In times of crisis, it's useful to think of international capital flows as floodwaters, or as mudslides.
Just as Hurricane Katrina's storm surge overwhelmed the levees protecting New Orleans, there is a point when the flood of capital is so strong that central banks can no longer protect their local economies. Whether their interventions are aimed at supporting a local currency or at preventing one from rising, the costs eventually become too great to continue with them.
Even when it does work, intervention tends to divert the effect of flight capital onto other, underprotected countries. Here the effect is comparable to the destruction of poor Filipino villagers' homes after Mount Pinatubo's 1991 eruption, when a massive lava-filled mudslide was redirected toward them by a dike surrounding a wealthier district.
There are lessons here for the Swiss National Bank. In a desperate move to limit gains in the Swiss franc, a traditional safe haven, it has imposed a CHF1.20 floor on the value of the euro and has committed to buy "unlimited" euros to maintain it. But the flood of incoming euros is now swelling by the day. This is raising the risks for both Switzerland's own economy and those of other countries.
Over the past 2 1/2 months, anxiety over the euro crisis has risen sharply, to the point that investors are now worrying about a meltdown in Spain and a Greek exit from the European monetary union. That has driven even more investors into the franc.
At first glance, currency charts suggest Switzerland's central bank has done a tremendous job of calming the market. Apart from a brief drop to CHF1.1990 on April 5 and an anomalous spike to CHF1.2077 on May 24, the euro has stuck to a very tight range versus the Swiss franc of CHF1.2006 to CHF1.2040--less than half a centime--since early April.
But as the chart tapers down to the CHF1.20 level, giving it the ominous impression of an EKG gone dead, it also demonstrates that investors are more willing than ever to hold this quasi-fixed Swiss currency rather than one that's fraught with the risk of collapse. That's despite the fact that Swiss short-term debt pays negative interest rates. In fact, if the SNB had truly been successful at changing market demand patterns, the chart would look more dynamic: The euro would move up and down within a range of, say, five centimes, instead of congregating around CHF1.20.
Meanwhile, the cost of the SNB's interventions is apparent in its reserves data. Last Thursday, the central bank reported that the value of its international currency reserves surged by 66.2 billion Swiss francs ($69 billion) in May to CHF303.8 billion. To put that in perspective, the increase was 1 1/2 times the size of Switzerland's monthly GDP.
The SNB doesn't break out the components of its reserves, but a very large part of that gain most certainly came from euro purchases. The SNB's policy is forcing it to accumulate an alarmingly large exposure to a currency that no one wants, the toxic unit of a monetary union that may not even survive the next 12 months. And if Spain drops into a true Greece-like crisis, or if the current debt-market contagion spreads to Italy, it is only going to have to buy more euros.
In short, the SNB could be facing its Katrina moment. Despite its repeated vow to maintain the CHF1.20-euro floor, the SNB's euro holdings could become too big to live with. And when that happens, the stable, horizontal line to which the euro/Swiss franc exchange rate hews could give way to a 10% or 20% vertical plunge.
However, some of the increase in the central bank's reserve balances would come from exchange-rate appreciation--not in the euro, but in the various other currencies in its portfolio. That's because the SNB isn't stupid enough to hold all its eggs in the euro basket. Trader say it is actively selling its growing stock of euros for Swedish kronor, Norwegian kroner, Canadian dollars, British pounds, Japanese yen and U.S. dollars.
In effect, the Swiss central bank is diverting safe-haven demand to other countries. But unlike poor Filipino villagers, these countries can fight back. And if they retaliate, they could exacerbate a nascent global "currency war." Japan, for one, is constantly threatening to intervene. And other governments often claim that the Federal Reserve's easy-money policies are a backdoor way of weakening the dollar. In this increasingly rancorous environment, the rise of beggar-thy-neighbor policies puts global trade itself under threat.
We cannot blame the Swiss for acting. Relative to the euro zone, their tiny economy is too small to take in such colossal amounts of flight capital. But for the same reason, investors should be wary of trusting their capacity to protect their economy from a once-in-a-lifetime storm.—(Michael Casey is managing editor for the Americas at DJ FX Trader, a foreign-exchange news service jointly produced by Dow Jones Newswires and The Wall Street Journal. He is the author of "The Unfair Trade: How Our Broken Global Financial System Destroys the Middle Class." He can be reached at firstname.lastname@example.org.)