What keeps central bankers awake at night? Sometimes it's the overwhelming pressure from politicians who want them to set aside being independent, for one moment, and listen to what the "people want." Sometimes it's the seemingly impossible task of keeping inflation rates in an emerging economy from getting out of hand. Sometimes it's the value of a country's currency. Central banks and governments have long grappled with this threat.

TUTORIAL: Investing 101

Currency and Economic Tension
On the face of things, the ups and downs of exchange rates and currencies don't really sound all that terrifying. After all, we're talking about coins and pieces of paper. However, at the heart of the issue is how currency influences the health of an economy; it's much more than something you use at the corner grocery. Rapidly appreciating currencies torpedo exports, lead to inflation at home and can add to unemployment. For this reason central bankers are often charged with keeping currencies in check.

The recent tumult in Europe has put a significant amount of pressure on both investors, who want to find better returns than what is provided by the risky euro, and banks, who want to keep their currencies from rapidly appreciating. One of the most recent victims has been Switzerland. Euro investors flocked to the currency this past summer, pushing the rate from 1.12 CHF/EUR to 1.03 CHF/EUR in a month. This was the more extreme end of a trend that had begun in April, when the exchange rate was 1.31 CHF/EUR. Switzerland's economy could simply not survive such a rapid appreciation. (For related reading, see Forex: Making Sense Of The Euro/Swiss Franc Relationship.)

The SNB Plays Dangerously
The Swiss National Bank (SNB) had a number of weapons at its disposal and ultimately settled on a specific exchange rate target. By publicly announcing that it was going to set a target of 1.20 CHF/EUR, and reiterating that it would buy an unlimited amount of foreign currency, it sent a signal to investors that the overvaluation of the franc would no longer be tolerated.

Currency traders reacted immediately. Since the announcement, the rate has continued to decline, though this could also be a function of declining domestic consumer demand, or of increased confidence in Eurozone governments of heading off sovereign-debt defaults.

By specifically targeting the CHF/EUR, the SNB put Eurozone economies in a precarious position. With the Swiss franc no longer be able to appreciate, relative to the euro, it would be increasingly difficult to release some of the pressure focusing on the euro, in recent months.

The SNB stated that it would buy an unlimited amount of foreign currency, including the euro, which could cause it to appreciate, as the supply of euros on the market diminished. Even if more euros were to be introduced into the market, a move which could add to inflation, the SNB could simply buy more. Additionally, the SNB could invest proceeds in Eurozone bonds, which would put even more pressure on Greek, Italian and Spanish sovereign-debt. In short, a dangerous game of chicken was on the horizon.

The Risks Could Pay Off, or Not
The SNB's move was far from an unprecedented strategy and economic history has shown that it can sometimes work. Switzerland had intervened during the 1970s, and New Zealand did so in recent years. Some currencies are at more risky than others, because they are heavily targeted by currency traders. Intervening in currency markets can be a risky macroeconomic proposition.

Central banks are limited as to what economic levers they can control at any one time, and focusing on limiting currency appreciation through pegging means that it won't be able to control inflation. In the case of Switzerland, quantitative easing would require the SNB to print more Swiss francs, which could lead to the Swiss economy heating up. (For more on central banks, see Get To Know Central Banks.)

From a macroeconomic perspective, a country generally prefers its currency to be valued lower than that of others. This allows its exports to be cheaper, which helps domestic industries chug along and keeps GDP on solid ground. Unfortunately, currency valuation is a zero-sum game. In order for one currency to depreciate, another must appreciate.

While the global economy can handle a few countries conducting strategies to push down currency values, if this becomes a more wide-spread strategy, then bigger problems are on the horizon. This type of currency protectionism was a precipitating cause of the global downturn that exacerbated the Great Depression. (For related reading, see What Caused The Great Depression?)

The Bottom Line
While the SNB may be partially lauded for first trying to save the franc through less invasive methods, by focusing on the money market, it has now set a dangerous precedent that other countries may be more willing to adopt. With the global economy still teetering on the edge, especially those of advanced economies, what would happen if central bankers all decided to print more money? The result would initially be like white noise, but could quickly devolve into the scream of a jet engine, if countries pursued expansionary monetary policy. The end result would be economic disaster.

Related Articles
  1. Budgeting

    Is Living in Europe Cheaper than in America?

    Learn how living in Europe has financial advantages over living in the United States. Discover the benefits to take advantage of when it makes financial sense.
  2. Economics

    The 2007-08 Financial Crisis In Review

    Subprime lenders began filing for bankruptcy in 2007 -- more than 25 during February and March, alone.
  3. Personal Finance

    5 Places Where Your Travel Dollar Goes Furthest

    The dollar is pretty strong right now, but where is it strongest? Canada? South Africa? Europe? Here are five places to travel to right now on a budget.
  4. Forex Fundamentals

    How To Calculate An Exchange Rate

    An exchange rate is how much it costs to exchange one currency for another.
  5. Forex Education

    Four Currencies Under the Spotlight in 2016

    With currencies having become the “tail that wags the dog,” in terms of their impact on the global economy, these four currencies will be under the spotlight in 2016.
  6. Investing

    Which Countries Will Drive Global Growth in 2016?

    Given the volatility that has already shaken the global economy, the world's largest economies will be leaned on to stimulate growth in 2016
  7. Economics

    3 Economic Challenges Russia Faces in 2016

    Learn about the three largest challenges facing the Russian economy in 2016. How will low oil prices and high inflation impact the Russian economy?
  8. Investing

    2 Opportunities Amid Today’s Market Volatility

    As you prepare your portfolio for the market volatility ahead this year, here are a few investing ideas to consider.
  9. Forex Fundamentals

    These Currencies Are The Biggest Losers Of The Stock Downturn

    Here’s a list of the hardest-hit currencies amid the global stock market mayhem.
  10. Economics

    A Brief History of International Trade Agreements

    Since the mercantilist era, world trade has become increasingly multilateral, but since WW2 there has been a definite rise in regional trade agreements.
  1. Who decides to print money in Russia?

    The Central Bank of the Russian Federation (CBRF), like its peers in most countries, is the governmental entity responsible ... Read Full Answer >>
  2. How is the Federal Reserve audited?

    Contrary to conventional wisdom, the Federal Reserve is extensively audited. Politicians on the left and right of a populist ... Read Full Answer >>
  3. Who decides when to print money in the US?

    The U.S. Treasury decides to print money in the United States as it owns and operates printing presses. However, the Federal ... Read Full Answer >>
  4. How can the federal reserve increase aggregate demand?

    The Federal Reserve can increase aggregate demand in indirect ways by lowering interest rates. Aggregate demand is a measure ... Read Full Answer >>
  5. How does the stock market react to changes in the Federal Funds Rate?

    The stock market reacts to changes in the federal funds rate in various ways depending on where it is in the business cycle. ... Read Full Answer >>
  6. How are NDFs (non-deliverable forwards) priced

    The price of non-deliverable forward contracts, or NDFs, is commonly based on an interest rate parity formula used to calculate ... Read Full Answer >>
Hot Definitions
  1. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  2. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  3. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  4. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  5. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
Trading Center