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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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