By: Nathan Lewis
all contents copyright Nathan Lewis 2005-2016

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What Is "Sterilization"?

August 28, 2016

The word "sterilization" is one of those economic terms -- like "inflation," "deflation," the "balance of payments," and several others -- with no clear meaning. It is applied to a wide variety of situations which are actually very different, in their causes and outcomes. This is confusing; and, like those other terms as well, it tends to be used by people who are confused.

The basic idea behind "sterilization" is a situation in which a central bank increases its holdings of one asset and decreases its holdings of another, which results in little change to overall assets and also little change to overall base money.

This condition can be the result of a variety of different processes, all of which have very different implications and consequences.

1) A central bank "intervenes" in the foreign exchange market, and then adjusts its holdings of other assets so that the forex intervention does not result in any change to the monetary base. This is extremely common today, and is the reason why "forex intervention" fails over and over to accomplish its goals, to either support or (occasionally) depress currency value. The reason is that it is ultimately the change in the monetary base which supports or decreases currency value, so if you eliminate that effect, then the "forex intervention" tends to have a fleeting effect. Often, the result is that foreign exchange reserves are dangerously depleted, and a currency crisis ensues. This is very common, and I illustrated several examples in Chapter 6 of Gold: the Monetary Polaris. A good recent example has been given by Russia:

October 23, 2015: Russia's Central Bank Might Be Getting A Clue After All
October 16, 2014: Russia's Currency Crisis: This Is So 2008!
November 24, 2008: Russia's Currency Crisis

Here you can see the drop in the ruble's value in the second half of 2014.

Substantial sales of foreign reserves ("forex intervention") beginning mid-2013 to support the ruble's value.

But no change in the monetary base, which continues to grow steadily (red bars). The blue bars indicate what the monetary base would have been if all of the rubles purchased in foreign exchange intervention had been removed from circulation, shrinking the monetary base. As you can see, the ruble base money supply would have contracted by roughly 50%! An actual contraction of this size would not have been necessary. The ruble's value would have been supported by a much smaller contraction.

Although the monetary base did not contract much, the YoY growth rate fell significantly beginning around December 2014. This was exactly the point at which the ruble's value rebounded and headed higher. Note also that, before December 2015, after the ruble had been falling (and the central bank intervening) for about eighteen months, there was not only no contraction in the monetary base, but the rate of growth remained very stable!

I think there is an idea among central banks that they should target a steady expansion rate of the monetary base. This was, after all, the idea presented by Milton Friedman in his 1962 Program for Monetary Stability. As you can see, it doesn't result in "monetary stability" at all, but rather a terrible decline in currency value, because there is no mechanism to support the currency value when necessary. Even a fairly large contraction (10% let's say) in the monetary base has no real economic effect ("deflation"), if it is done to support the currency value. For example:

This is the Bank of England's balance sheet, liabilities side, including base money (teal, "notes+deposits"). As you can see, there is no smooth curve of growth here. In fact, there were extended periods of contraction. These periods of contraction had no effect on monetary conditions, which reflected the pound's solid link to gold during most of this period (except for 1797-1821).

This is how it looks in terms of YoY% change.

2) Gold (or foreign exchange) has an "outflow" due to conversion at the parity price, indicating a sagging currency value. This outflow is "sterilized" via purchases of debt assets, producing no change in the monetary base. This is very similar to #1 above, except that instead of an occasional "forex intervention" done via central bank discretion, sales of gold (or foreign exchange) are the result of convertibility at the parity price. The motivation seems to be similar -- the belief that a contraction in the monetary base would cause "deflationary" consequences. This is not true. A thinking process along these lines may have been responsible for the British pound devaluation of September 1931, which we looked at here:

May 22, 2016: The Devaluation of the British Pound, September 21, 1931

(Click the link for relevant charts.)

In this case, a decline in gold reserves due to conversion was offset by a rise in government bond holdings, producing no change in the monetary base. If the decline in gold reserves was accompanied by a corresponding decline in base money -- which would have been the case, if the BoE been otherwise inactive -- then the British pound would not have been devalued.

However, in this case, it is a little hard to see what is going on here. Probably, the gold conversion happened first, and the bonds were purchased later, because of the fear that a decline in the monetary base would have some kind of recessionary consequences, or possibly lead to a rise in interest rates. However, it is possible that the bonds were purchased first, for some kind of reason, and then the gold outflows happened as a consequence, because the increase in the monetary base would have depressed the value of the pound, causing outflows.

3) A reserve asset swap. The Bank of France did this in 1928-1932. Before 1928, the Bank of France had large holdings of foreign reserves (mostly British pounds). Beginning in 1928, the Bank of France swapped some of these reserves for gold bullion. This was basically a return to the BoF's pre-1914 condition, when the BoF held large bullion holdings and no foreign reserves.

July 31, 2016: Blame France 2: Balance Sheet Peeping

(Click on the link for relevant charts.)

A central bank can swap one asset for another at any time. The difference between this, and a #2 situation is that in #2, the decline in gold reserves was due to a conversion outflow. The correct action here would have been to reduce the monetary base to support the currency's value vs. its gold parity. This happens naturally, if the central bank does not cancel the effect by a discretionary purchase of bond assets. Thus, #2 is BAD because it leads to a failure of the gold standard system (as in Britain in 1931). In the reserve-asset swap, the currency's value is not weak vs. its gold parity, and thus there is no need for any change in the monetary base. The central bank is just changing one asset for another, without changing the monetary base. This is basically harmless.

I think we will stop there, and continue this discussion later.

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July 31, 2016: Blame France 2: Balance Sheet Peeping
July 29, 2016: Don't Be Fooled: "Stable Money" Means Gold
July 24, 2016: Blame France
July 18, 2016: The "Price-Specie Flow Mechanism" 2: Let's Kill It For Good
July 10, 2016: The Tyranny of Prices, Interest, and Money
July 8, 2016: The 15% (of GDP) Solution
July 4, 2016: The Declaration of Independence, July 4, 1776
June 30, 2016: The Nonexistent 'Social Costs' of a Gold Standard System
June 26, 2016: Foreign Exchange Transactions and the "Gold Exchange Standard."
June 19, 2016: Where Does All the Money Go? Let's Kick Around Colgate University
June 16, 2016: A "Cashless Society" -- Based on Gold
June 12, 2016: Milton Friedman Blames the Federal Reserve
June 5, 2016: Irving Fisher and "Debt Deflation"
June 2, 2016: A Flat Tax and a Fair Tax -- Together
May 29, 2016: Book Review: Who Needs the Fed? by John Tamny
May 22, 2016: The Devaluation of the British Pound, September 21, 1931
May 14, 2016: Credit Expansion And Contraction Of The 1920s and 1930s #2: Paying Off Debt
May 5, 2016: China Is Laying The Foundation For The Next World Gold Standard System
April 24, 2016: Arterial Hacks
April 17, 2016: "Good Money Is Coined Freedom" Speech by William McChesney Martin, 1968
April 9, 2016: George Gilder Takes On The Big Question: What Is So Great About "Stable Money"?

April 3, 2016: Credit Expansion and Contraction in the 1920s and 1930s
March 24, 2016: The Simple Simplistic Simplicity of "Nominal GDP Targeting"
March 19, 2016: The "Price-Specie Flow Mechanism"

March 3, 2016: The Myth of "Price Instability" During the Gold Standard Era
February 28, 2016: Let's Take A Look At Hudson Yards
February 25, 2016: The One Chart That Makes People Into Gold Standard Believers
February 21, 2016: Problems of Coinage
February 14, 2016: The Balance of Payments
February 9, 2016: Why So Many Historians Agree With Ted Cruz On Gold
February 7, 2016: Blame Benjamin Strong 2: So Obvious It's Hard To Believe
January 31, 2016: Blame Benjamin Strong
January 24, 2016: The Gold Mining Boom of the 1850s

January 21, 2016: 'Nominal GDP Targeting' Is Just Another Red Herring To Divide Conservative Monetary Consensus

January 17, 2016: David Hume, "On the Balance of Trade," 1742

January 11, 2016: Steve Forbes Shows The Way Out Of Governments' Spiral of Self-Destruction