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We have been talking about the term "sterilization," and various
situations to which it is applied.
August
28, 2016: What Is "Sterilization"?
Look at the previous item to see the first three examples. By the way,
that item was significantly updated, and is worth a re-read.
Now we will look at the fourth, and perhaps most complicated, notion of
"sterilization," having to do with the regular activities of central
banks in the pre-1930 (and especially pre-1914) period.
At its simplest, the "100% reserve" or "warehouse receipt" system,
which I call the "Making Change" system in Gold: the Monetary Polaris, the
reserves of the currency issuer (for example, a central bank) are 100%
gold bullion. The issuer agrees to swap banknotes and bullion at any
time, at the parity price.
If we step up the complexity a little bit, we come to what has been
called a "fiduciary" system. In this system, some portion of the
reserve assets consist of debt, typically government debt. However,
this debt portion is generally unchanged. All of the activity is in
bullion itself. One example of this was the Bank of England Issue
Department 1844-1914. This is something of a hypothetical example,
since the "Issue Department" was something of an internal accounting
convention for the Bank of England, which also had a Banking Department
engaged in a variety of other activities.
 
Here we see that the Issue Department
held an unchanging quantity of government bonds, plus holdings of Other
Securities which was not active on a day-to-day or even month-to-month
basis. (The increases in Other Securities can be considered an asset
swap, described previously as Example #3.) All of the variability was
in bullion. The variability in bullion came about via conversion. Thus,
total base money again reflected exactly that amount that was necessary
to maintain the value of the currency at the gold parity value.
However, it was common for central banks, or other currency issuers, to
also be active in discounting and lending. This produced interest
income. The volume of discounting and lending changed on a daily basis.
Here's an example of the Bank of England, aggregate balance sheet
(Issue and Banking Departments combined), for 1905-1910.
This is a complicated chart. The shaded
area portions represent the liabilities side of the balance sheet --
deposits, banknotes, and total base money. The lines represent the
asset side: bullion, discounting, and securities (government bonds).
This is weekly data.
For most central banks of the pre-1914 era, the situation was even more
complicated because they were also active in foreign exchange on a
constant basis.
June
26, 2016: Foreign Exchange Transactions and the "Gold Exchange
Standard"
Now, we see that the total base money is highly variable, on a weekly
basis. Discounting and lending is highly variable; plus, there is a
little variation now in government securities ("open market
operations") as well. The basic process here is much the same as the
"fiduciary" system, except that, instead of having an unchanging amount
of debt assets, the debt assets (discounting and securities) are
constantly changing. Nevertheless, the process of gold convertibility
at the parity price ensures that the overall supply of base money is
that which is appropriate to maintain the value of the currency at its
gold parity.
Let's say that, on some given day, the appropriate amount of base money
is 100 pounds. If the amount of debt assets is 60 pounds, then the
amount of gold assets will be 40 pounds, to produce the 100 pounds.
Now, if debt assets rise to 70 pounds, such that base money rises to
110 pounds, then the value of the currency will tend to sag vs. its
gold parity value. The result would be 10 pounds of gold outflows,
producing the proper base money of 100 pounds. The same process happens
the other way: a decline in debt assets would (in the first instance)
cause a decline in base money and a rise in currency value, causing
bullion inflows until the overall base money again returns to 100
pounds.
This process tends to produce a "see-saw" effect. Debt assets rise and
bullion declines. Debt assets fall and bullion rises. If bullion assets
fall to a degree that is unwanted, then the central bank might
intentionally reduce its debt assets to produce a bullion inflow. This
could include sales of securities, or a reduction in discounting and
lending. This reduction in discounting and lending might be
accomplished by a rise in the discount rate, which would make the bank
uncompetitive with other banks offering similar services. Thus, overall
lending would fall. The opposite might occur if bullion assets were
deemed to great. To produce more interest income, the central bank
might increase its discounting, lending and holdings of government
bonds. This would produce an outflow of bullion.
This "see-saw" effect is sometimes called "sterilization." A lot of
confusion has resulted, regarding the regular operation of central
banks in the pre-1914 era (notably following the description of this
supposed "sterilization" by Arthur Bloomfield in 1959). However, it has
nothing to do with the process identified in examples #1 or #2. In
example #2, you would have a decline in currency value and a gold
bullion outflow due to conversion. Normally, the monetary base would be
reduced by the amount of the conversion, thus supporting the currency.
However, this process would be cancelled out by increases of debt
assets.
In example #4 here, we would have an increase (or decrease) in debt
assets, leading to a compensatory decrease (or increase) in bullion due
to conversion. The mechanism of conversion leading to monetary base
adjustment is fully active here -- in this case, fully active in
compensating for the change in debt asset holdings.
Here is an example from the Federal Reserve, operating with similar
principles, in the 1920s and early 1930s:
Here we see base money (top pink line), which follows a smooth curve
during the 1923-1930 period, and then begins to rise after 1931. This
smooth curve (with a little seasonal wiggle) is basically the amount of
base money that was necessary to maintain the value of the dollar at
the $20.67/oz. parity -- in other words, the "demand for money" at that
parity. Bullion conversion was active during this time.
Here we see the asset composition of the Federal Reserve's balance
sheet. The teal line "Total Credit" represents the aggregate of
discounting, lending, and securities -- all debt assets. We can see the
"see saw" effect here, where an increase in Total Credit in early 1925,
and 1927-1928, leads to a bullion outflow; and a decrease in Total
Credit in early 1927 and 1928-1931 leads to a bullion inflow. I also
mentioned the 1932 government bond buying program, which was totally
cancelled out by gold outflows and also a reduction in Bills
Discounted. In all of these cases, gold conversion was actively
cancelling out the changes in debt assets, to produce the smooth curve
of base money during those times.
June
12, 2016: Milton Friedman Blames the Federal Reserve
February
7, 2016: Blame Benjamin Strong 2: So Obvious It's Hard To
Believe
January 31, 2016: Blame Benjamin Strong
The overall effect was something like the "reserve asset swap" of
Example #3, although accomplished via automatic gold conversion rather
than some deliberate program. Despite all this complexity, the basic
situation here was that gold conversion was actively maintaining the
value of the currency at its gold parity, not really all that much
differently than in the "fiduciary" example shown earlier, or even in a
"100% reserve" or "Making Change"-type system. Since this is also
basically how currency boards work today, we can see that, despite all
this complexity, central banks basically operated much like currency
boards, a "currency board linked to gold."
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