is, print money to replace lost tax revenues)?
    Do that for the duration?

  9. 9 Frank Restly January 21, 2015 at 8:23 am


    In the Market Monetarist world, only the central bank exists as a macro tool.
    Yes, fiscal policy can offset monetary policy (one is “tight”, one is “loose”).

    The problem is in coordinating the two.

  10. 10 Max January 21, 2015 at 8:57 am

    W. Peden, absolutely right. But I did say “so to speak”. (Meaning, not to be taken literally).

  11. 11 David Glasner January 21, 2015 at 1:02 pm

    Diego, I think that there are currency pegs and there are currency pegs. A government can take a decision to establish a legal peg between its currency and some other currency, but a central bank can make a policy decision to peg its currency to another currency. Obviously the policy decision of a central bank involves a lesser degree of commitment to the peg than if the government establishes a legal peg. I actually can’t think of any historical examples to illustrate the distinction, but it seems fairly plausible to me.

    Bill, Yes, I agree with you completely that economic rationale for Germany to give up its peg to the dollar in 1971 was far stronger than the rationale for Switzerland in 2015.

    Max, I think that the SNB was imposing a negative interest rate on reserve balances. I don’t know what considerations made them unwilling to impose a steeper charge on balances.

    W., There is a “purchase” price of money which is the inverse of the price level or the purchasing power of money, and there is a “rental” price which is the spread between the interest rate on loans and the interest rate paid on cash balances.

    Peter K., Happy of course. What’s not to like?

    Frank, Well, I was thinking about the situation that Swizerland now faces, and I think that there action has significantly increased the chances of an unpleasant outcome.

    Mark, What are the disadvantages to Swiss citizens of a euro peg, especially as related to the pension funds?

    Benjamin, I agree; so what? What problem is your Swiss tax holiday idea supposed to address?

  12. 12 Benjamin Cole January 22, 2015 at 6:51 am

    David–Well, I think if Switzerland keeps monetizing tax revenues and says that will be what the SNB does until it gets the Swiss franc into a trading range it wants, that would work. Swiss citizens would benefit too.

  13. 13 JP Koning January 22, 2015 at 11:27 am

    “Given an increased Swiss demand to hold francs, the SNB will either have to increase the amount of base money, thereby increasing the size of its balance sheet, or it will have to allow the increased demand for francs to add to deflationary pressure, thereby causing further franc appreciation in the forex markets, attracting further inflows of foreign cash to acquire francs. ”

    Well, it can also reduce the deposit rate on deposits left at the central bank, which doesn’t require a balance sheet expansion. It did this on the day of the peg’s withdrawal, dropping the rate from -0.25 to -0.75%. I suppose if it had dropped them further, say to -2%, the effect of the peg’s withdrawal might have been completely counterbalanced by the effect of a lower deposit rate.

  14. 14 David Glasner January 23, 2015 at 9:03 am

    Benjamin, I looked at your post on Marcus Nunes’s blog, so now I get what you are saying. How does you idea differ from the 2-year cut in payroll taxes in the first Obama administration, aside from the explicit linkage between the tax cut and the increase in Fed liabilities?

    JP, Yes, that would also be a possibility. Do you know if the SNB applies the negative rate just on foreign balances or does everyone get charged a negative rate? There might be an issue about treating foreign and domestic balances differently.

  15. 15 Benjamin Cole January 24, 2015 at 3:57 pm

    David–thanks for reading my post. My idea is close to the payroll tax cut-QE marriage, except the Fed did not deposit Treasuries in the Social Security and Medicare trust funds, as I advocate.
    In fact QE-financed FICA tax cuts are my favorite macroecomic stimulus tool.
    If the Swiss are really worried about a central bank balance sheet of crappy bonds, then this is a better idea for them too.

  16. 16 JP Koning January 26, 2015 at 6:33 am

    Here are the details:

    “Negative interest is charged on sight deposit account balances (cf. art. 2.1.1, Terms of Business) denominated in Swiss francs, provided that the account holder is a bank, securities dealer, cash processing facility, clearing and settlement organisation, mortgage bond institution, insurance company, international organisation or central bank. As a rule, negative interest is not charged on balances of other holders of sight deposit
    accounts denominated in Swiss francs (in particular the Confederation and associated enterprises as well as domestic authorities). The SNB will monitor developments in the sight deposit account balances of these account holders. It reserves the right to impose negative interest on additional account holders.”

  1. 1 Browsing Catharsis – 01.31.15 | Increasing Marginal Utility Trackback on January 31, 2015 at 5:16 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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