From the May 2013 issue of Research Magazine • Subscribe!

April 29, 2013

Stolid Switzerland’s Different Path

Both the United States and Switzerland are pulling out of the post-2008 global economic slump on the wave of speculative bubbles. But while Washington is stoking its bubble in the hope of achieving faster economic growth, the Swiss are working to prevent their bubble from getting out of hand.

It is by now evident that the economies of rich industrial nations grow in a boom and bust cycle that was previously a prerogative mainly of emerging economies. In the U.S., the bust after the dot-com-driven economic upswing was followed by a boom in housing. When that, too, came a-cropper in 2008—spectacularly so—it was replaced by the easy-money bubble of the past five years, which pushed the prolonged rally in Treasuries into a speculative phase and extended the bubble in oil and other commodities.

The economic consensus continues to allay our fears, claiming that there is no bubble either in U.S. government bonds or in oil prices. Treasuries look good in comparison to European and even Japanese government bonds, and the U.S. is in no danger of defaulting. And oil prices can be expected to stay elevated since we have reached the historic peak of oil production and output will now start to decline steadily.

However, with U.S. inflation averaging above 2% a year, the yield on the 10-year Treasury, averaging 1.75% over the past year, has been negative in real terms. In other words, long bond investors have been paying Uncle Sam for the privilege of lending it money. Meanwhile, the 30-year bond, with its 3% yield, incorporates wholly unrealistic expectations about U.S. public finances over the next three decades. Similarly, hopes that inflation-adjusted oil prices will remain at more than twice their 50-year average are illusory, given new sources of supply and energy-saving technologies.

In fact, assurances that these two bubbles will endure are uncannily reminiscent of the talk of the “new economy” in the 1990s and the belief that “homeowners never default on their mortgages” and that “house prices never go down” in the mid-2000s.

Of course, bubbles could emerge again in the same market after a while—just as they used to do in Hong Kong or South Korea. But it hasn’t worked like that in the U.S. More than a decade after the high-tech bubble burst, the Nasdaq Composite index stands at two-thirds of its 2000 high, while the number of issues traded today is less than half of what it was back then and continues to dwindle.

Similarly, the housing market and the construction industry, despite an uptick in early 2013, remain in the doldrums more than six years since house prices started to decline. Worse, each new bubble appears to produce a weaker recovery, with fewer jobs created, whereas busts have shown an alarming tendency to increase in severity and length.

Uneven Distribution

Speculative bubbles tend to distort the markets, attracting a disproportionate amount of financial resources to selected sectors while starving others. The Federal Reserve and other major central banks have created an unprecedented amount of liquidity—several trillion dollars’ worth since the advent of the global financial crisis in 2008. But only a small portion of the money has gone where it could be used productively, i.e., to make loans to businesses and consumers. The bulk of the newly created liquidity ended up in the U.S. Treasuries and in Switzerland, which has emerged as a safe haven of last resort.

The Swiss have experienced a massive inflow of funds from the crisis-ridden euro-zone, and not only from troubled economies on its periphery, but from stronger ones in the north, as investors fear the collapse of the single currency and financial chaos everywhere in the European Union. Since 2008, the franc has risen by one-third against the euro. And even against the U.S. dollar, which strengthened against the euro as a result of financial turmoil in the eurozone, the franc has moved up substantially over the past five years.

For Switzerland’s exceptionally open economy a strong franc is something of a catastrophe. Exports of goods and services account for almost 55% of the country’s GDP, compared to less than 15% for the U.S. Switzerland’s current account surplus, which measures 11% of GDP, is a key determinant of economic growth. An overvalued franc—and it is overvalued by some 60% according to The Economist’s Big Mac index—threatens to undermine Swiss manufacturing, hitting its exports and hooking consumers on cheap imports.

Switzerland’s tourist industry, already decimated in the final decades of the 20th century, is suffering further damage as the country becomes unaffordable for middle-class visitors. At a Zurich Starbuck’s, for instance, a cup of medium-sized fresh-brewed coffee, which sells for around $2.40 in New York, will set you back by more than $5.

Righting the Ship

The Swiss government and the Swiss National Bank, its central bank, have been running a very tight ship. The SNB gets nervous when Swiss GDP grows at a rate of more than 2%, and it has been steadily mopping up the liquidity flooding Swiss banks. Wages and consumption have been crimped, and consumer prices actually declined during 2012. Since, in the Eurozone, inflation has been running at close to 2%, while prices in Switzerland have been flat or declining, the franc’s overvaluation against the euro, as well as the dollar, will gradually disappear.

But this is only part of the solution. Looking ahead in the not-too-distant future, the Swiss authorities can easily see new waves of foreign money washing over their borders. The crisis in Cyprus has left vast sums of Russian money stranded in the island’s banking system. Corporate and private depositors will suffer losses, and likely will withdraw the bulk of their funds from Cyprus once it becomes possible. Henceforth, Russian capital flight, measured at some $54 billion last year, will probably opt for greater safety, which at this point means Switzerland.

Since 2011, the SNB has maintained a ceiling on the euro exchange rate at 1.20 Swiss francs. By now it has established considerable credibility for this policy, so that if the eurozone crisis flares up again—for instance, as a result of the Cyprus debacle or the decision by the Supreme Court in Portugal to strike down austerity measures—the Swiss will be prepared to keep the franc from rising into the stratosphere.

Stocks Benefit

Measures to restrain economic growth, limit consumption and not allow a speculative bubble to develop may make the Swiss economy staid and less dynamic. After all, it is Switzerland, the land of the cuckoo clock. In fact, for all the inflow of funds, the Zurich stock market has performed largely in line with other major markets in Europe, such as Frankfurt and London. But over the longer term, its gains in dollar and euro terms, as well as adjusted for inflation, have been substantially higher.

If the euro does tumble, and capital flees to Switzerland, it is unlikely to be attracted to the Confederation’s long bonds, which yield less than 0.7% on an annualized basis, the lowest in the world after Japanese government bonds. Swiss blue chip corporations, on the other hand, offer safety that is similar to government bonds and often pay attractive dividends, which for such companies as ABB, Novartis and Nestle measure in the environs of 3%.

There have been concerns about the performance of the Swiss corporate sector in the future, following the referendum in March to make decisions on executive pay contingent on shareholder approval, as well as to limit golden handshakes and golden parachutes. Opponents of such measures saw them as unwarranted interference into the private sector and claimed that Swiss companies will either be unable to attract executive talent or decamp abroad.

Defenders of the measure, meanwhile, have suggested that a compulsory say-on-pay requirement will improve corporate governance and align the interests of executives with those of shareholders. As to finding a more attractive place to do business, it should be kept in mind that Switzerland finished first in the Global Competitiveness Index compiled by the Davos World Economic Forum four years running.

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