In the wake of the SNB exchange rate shocker I think we’re learning a very important lesson – Central Banks are politically constrained. I think the most plausible reason for the exchange rate shocker is an explanation that has been relayed to me from many people in Europe – that the SNB acted because they were concerned about mark to market losses potentially undermining their balance sheet in the case that they were forced to follow the ECB along with QE.
While the SNB can’t go bankrupt in a currency it can produce, this could have weighed heavily on Swiss politics as the country views its monetary credibility as being above all else. Politically, this was a risky policy to continue as politicians might have felt that, at some point, they were going to have to “bail out” a Central Bank that was just digging a deeper and deeper hole. The SNB was clearly being forward looking here and took measures into their own hands before they had to even confront such an environment.
In reality we are constrained by the laws and institutional structures that allow certain entities to operate in certain ways. This is why it’s so important to understand the monetary system as it exists, as opposed to how politicians and economic theorists want it to exist. Of course, a Central Bank can’t become insolvent in a currency it can produce. That’s an obvious fact. But the fact that a Central Bank doesn’t need financial capital is only useful up to a certain point. After all, the Central Bank is a product of a certain country’s laws and it answers to the same politicians who created it and allow it to operate.
What the SNB experience is teaching us is the very real political constraint that controls so much of what government institutions can and can’t do. In this case the SNB clearly thought that following the ECB into the QE rabbit hole was a risk that could undermine their political capital. How rational is all of this? Not very in my view, but politics trumps reality in this case.