Tuesday, February 17, 2015

More Basic Macro

David Glasner again argues against the identity between saving and investment.    He finds some quote by Scott Sumner where it sounds like Sumner claims that the profession has just decided to define saving so that it means the same thing as investment.   I don't really think that is true.

I certainly see saving and investment as quite different things.   Saving is that part of income not spent on consumer goods.   Investment is spending on capital goods.   They aren't anything like the same sort of thing.   That they must always be equal as a matter of arithmetic is a bit remarkable.   But it is true.

In my opinion, there was a tendency by Keynes and some of his followers to confuse the identity with an equilibrium process by which a change in planned saving or investment causes output to change until planned saving again equals planned investment.    Worse, very poor arguments were sometimes made against the orthodox view that interest rates adjust to bring saving and investment into equilibrium on the grounds that saving and investment are always equal.  

Planned saving doesn't have to equal planned investment.    It is certainly possible that interest rates might change to bring planned saving and planned investment into equilibrium.   It is even possible that output and income might adjust to bring planned saving and planned investment into equilibrium.

Purchases and sales are equal by definition.   But quantity supplied and quantity demanded can be different.   Quantity supplied is planned sales and quantity demanded is planned purchases.   They don't have to be equal, but the price can adjust to bring them into equilibrium.   It would be a very poor argument to say that the price cannot adjust to bring quantity supplied and quantity demand into equilibrium because purchases and sales are always equal by definition.   And then to insist that the quantity will adjust to the amount purchased at a given price and call that equilibrium.   That might be what would happen, but it is what we call "surplus."

Suppose there is an all service economy.   Further, everyone is an independent businessman.   Everyone's income is someone else's expenditure.    Everyone's expenditure is someone else's income.

The barber's expenditure on massages is the income of the masseuse.   The expenditure of the masseuse on haircuts is the income of the barber.   The expenditures of the barber and masseuse on musical performances is the income of the musician.

And, further, the expenditure of the musician on music lessons is the income of the teacher of music.

Income and expenditures are equal.   It is like receipts from sales are equal to spending on purchases.  No, it is exactly the same thing as receipts from sales are equal to spending on purchases.

Now, that part of income not spent on services that start with the letters A to M must equal spending on services that start with letters N to Z.    It isn't that anyone must spend some particular amount on any particular service, it is rather that the economist is partitioning income and expenditure.

And really, it is just a partition of expenditure.   To say "that the part of income not spent on services that start with the letters A to M" is the same thing as saying "that part of expenditure that is not expenditure on services that start with the letters A to M."   The other part of expenditure must be expenditure on services that start with the letters N to Z.

If we define that part of income not spent on services that start with letters A to M as saving and spending on services that start with N to Z as investment, then saving and investment must be equal by definition.

Further, in a four service economy, that part of income not spent on haircuts, massages, or musical performances must be equal to the amount spent on music lessons.   That part of income not spent on haircuts, massages, or musical performances is saving.   Spending on music lessons is investment.   Saving equals investment.

Does adding entrepreneurs hiring workers to produce the services make a difference?   No.   Because the revenues of the firms will equal wages plus profits--income to the employees plus income to the entrepreneurs.

Does the production of goods make a difference?   Well, there is the possibility that goods will be produced and not sold.    But that doesn't really matter either.   What is in fact done is that unsold goods are counted as purchased by the producer, and included as inventory investment.   What this implies is what is actually produced results in a matching income and as well as matching expenditures.   Income equals output and output equals expenditures, so income equals expenditures.   But consideration of the all service economy where unsold output isn't an issue shows that income equals expenditure anyway.

Nothing in this argument says that expenditure equals potential output--which is more or less the same thing as saying quantity demanded equals quantity supplied.   The prices need to be right for that to happen.   The interest rate has to be right for planned saving to equal planned investment while expenditure equals potential output.   Again, this is the same thing as the prices have to be right so that quantity supplied equals quantity demanded.   And finally, the nominal quantity of money very much impacts which money prices and wages are the ones that keep quantity supplied and demanded equal.

Saturday, February 14, 2015

Sumner and Glasner on Identities

Sumner has repeated his claim that saving and investment are always equal as a matter of definition.   Glasner has taken him to task.  As always, I disagree with both of them.

Sumner is correct, but makes the same error as Keynes in giving these identities much significance.

I think Glasner is pretty much in error about the identities, but is correct that the equilibrium conditions are all that matter.

In my teaching, I have long emphasized what I was told is the "basic identify of macroeconomics."   This identity is income equals output.

The reason that it is true, and true by definition is that profit is both defined to be a part of income and also as the value of output minus the other sorts of incomes--wages, interest and rents.   Wages, interest, and rents usually involve some flow of funds from the firms, though they can just be an accrued cost.   And the value of output usually represents a flow of funds to firms, but output that is unsold or else sold with no funds collected still counts.

Anyway, with profit being output minus other sorts of income, then by the definition of addition and subtraction, output must equal profit plus other sorts of income.  Since profit plus other sorts of income is income (in total,) then income equals output.

That output equals expenditure is also an identity.   That is because all output is counted as having been purchased by someone.   And while most output is sold and purchased by some buyer, that part of output that is not purchased by anyone counts as inventory investment.   The firm that produced it and did not sell it is counted as having purchased it.

Now, with expenditure equal to output due to inventory investment, and output equal to income because of the definition of profit, then by a matter of the definition, income equals expenditure.

The big fudge factor here is the profit on inventory investment.   If firms produce something with the intention that they will sell it to someone else, and they don't, the payments they would have received as profit if they had sold it is counted as part of profit and so income.   What kind of income is that?  It is hardly something you can spend.

The equilibrium condition that Glasner emphasizes is that firms will not produce output to obtain these pseudo-profits, and so will adjust output to sales plus desired inventory investment.   In other words, firms will adjust production to avoid unplanned inventory investment.

I am embarrassed to admit that it was just over the last few years after reading Nick Rowe it became obvious to me that much of this is irrelevant for the service sector--not a small consideration.   The actual output of the services necessarily equals the expenditures on services.    And so expenditures on services must then always equal income from services (including profit or loss.)

As I have pointed out before, this is equivalent to pointing out that purchases and sales for some good are equal.   Spending by buyers matches receipts to sellers.  

But, of course, in microeconomics, we are concerned with quantity supplied equaling quantity demanded, which involves planned purchases and sales--an equilibrium condition.

And so, while income equals output equals expenditure is true enough, and I can never understand why Glasner says they are not, I don't think it matters much.   And so when Sumner seems to think it does matter, I find it puzzling.

In a closed private economy, saving must equal investment.   This is a matter of definition.  Saving is defined as income less consumption.   All output is defined as either being consumer goods or capital goods.   Consumption is spending on consumer goods and investment is spending on capital goods.   All expenditure is either on consumer goods or capital goods.   Since income equals expenditure, and consumption is itself, then income less consumption must equal expenditure less consumption.  By the definition of saving and investment, saving and investment are always equal.

I guess someone might think that is all insightful, but it comes down to saying that purchases equals sales.

To say that at the natural interest rate saving equals investment is like saying at the equilibrium price quantity supplied equals quantity demanded.   To say that savings always equals investment is like saying that purchases always equals sales by definition.

What about Sumner's argument?   Suppose nominal (and real) income falls.   Households don't want to cut consumption and so reduce saving.   That makes sense.  It is based upon what households choose to do.

Now, investment must equal saving by definition, so investment must fall more than in proportion to nominal income?

Well, no.   What causes firms to choose to spend less on capital goods?    It isn't that the definitions make them do it.   Real firms have to choose not to order up capital goods.   Now, if they didn't cut back their capital spending, then perhaps nominal income wouldn't have decreased as much after all.

Consider the expectation that nominal income will fall.   Households respond by cutting consumption now, but just a little because of consumption smoothing.  Firms cut planned investment a lot.   But it is because the reduction in expected sales causes them to want to cut investment a lot, and it is that actual decision by firms that causes current nominal income to fall more than in proportion to the decrease in consumption.   It isn't that there is a given decrease in nominal income and because consumption falls less than in proportion to the decrease in nominal income, investment must fall more than in proportion to the decrease in nominal income.   The decrease in velocity (or increase in money demand) or even the decrease in the quantity of money due to the expectation of lower future nominal income depends on the decisions of the firms and households.

Friday, February 13, 2015

What do Central Bankers Want?

Scott Sumner asks if central bankers are more concerned with the bond market than the labor market.

My theory of central banker behavior is to minimize the increase in short term interest rates subject to the constraint that neither unemployment or inflation rise to high.

So, that is different from being worried that long term interest rates will rise,  creating capital losses in bond markets.   A series of small increases in short term rates should immediately depress long term bond prices if anticipated.  

In the old days, a liquidity crunch would cause a spike in short run interest rates.   This would be really bad for money center commercial banks (who borrow "hot" money,) as well as investment banks borrowing short to fund their inventories of securities that they have underwritten and not yet sold.

Central banks have not forgotten.   Avoiding spikes in short term rates is their key mission.

Now, they have learned that never increasing short term rates can be a disaster in some circumstances.   Inflation might rise too high.   While this is bad because of voters and politicians don't like high and especially higher inflation, it is also true that when they are finally forced to respond to the inflation, they must hike short term rates.   A series of small and modest interest rate increases now is better than much larger increases later.

And, of course, they have learned that when they finally act to choke of the inflation, unemployment will rise and voters and politicians hate that as well.

So, raise interest rates a smaller amount now each month and keep it up.   While that is "bad" compared to leaving interest rates the same, which is ideal, waiting until inflation picks up and interest rates must rise alot and unemployment will rise--so much the worse.

While this theory provides no explanation of why central bankers don't like lower short term rates, I think there the problem is almost entirely a worry that they will be forced to raise them latter.

They don't mind lower interest rates, but they don't really see it as a  good thing, but if they must raise them latter, that is really bad.

Of course, presumably they understand that failure to lower interest rates when needed can lead to rising unemployment, which voters and politicians hate.   And so, they do need to lower interest rates sometime.

Basically, the ideal is for short term interest rates to stay constant.   And when that troublesome economy forces them to adjust them to avoid unemployment or inflation, they will do so.   And a series of modest changes is better than sudden changes.

Tuesday, February 10, 2015

Richard Wagner's Critique of Market Monetarism

Writing with Vipen Veetil, Richard Wagner of George Mason University has criticized Market Monetarism and particularly nominal GDP level targeting as chasing a mirage.   (Wagner was my public finance professor at Virginia Tech in the late seventies.)

Some of their arguments are mistaken characterizations of market monetarism.   They make an implicit claim of "all" when a more appropriate statement would be "some."   While Scott Sumner's approach to macroeconomic theory is sometimes a bit baffling to me, and I have no problem with them citing the Nunes-Cole monograph, their criticism of Leland Yeager's monetary disequilibrium approach is far off the mark.   Leland Yeager did not use representative agent models, and to transition from claiming that market monetarists are implicitly using a representative agent model to to claiming that they do use such models is an error.

The monetary disequilibrium approach to recession is not based upon the assumption that all increases in the demand for money are proportional for each and every individual demanding more money.   This is no more implicit in the analysis of the supply and demand for money than it is in the analysis of the supply and demand for apples.   An increase in the market demand for apples might well involve some households planning to purchase more apples and others planning to purchase the same amount of apples and even some purchasing  fewer apples.    All the same, there is a shortage of apples at the current market price.   If the market demand were unchanged, despite some households purchasing more and others purchasing less, there would be no market disequilibrium.   And perhaps I am wrong, but I am pretty sure that those who plan to purchase more could complete their plans by purchasing those apples that would have been sold to those households who chose to purchase less.

In the case of money, when those demanding more money restrict expenditures out of current income, this does necessarily impact those who would have otherwise sold them products    And if this is matched by others demanding less money and so spending more on goods and services, then that will also impact those that have increased sales.   In aggregate, total spending, sales, and income are unchanged.   It is conceivable that the person demanding more money would reduce expenditure on the very same product that those demanding less money choose to purchase.   In a one good economy, that is necessarily true.   However, more generally, this shift in the demand for money among different individuals will impact the composition of the demand for output.

There is nothing unique about money.   Suppose rather than accumulating money, an individual saves by purchasing bonds.   At the same time, someone else dissaves by selling bonds.   If we had a single consumer good, then the decrease in demand for the consumer good by the saver would be exactly offset by the increase in the demand for the consumer good by the dissaver.   However, more generally, there will be a change in the composition of demand for consumer goods--less on the particular goods the saver refrains from buying and more demand for the particular goods the dissaver chooses to buy.

Rather than dissaving, a firm might sell bonds that were previously held as retained earnings or perhaps issue new bonds.   In that situation, there is a decrease in spending on some particular consumer goods favored by the households that are saving and an expansion in spending on some particular capital goods that the firms selling the bonds believe can be profitably employed.   This reduced spending would impact those who would have sold the consumer goods and the increased spending would impact those selling additional capital goods.   This would be no different than if the household had saved by accumulating money, while the firm had reduced money holdings and used it to fund the purchase of capital goods. Further, if the firm purchasing capital goods was in a position to fund them by issuing new money, the effects on the sellers of the capital goods and those who in turn sell to them would be the exact same.    

Back to the apples.   If the market demand for apples increased, then at the existing price there is a shortage.   Superficially, the solution is a higher market price for apples.   If the quantity of apples is fixed, then the higher price simply rations the apples to those households that value them most.   There is no assumption that all households end up with the same amount of apples as before.   As the price increases, the quantity of apples demanded would decrease.   The most likely pattern is that those households that did not initially demand more apples would end up purchasing fewer apples and those households that did demand more apples, while purchasing less than they would have liked at the old market price, will end up purchasing and consuming more.   The apples would be redistributed from those with unchanging demand to those demanding more.   And if there had been some households who happened to be demanding less anyway, the higher price would reinforce that reduction further reducing their purchases by more than they had planned.

However, if the supply of apples is not perfectly inelastic, then the sellers of applies will produce more--quantity supplied will increase.  Now, is there an assumption that all apple producers increase quantity supplied in proportion?   Not at all.   Market clearing just requires that the quantity supplied match the quantity demanded by the market.   There could easily be a shift in market shares among apple producers along with the shift in the distribution of apple consumption among households.

If the supply of apples were perfectly elastic, then the shortage of apples would be cleared up by an increase in the quantity of apples at an unchanged price.    Those households demanding less apples would get less, those demanding the same would get the same, and those demanding more would get more.

Now, would it be bad for the supply of apples to be perfectly elastic?   If apples could be produced at constant cost, would it be socially desirable to make sure that the quantity of apples did not increase so that the increase in demand were entirely choked off by a higher price?

I think not, and in fact, there is a sense in which I would think that it would be desirable if the supply of apples were perfectly elastic, so that the quantity could adjust with demand.   Of course, if that isn't the cost structure of the industry, then trying to make the supply of apples perfectly elastic would likely do more harm  than good.

The monetary disequilibrium approach suggests that it is quite possible for the supply of money to be perfectly elastic.   And that there is no problem with the quantity of money adjusting to changes in the demand to hold money.   There is nothing in the approach that suggests  that these shifts in the demand for money accommodated by changes in the quantity of money would have no impact on the the pattern of expenditures in the economy.   In a world with many firms and households and many goods and services, in general, the pattern of expenditures would and should change.

Wagner and Veetil make the same error as Hayek.   They dwell on some bizarre notion of perfectly neutral money, and fail to see that a reallocation of expenditure in the economy is generally appropriate and coordinating when the quantity of money adjusts to meet the demand to hold money.   Imagining that the "proper" way for new money to enter the economy is as a free gift to those demanding more money so that they continue to spend as before, is just groundless.

For example, if households choose to save by spending less on consumer goods and services out of income--refraining from writing checks to purchase consumer goods while continuing to have income payments credited to their checking accounts, then this is going to impact those selling the consumer goods they would have bought.  Those sellers will in turn have to restrain expenditure and so on.    That the banks extend new loans to firms wanting to purchase capital goods will certainly result in those selling capital goods having greater receipts, and they will spend more and so on.   This change in the pattern of expenditure is exactly what would have happened if the households had saved by purchasing bonds newly issued by the firms who wanted to invest.  An increase in saving matched by an increase in investment is exactly the appropriate reallocation of expenditure in the economy.

But what if the banks had to lower interest rates to generate more loan demand?  Is this some kind of distortion of interest rates?   No.   If the households had purchased bonds, the prices of the bonds would have increased and the interest rates would have fallen, which would motivate the firms to issue new bonds and buy capital goods.    This is exactly what should happen.

I am a market monetarist.   I am pretty much a "charter member" of the club.   I hope that this brief analysis shows that at least some market monetarists are well aware of microeconomics (the supply and demand for apples) and do not assume that changes in the demand for money are necessarily proportional and further, do not ignore the impact of shifts in money demand on the composition of spending on output and the allocation of resources.

Personally, I find analogies using the supply and demand for apples much more useful than highly abstract discussions of plan coordination, number matching games, or airplane piloting.

And nothing is a substitute for actually thinking about what happens when households and firms choose to change their money balances along with the money supply process.   And, of course, what happens when there are other changes in the pattern of demands, including changes in saving and investment coordinated by the purchase and sale of nonmonetary financial instruments.

In this post I have focused on Wagner and Veetil's mistaken claims about monetary equilibrium and disequilbrium theory and particular their claim that market monetarists necessarily assume that aggregates directly impact one another or shifts in the demand for money or changes in velocity must be proportional or that there is an implicit or explicit assumption of representative agents.

I will later briefly review why needed reallocations of resources are best coordinated in an environment of stable aggregate expenditure rather than having total expenditure shift.   This includes all sorts of changes, but including especially some need to shift from the production of capital goods to consumer goods (the Mises problem) or with the introduction of new products or more efficient production processes (the Schumpeter problem.)

And finally, I will discuss the theory that an increase in the demand to hold money because plans are not coordinated should not be accommodated by an increase in the quantity of money because it would interfere with the supposedly desirable situation of resources waiting patiently to be utilized in entrepreneurial plans.   In my view, while entrepreneurship and plan coordination are important in economics, it is important not to ignore some fundamental microeconomic concepts such as scarcity.

Monday, February 9, 2015

Renewing the Search for a Monetary Constitution

The book from the Liberty Fund Conference is finally out.   I have a chapter about nominal GDP level targeting and free banking.

There is a Cato Event with editor Larry White about the book.   It will be in the D.C. area on February 25.   Here is the information.   You can watch it live online.

Two Visions: Short Videos

Watch them both!

Capitalism as exploitation

Capitalism as liberation

Thursday, February 5, 2015

Murphy's Puzzling Reply Regarding Swiss Francs

Robert Murphy made a reply to my post about Swiss Francs.

David Beckworth–who wants a kinder, gentler Market Monetarism–sent me Bill Woolsey’s reply to my stuff about Switzerland. Sure, as with any intervention, you could do follow-up interventions to postpone the bad consequences. In this case, Woolsey (among other things) says that the Swiss might have to restrict the issuance of large-denomination bills, to thwart the desires of people to save. And this is at the “Monetary Freedom” blog, mind you.


I am not sure what was the "intervention" I was proposing or the "further intervention" that will merely "postpone" bad consequences.   

I believe that anyone who wants to try to borrow by issuing large denomination notes should be free to do so--if they can find someone to hold them.   And further, people who want to lend by holding such notes should also be free to do so, if they can find someone to issue them.

As a rule, I don't think anyone should be obligated to either hold or issue large denomination notes against their will.

In particular, if some private bank wants to issue Swiss Franc notes in large denominations, they should be free to do so.   They can determine whether they can find a profitable use for the funds.  If they choose to issue them, then people who want to hold them should be free to do so.

As I mentioned before, I don't favor having the Swiss National Bank, any other central bank, or any other government agency issue hand-to-hand currency.   I support full privatization of hand-to-hand currency.

However, if they monopolize the issue of currency,  I think they have some obligation to meet the demand.   But more importantly, if they make it legal tender for all debts private and public, failure to accommodate shifts in demand is criminal.  (Well, I really mean sinful and wicked.)    They really should issue more when the demand to hold it rises and issue less when the demand to hold it falls.

I also favor having the interest rate paid on reserve balances float below the interest rate on other sorts of short and safe assets.   Preferably, something more like a mutual fund than a debt instrument, with the yield based upon the central bank's asset portfolio and its operating costs being covered by the service fee.  In other words, I don't favor having the central bank help private banks "save" either.   The purpose of reserve balances should be to clear checks, banknotes, and electronic payments.

I admit that I am a bit partial to saving.   Especially when savers purchase equity used to finance capital goods for private enterprise.   I understand that debt finance allows for risk sharing creating gains from trade among savers.   That includes bank deposits of various sorts, as well as banknotes.    And I can see the value in consumer lending too.  Still, savers buying newly issued stock to finance a new wing for a factory--just seems right.

But I don't favor having the government run budget deficits so that there will be a bigger national debt because savers will benefit from lending to the government.  And that includes government borrowing by the issue of currency either directly or through a central bank.

So, is this violating the liberty of savers?   Well, only if you believe that they are entitled to have the government create convenient assets for them to buy.   I don't think that.   If they want to save, they should buy private assets.   You know, assets freely created by those wanting to issue them.

Sunday, February 1, 2015

SNB and Swiss Francs

I have written a couple of comments on other blogs about the Swiss National Bank's decision to let the Swiss Franc float, and the resulting 20 percent appreciation against the Euro.   The SNB held a substantial amount of Euro denominated assets, and so the result was heavy financial losses.    The rise in the value of the Swiss Franc will result in cheaper imports from the Euro-zone, and so exacerbate  consumer price deflation in Switzerland.   That is inconsistent with the Swiss National Bank's inflation target.

Robert Murphy reproduced a graph that showed a large increase in the Swiss monetary base.   It was approximately equal to Swiss GDP.   I wrote a comment pointing out that creating base money is easy.   What is the problem?

Of course, I do realize the problem is possible losses on the assets that the Swiss National Bank is purchasing.   I discussed that in a comment on a post on Sumner's Money Illusion blog.   He reproduced it in a later post on Econlog.   If the demand for Swiss base money increases temporarily, then the proper response is for the SNB to expand the quantity temporarily.  However, if it finds itself purchasing risky assets to match the added liabilities, then it should lower the interest rate it pays on reserve balances, perhaps below zero.   As Koning pointed out in a post on his blog, if the interest rate on SNB reserve balances falls below zero, then this will create an incentive to hold currency.    This would be an incentive by banks (especially Swiss ones) to hold vault cash and for people to keep currency in safe deposit boxes.   I endorsed Koning's point that if the SNB is charging for reserve balances, then it needs to stop issuing large denomination banknotes convenient for hoarding.   I argued that it should limit its issue of currency to denominations appropriate for retail trade in Switzerland.

Now, I don't believe that the SNB should be targeting the Euro or consumer price inflation.  The SNB should not worry about deflation of import prices, but only the impact on the demand for Swiss exports and the secondary effect of import deflation on the demand for Swiss import competing products.   Well, more exactly, it should be targeting Swiss nominal GDP which includes exports and import-competing (and other) Swiss goods and services.

Given its close trading ties to the Euro-zone, keeping nominal GDP growing on a stable growth path (say 3 percent) would likely result in depreciation of the Swiss franc relative to the Euro as long as the ECB continues with a deflationary policy.   A commitment to allowing the Swiss franc to depreciate in that way would tend to reduce the demand for Swiss francs.   Or at least, it will tend to reduce the demand for currency issued by the SNB and by refraining from raising the interest rate paid on reserve balances, the SNB could reduces the demand for reserve balances.  Swiss banks, similarly could limit the increase in deposit interest rates to limit growth in their deposits.

Murphy's response to my brief comment on his blog was to describe a scenario where the huge increase in the quantity of Swiss francs starts to cause inflation.   The SNB needs to reduce the quantity of base money to prevent the inflation.   But at that same time, the Swiss franc rises relative to the Euro and so the SNB takes large losses on Euro-denominated assets.   More importantly, sales of these lower valued Euro-denominated assets will cause a smaller reduction in the the quantity Swiss base money.   In the extreme, the SNB may not be able to reduce its issue of base money enough to prevent inflation because it lacks sufficient assets to sell.

The first problem with the argument is the presumption that any increase in the quantity of money is inflationary.   While this is true if we start in equilibrium and the demand for money is held constant, it is false if the quantity of money only rises to match an increase in the demand to hold money.   It is supply and demand, not just supply.  

So, the worry isn't some kind of inevitable inflationary impact of an increase in the quantity of Swiss francs, but rather the possibility that the demand to hold Swiss francs might fall.   The SNB must be in a position to sell off assets and reduce the quantity of Swiss francs to match possible reductions in the demand to hold them.

Now, how exactly is it that the Swiss franc is going to appreciate against the Euro in this scenario?   If anything, the reduction in the demand to hold the Swiss franc would cause it to depreciate.   This would increase the value of Euro-denominated assets and make them more able to absorb Swiss francs when sold.

Suppose that the Euro-zones deflationary problem shifts to inflation.   This could cause the Euro to depreciate.   And so now, the SNB has Euro-denominated assets that have lost value.   But is this realistically a situation where the demand for Swiss francs would fall?   Wouldn't inflation in the Euro-zone instead result in a higher demand for Swiss francs?

And finally, as Sumner has pointed out, maybe the SNB should diversify its asset portfolio--don't just purchase Euro-denominated assets, purchase dollar (and yen) assets too.   Remember, the problem isn't that the increase in the quantity of base money is inherently inflationary.   It is to avoid net losses on the SNB's asset portfolio.

Consider a scenario that has been common in history, but far removed from the current situation:

Suppose the SNB was propping up the Euro by purchasing Euro-denominated assets.  The problem is that the Euro zone is suffering from inflation and the SNB is responding to concerns by Swiss exporters.   A higher Swiss franc will hurt their sales and profits.    The SNB is purchasing Euros with newly-created Swiss francs, causing an excess supply of Swiss francs.   Eventually (after the long and variable lags,) this excess supply of Swiss francs will lead to inflation in Switzerland.   It would be  a classic case of imported inflation.   If and when the SNB gives up on the policy and no longer supports the Euro, the Euro will fall.   Just when Switzerland needs to reduce the quantity of Swiss francs, its Euro-assets will have fallen in value.

Well, that would be a bad policy.   But that is not what is happening.   The demand for Swiss francs has risen.   And the SNB needs to accommodate the higher demand to hold its liabilities by issuing more or else come up with a way to dampen the increase in demand by lowering the interest rate paid (or raise the amount charged) for deposit balances.   As for hand-to-hand currency, it can quit issuing denominations convenient for large scale hoarding.   I believe that the SNB, like other central banks, should get out of the hand-to-hand currency business, so that this would not be a policy matter, but rather a decision by private banks to limit their issue of hand-to-hand currency when they find it profitable to do so.