Introduction via cointelegraph.com
Cracks in the financial system and currency pegging
If a country is able to control its domestic currency it can and will in effect keep its exchange rate low. This helps support the competitiveness of the country’s exports sold abroad. These low exchange rates help boost profitability from domestic companies selling goods internationally by keeping the costs of production low and selling to countries with stronger currencies (think China, the U.S. and Eurozone).
By pegging your currency, you are ensuring that your currency can’t strengthen to a point where it hurts the domestic economy and placing a tight band so as to smooth out volatile currency swings and reduce the likelihood of a currency crisis. If your currency experiences a sharp appreciation, it makes your products and services more expensive and less competitive in the market, which is recessionary.
However, this does come with a cost. When a country fixes (pegs) its exchange rate, it must be maintained within the band that is set. This requires a large amount of reserves because the country’s government and central bank have to constantly buy and sell its domestic currency. The problem with this is it can have really bad inflationary side effects. In order to maintain this reserve a country has to increase its money supply, since you need to hold more currency reserves in order to take action as necessary.
This will cause rising domestic prices and increase domestic instability, which is the exact opposite of what a currency peg is designed to do i.e to support a rising standard of living for the population and protect the domestic economy from price spikes. Below is an example of what the peg looks like.
The Swiss decided to peg their currency to the Euro because the Swiss Franc is seen as a flight to safety and as a safe proxy to global growth.
The logical sequence is:
- The central bank prints money and artificially makes local assets cheaper for foreigners
- Asset prices in the local economy go up
- Real estate prices move into higher rents
- Higher rents and higher asset prices translate into higher living costs
- Wage earners want to be compensated for higher living costs
- Wages go up –> wage inflation
- Entrepreneurs raise prices so that margins are maintained
- Result is price inflation or potentially a wage-price-spiral
The “Save Our Swiss Gold” backdrop has arisen out of a failed policy of currency pegging.
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