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On Thursday, the European market woke up to a surprise shock from the land known for its cuckoo clocks. The Swiss National Bank (SNB) delivered a one-two punch to the financial market by abandoning its policy to cap the relative value of the Swiss franc (CHF) to the euro (EUR) and cutting its deposit interest rate to MINUS 0.75 percent. You didn’t read it wrong. Negative interest rate. Needless to say, the market is in turmoil.

With an excellent hindsight vision, several things ensued. Within minutes, CHF appreciate by 17 percent against the euro before settling at parity by the weekend. The decision caught majority of speculators by surprise as pointed out in this article. They then had to cut losses by selling euro quickly. The gold price went up by 4 percent as investors scrambled towards the next “safe haven”. Volatility spiked, and as a result, CME tripled the trading margin requirement for CHF. It is too early to list all other knock-on effects, but they are sure to surface.

All these reactions indicate fearfulness in the market. And rightly so. The SNB effectively changes the rules of the game. By unpegging its currency from the euro, it is equivalent to saying to investors that we are giving up fighting the deflationary forces that plague major economies around the globe during the last five years.

On the other hand, negative interest rate supposes to encourage more borrowing and investments. I seriously doubt that this would have much effect. The yields of major long-term bonds around world are already negative (Swiss, Germany, Japan) It looks like many 10-year Government bonds would soon enter the negative territory too. Put this simply, investors are willing to lend money to the Governments in full knowledge that they will get less money back in five years time! Or soon in ten years time! That is the current level of risk-aversion in the market. Setting negative interest rate will not deter banks away from holding more money in their reserves.

Going against my better judgement of not giving prediction, I see that the SNB action has a net deflationary effect on the Swiss economy. It reminds me so much of the Great Depression. I recommend reading Liaquat Ahamed’s Lords of Finance to understand that we are living in a similar deflationary period and what we can learn from it. Without going into details, the SNB’s decision demonstrates that central banks around the world are running out of tools to combat deflationary risks, or perhaps, that politics trumps good economic management. Expect things to get worse before it gets better.

It is tempting to say that cutting government spending in a depressed economy is the main culprit. But, it is worth learning something from Franklin D. Roosevelt, who took the U.S. off gold standard, which allowed the US dollar to depreciate and the U.S. economy to recover during the Great Depression:

 It is common sense to take a method and try it. If it fails, admit it frankly and try another. But above all, try something.

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