The Swiss won't be rolled over

Although it has tended to fly beneath the radar screen, overshadowed as it is by Brexit, Switzerland has been involved an acrimonious dispute with the EU. Unfortunately for the Swiss, it is the fallout from Brexit that has brought matters to a head as the EU seeks to demonstrate that countries that do not play ball will feel the effects of exclusion from the EU market.

To put this into context, although Switzerland is not a member of the EU it has a series of bilateral agreements which allow access to parts of the European single market. One of the prerequisites for maintaining access to the single market is that the network of bilateral agreements be replaced with an overarching framework agreement. This would include a mechanism for settling any legal disputes between Bern and Brussels. Negotiations on these institutional issues began back in May 2014 but progress has been slow due to domestic political feeling, primarily opposition from the right-wing populist SVP which whipped up a storm by highlighting the role of “foreign judges” in Swiss affairs. At the end of 2017, the EU raised the pressure by granting Swiss stock exchange equivalence only for a year unless progress was forthcoming, and at the end of 2018 a further six month extension was granted. But no further progress has been made and at the end of June 2019, exchange equivalence expires.

In practice, this means that Swiss stocks cannot be traded on EU exchanges (and vice versa, thanks to the Swiss decision to reciprocate). Nobody knows what it will mean in practice. But Swiss companies account for around 20% of the Stoxx 50 market cap and 30% of the trading in Swiss large cap stocks takes place on other EU exchanges, primarily London. The companies involved remain sanguine, with a large chunk of trading expected to switch to Zurich and foreign trading shifting to markets such as New York. There is no doubt that this is more than a minor inconvenience and could have potentially damaging market impacts. But the bigger issue reflects global politics, and not for the first time Switzerland finds itself squeezed by the actions of far larger economic blocs.

In the wake of the 2008 financial crisis, pressure from the US and EU forced Switzerland to water down its banking secrecy laws by requiring it to share account data with foreign authorities. Ironically, the state of Delaware remains one of the world’s most important tax havens, and protects the identity and personal information of privately held corporate business owners from public record. Nor is the record of EU Commission President Juncker exactly spotless: After all, he was Prime Minister of Luxembourg when its tax avoidance regime, which was conducive to foreign companies wishing to minimise their tax bill, was set up. It is therefore understandable that the Swiss electorate is not prepared to roll over in front of yet more international pressure on their economic model.

In the current case, the actions of the EU to put pressure on Switzerland have to be seen in the context of the Brexit debate in which the EU wants to be seen to be intolerant of foot-dragging on the part of those countries which do not adhere to their commitments. The UK will watch with interest given that the EU has chosen to make an issue of market equivalence. In the absence of a more concrete plan, the Withdrawal Agreement drawn up between the UK and EU will allow UK financial services providers to access the EU market on the basis of equivalence rather than the current model of passporting. This is granted on the basis that the rules in the UK market are deemed “equivalent” to those in the EU (which given that both sides currently follow the same set of rules is clearly the case). One of the great disadvantages of this model is that either side can end equivalence-based access at short notice, which means it cannot be used as the basis for multi-year financial planning. Nor does the EU have any equivalence-based rules for commercial lending, deposit taking or parts of the insurance sector. Those who can bear to tear themselves away from the unfolding drama of the Conservative leadership race should take note of the EU’s ability to exert pressure.

As for Switzerland, it now finds itself in a very awkward position. The journalist Steffen Klatt has pointed out that there is an inherent contradiction between the will of the people as expressed in the Swiss direct democracy model and the membership requirements of international organisations. The UK might argue that it is in a similar position today. But the crucial difference is that the UK operates a system of representative democracy, and resorting to referendums is an abrogation of responsibility on the part of MPs who the electorate pays to take decisions. Swiss access to the single market was negotiated on the basis of its long-standing commitment to direct democracy - in this sense Switzerland enjoys a far higher degree of democratic engagement than the EU. Unfortunately, it is the EU that has changed its stance more than Switzerland and its criticism is based on the fact that Swiss laws have been slow to adapt to changes in EU internal market law.

Ultimately, the dispute boils down to a conflict between social and economic objectives. Concern about immigration into Switzerland has been rising for some time. Roughly 24% of the Swiss population is foreign born and in 2014 the electorate narrowly voted to support a popular initiative “against mass immigration”. This undermined relationships with the EU, and at the time Switzerland was seen as a European outlier in terms of immigration concerns. However, immigration levels remain the biggest issue for voters across the EU according to the most recent Eurobarometer which is why the likes of the AfD have been making ground in Germany.

Whilst the EU does have legitimate concerns about the way single market laws have been applied in Switzerland, there is also a sense that the EU is using its economic muscle to force compliance at a time when immigration concerns expressed by the Swiss are being reflected elsewhere. I have pointed out before (here) that the political legitimacy of the EU rests on its ability to act in accordance with its citizens’ wishes, and the results of the European Parliament elections last month suggest that there is a diverse range of opinions. The EU is certainly big enough to push Switzerland around, but this kind of behaviour will do nothing to assuage Italian concerns with regard to the EU’s approach to fiscal matters and will only enrage Brexiteers. Sometimes the whole point of carrying a big stick is that you never actually have to use it. In striking at the Swiss, whilst failing to sanction member states such as Poland or Hungary for their flagrant breaches of EU democratic norms, the EU may be lashing out at the wrong target.

The Swiss Vollgeld proposal

On 10 June, the Swiss electorate will be asked to vote on the question of whether the National Bank will be the only institution allowed to create money within Switzerland (the Vollgeld initiative). This is not a vote sanctioned by the government: It is a so-called people’s initiative which allows any changes to the Swiss constitution to be put to a vote so long as the supporting petition contains 100,000 signatures. Indeed, the government’s official position is to oppose the initiative and in all likelihood it will be rejected by the electorate. But it is nonetheless a subject worthy of debate (if not a vote).

The motivation for the vote is simple enough: Since banking crises throughout history have tended to be propagated by a fractional banking system that creates money as a sizeable multiple of that created by the central monetary authority, stripping banks of their money creation powers will enhance the stability of the financial system. The idea is far from new: Indeed, one of the first intellectually coherent forms of the plan was drawn up in the US in the 1930s (the so-called Chicago Plan). The Chicago Plan envisaged the separation of the monetary and credit functions of the banking system by requiring 100% reserve backing for deposits and by ensuring that the financing of new bank credit can only take place through retained earnings. The Vollgeld initiative applies the same principle.

It is all very radical and the SNB wants nothing to do with the idea. It argues that the Swiss financial system has a proven track record and regulation put in place over recent years has made the system more secure. In its words: “There is no fundamental problem that needs fixing. A radical overhaul of Switzerland’s financial system is inadvisable and would entail major risks.” It also points out that forcing the central bank to be the single issuer of money would erode its independence by subjecting it to undesirable political influences. This arises from the fact that the SNB would have to make a decision about the desired quantity of money in the economy, which will undoubtedly be subject to political influence at times when government wants to curry favour with the electorate. In any case, introducing a Vollgeld experiment in a small open economy such as Switzerland will do little to reduce the risks to a banking sector which operates across a whole range of international jurisdictions.

Whilst the Vollgeld proposal is generally viewed by the mainstream of the economics profession as a left-field idea, it does have some support from sane commentators such as Martin Wolf at the FT. Wolf is not exactly an unbiased observer, having served on the UK’s Independent Commission on Banking back in 2011, which was tasked with making the banking system less vulnerable to shocks that could propagate throughout the rest of the economy. There is a belief in many quarters that the ICB’s recommendations were ignored as governments rushed back to business-as-usual so Wolf’s views may be coloured by this experience. But he has long believed that under the current system, banks have an incentive to cram their balance sheet full of risky assets which ultimately require a public guarantee in the event that the economy turns south. And there is truth in this. As a consequence, banks are now required to have much greater capital buffers than in the past. However, it is one thing to raise capital requirements but another thing entirely to require 100% reserve backing.

For all the advantages associated with curbing the powers of private sector monetary creation – it would after all limit the private sector’s involvement in what is essentially a public good – I  am struggling to get my head around how much money the central bank should be allowed to create. Milton Friedman once advocated a k-percent rule in which “the stock of money [should be] increased at a fixed rate year-in and year-out without any variation in the rate of increase to meet cyclical needs.” In such an instance, it is difficult to avoid the conclusion that a slower rate of credit growth will impose limits on the pace at which living standards will rise. For example, there will be limits on the central bank’s ability to create sufficient credit to match demand for mortgages. And someone will have to make a decision on how to prioritise one category of borrowing over another.

In any case, as the Swiss government points out, banks cannot increase the supply of credit indefinitely. The price of credit in the form of the central bank interest rate acts as a constraint on both demand and supply. Although full deposit coverage of credit creation has not been tried before, the UK experience of limited credit rationing prior to 1971 was not good and was perceived to be one of the factors restraining UK growth compared to other European nations. The real irony in all of this is that Switzerland is one of the world’s most stable economies. As the chart (taken from the FT) indicates, Latin American and Asian nations have taken a big hit in the wake of a credit crunch in recent years – as have the US and UK. But of all the places to justify experimenting with a Vollgeld programme, Switzerland would not be high on the list.