“Woe to the land whose king is a child and whose leaders are already drunk in the morning. Happy the land whose king is a nobleman, and whose leaders work hard before they feast and drink, and then only to strengthen themselves for the tasks ahead”. (Eccl 10: 16-17)

"When misguided public opinion honors what is despicable and despises what is honorable, punishes virtue and rewards vice, encourages what is harmful and discourages what is useful, applauds falsehood and smothers truth under indifference or insult, a nation turns its back on progress and can be restored only by the terrible lessons of catastrophe." … Frederic Bastiat

Evil talks about tolerance only when it’s weak. When it gains the upper hand, its vanity always requires the destruction of the good and the innocent, because the example of good and innocent lives is an ongoing witness against it. So it always has been. So it always will be. And America has no special immunity to becoming an enemy of its own founding beliefs about human freedom, human dignity, the limited power of the state, and the sovereignty of God. – Archbishop Chaput

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Thursday, September 6, 2012

ECB Sterilization Details Sketchy

One of the big selling points by Draghi and those favoring the ECB bond buying program, to assuage investor fears of its inflationary impact, was that the purchases would be offset or sterilized so as to provide for "price stability". I suspect that this was emphasized to deal with the strong German opposition to the plan as the German experience with hyperinflation during the Weimar republic has deep roots in the German national psyche.

The question that myself and others have, is exactly how this sterilization is supposed to proceed. What will the ECB buy in order to reduce the amount of money in circulation in those nations that ask for the "bailout mechanism"?

Remember, any of those troubled nations' bonds that get purchased by the ECB mechanism will be sitting on the balance sheet of the ECB in exchange for Euros. One assumes that the nations will of course spend these Euros to meet their various obligations, whether those be pensions, salaries, infrastructure, medical, etc. That means this money can reasonably be expected to go into circulation. So what exactly does the ECB then do to extract a corresponding amount of money out of circulation so as to render its bond buys neutral?

I for one am most anxious to see the details as I do not believe for one moment that in practice this is what is going to happen. This for certain is going to be an interesting laboratory experiment.

It also seems to me that gold is not buying into any sterilization talk. It would not be sitting at a mere 14-16 Euros off its all time high if it did!


  1. Today is a classic day where Bernanke is exercising his might.

    1. The TBTF banks are rallying the hardest.
    2. Oil is crashing into the closing bell
    3. Gold is being capped
    4. 10-yr. yield still way below 1.8%
    5. QQQ hitting 12 year highs
    6. Retail stocks (XRT) hitting world record highs

    All this despite record unemployment, food stamps, gigantic deficits, municipalities going broke left and right, etc., etc.

    Bernanke has successfully meatballed all the Algos to buy consumer stocks, sell down commodities, soothed by the fact that the TIPS spread is pricing in 1.5% inflation or less for the next 10 years.

    All while racking up $16 trillion in debt, plus hundreds of trillions of unfunded contingent liabilities, and quadrillions of derivatives piled up on the balance sheets of the banks which are rallying the strongest today.

    Quite simply, a financial miracle.

  2. This comment has been removed by the author.

  3. Is it plausible that the ECB is planning to hold bailed out country's gold bullion as collateral? I assume to do this that gold would need to be brought back as money (i.e. the new Basel III proposal). I can't imagine that the few remaining capital laden banks would be willing to part with their funds for the small returns generated from this theoretical sterilization mechanism. How also would that effect their hypothecated balance sheet requirements?

  4. It’s a regular blizzard of monetary manna out there blowing around…all that ”sterilizing”, “deriving” and “conniving”.

    It’s really sumpt’m watching and wondering what the wizards and pretenders gonna do next…

    PM's are still a good buy you know...

  5. Ah, yes the paper market in boullio came back to earth. But, did everyone notice the gdxj, ^hui, and ^xau to gold? Seems that whatever the "sterilization" method being sold today, is attracting long term heavy money. Volume was considered heavy, with most ^hui, and juniors, exceeding 90 day averages. Not sure, but next weeks FOMC will then dictate. I can only assume the currency wars are starting. Whatever the political medium today, alot of someones are positioning themselves in "MINERS"!!

  6. Turd is a bit nervous because of the COT's. Me not so sure. Cover and go. Going to be real interesting and I am sure the election is going to drive things, albeit, the big "5" will certainly help winner destroy the momentum and "hedge against central bank insanity". Thanks Dan, you are an information and thought provoker.

  7. Dan,

    if the ECB purchases $1bn of bonds and say they sterilize, they mean the following. When they buy the bond and pay with newly created base money, they replace a non-fungible asset (the bond) by a fungible one (Euros). By fungible I mean that you can go shopping with it. You cannot pay your grocery store with a bond, but you certainly can with Euros.

    Now sterilization means that the ECB takes some $1bn somewhere else and make them non-fungible. There are different ways of doing so, for example:
    1) The ECB offers a term deposit (perhaps paying interest). So any saver who wants a very secure savings account can "buy in". But these funds are locked up for a certain period and meanwhile cannot bid for goods and services in the supermarket.
    2) In reality, they probably use a reverse repo. This means some investor lends money to the ECB and receives some bond as the collateral. Again, the bond cannot be used in the supermarket.

    So why the heck would the ECB buy bonds? The ECB may eventually have the problem that the inflation rate in some countries is well over their inflation target of "below but close to 2% annually" while other countries experience deflation. In this case, the ECB has to fight inflation in one country while they have to create inflation somewhere else.

    So if there is deflation in Greece, say, they could, for example, buy a Greek government bond. This injects new base money into the Greek public budget which the government will largely spend on consumption. This creates inflation in Greece, as desired.

    But at the same time, the ECB sterilizes the bond purchase. They could offer, for example, a term deposit facility. If some risk averse German savers make use of this term deposit, this would remove money from circulation in Germany which is slightly deflationary. Voila. This is what they wanted: create inflation in Greece and fight inflation somewhere else (I said Germany, but they need to actually do this in Italy - take a look at the most recent Eurostat inflation figures).

    Summary: All the ECB bond buying is about maintaining their 2% inflation target. The ECB has ***no*** reason and no incentive to artificially lower the interest rates on government bonds. These bonds carry a risk premium for a good reason, and this premium is required in order to discipline the respective governments and to teach them to live within their means.


  8. ...

    This is fundamentally different from what the Fed or the Bank of England do. They deliberately suppress interest rates in order to allow their governments to run their 6-8% GDP deficits by inflating their currencies. The ECB, in contrast, is not anyone's government agency. They have no incentive to please a specific government, but rather have the sole mandate of making sure the Euro zone inflation is "below but close to 2% annually". Individual governments can be bankrupt and default on their debt, just as Greece did on about 5% on their debt at the beginning of this year. Both the U.S. and Britain have made clear that they will use the printing press in order to make their governments' debt risk-free (only nominally, of course).

    On the gold reserve:

    The gold reserve of the Eurosystem exists in order to support the Euro. It does not back any of the government debt of the individual countries. In fact, no government can pledge their gold as the collateral for a loan without ECB approval. The only purpose of the gold is to inspire confidence in the Euro. Take a look at the balance sheet of the Eurosystem:


    Assets, "Item 1 - Gold" is the gold reserve. Wait, Item number one? Number one is the most important, isn't it? You notice that whenever the gold price in Euros increases, Liabilities "Item 11 - Revaluation Accounts" grows. The equity on the balance sheet increases, offsetting possible credit losses elsewhere. So the ECB has a huge incentive to let the Euro price of gold rise. You can even see this in the dollar gold price chart:


    Why do you think *this* started precisely when the Euro was introduced?

    Again a fundamental difference to the U.S. and the UK. In those countries, the governments (i.e. their treasury departments) have control over the gold. So should the government need "more funds", these governments can sell some of the gold. Not so in the Euro zone. The Eurosystem gold is the primary reserve that backs their currency. No individual government can sell their gold without ECB approval.


  9. typo: Greece defaulted on 50% of their debt of course.

  10. Victor:

    Thanks for taking the time to write such detailed comments.
    Put me in the category however of believing that the size of the potential bond purchases cannot or will not be offset by any practical sterilization techniques.

    I would have to disagree with you on the purpose of the ECB bond buying program. I do think it is specifically designed to drive down interest rates artificially so as to lessen the interest burden on the problem countries in the Euro Zone. The facts are that no one wants to buy that debt over fears of default and that is why interest rates have been rising. The ECB is thus stepping up and becoming the buyer of last resort effectively capping the interest rates on that debt and preventing it from rising further.

    The ECB can always promise to sell those bonds later and thus reduce its balance sheet but that raises the question of how much debt will they end up holding on their balance sheets and can they possibly find enough willing buyers to take it all?

    Just look at what has happened to the US Fed's balance sheet after its QE forays. To whom is the Fed going to end up selling this massive amount of debt to down the road???

  11. On the sterilization: The ECB bought some E210bn in government debt between spring 2010 and the end of 2011. All this has been sterilized all the time (which is easy because investors in bonds or money market instruments have to accept either negative nominal rates when the investment is safe, or they have to accept considerable credit risk in order to get positive nominal yield - so there is a huge demand for "safe" savings held at the central bank - very easy to collect enough funds to sterilize).

    You see, all these huge sums of base money don't cause inflation simply because people want to save the money for the future. They don't want to spend it, and so you don't get inflation.

    Inflation is rather caused when the banking system expands the money supply (either commercial banks by lending or the central bank by monetizing bonds) and if this new money is used for consumption. Since private consumer loans are contracting, the primary culprit is governments that run large deficits funded not by savers buying their bonds, but rather by their own central banks. The ECB has used this in order to prevent price deflation in some of the southern countries between 2010-11. They basically gave their governments more money to spend, just to create more inflation whenever the inflation rate fell substantially below 2%.

    I do think it is specifically designed to drive down interest rates artificially so as to lessen the interest burden on the problem countries in the Euro Zone.

    I don't. The ECB is not in the deficit funding business. They have only one primary job: to ensure that the Euro zone inflation rate is below but close to 2% annually. They don't answer any one specific government. And they know the dollar will collapse one day (because of the twin deficits of the U.S.) and they have set up the Euro for precisely this purpose: to survive economically when the dollar dies.


  12. Also, the Europeans have been frustrated with the inflationary U.S. monetary policy for decades. They despise using inflation to fund government expenditures, and they know this U.S. policy will one day break the dollar's neck. Here is ECB's Bini Smaghi from


    One is the monetary pillar, which is supported by an independent central bank with a clear price stability objective. This implies that the ECB will not use an inflation tax to reduce the real value of government debt. Euro area governments have thus to rely on budgetary measures to address their own fiscal problems. These measures are difficult to adopt, especially in countries with fragile political systems, such as those with minority governments or weak leadership, or where growth is projected to be slow due in particular to lost competitiveness or heavy reliance on external borrowing. Financial markets are testing each country, one by one, to see whether they are willing to adopt the necessary budgetary measures, starting with those which seem to be facing the greatest hurdles to consolidation.

    Let me digress briefly on this point. Some may think that the fact that the ECB cannot use the inflation tax to bail out Governments is a weakness of the euro area’s construction, because it obliges some countries to make fiscal adjustments earlier than others. In my view, this is a strength. To believe that an inflation tax can solve the problem posed by the mounting public debt is an illusion that some people like to cultivate. For several reasons. First, people are less naïve than some might think – they dislike an inflation tax as much as other forms of fiscal adjustment. Second, it’s not so easy to generate inflation, in particular ‘surprise’ inflation, without provoking a more-than-proportional increase in interest rates, also in light of the short average maturity of public debt in most countries. Third, a rise in inflation, and inflation expectations, would produce a major upward shift in the yield curve, inflicting major losses on the banks and financial institutions which have been heavily investing in these markets, potentially undermining the recovery.

    In short, the impossibility of resorting to an inflation tax is forcing euro area countries to tackle the burden of public debt sooner rather than later. In other countries the illusion of being able to resort to the inflation tax might delay the adjustment, but the longer the treatment is postponed the harsher it’s likely to be.

    It is always instructive to read the original. The ECB people are quite open about their goals. Here is some more Smaghi to read:



  13. Whenever they talk about international imbalances and the new international monetary system, you should replace "SDR" and "global currency" by "physical gold". The latter is the one issue they don't spell out since it would be a considered a direct attack against the U.S. But they know it will one day be gold, and the Euro was set up in order to be able to handle this transition.


    1. victorthecleaner wrote:

      "...you should replace (in your thinking) 'SDR' and 'global currency' by 'physical gold'."

      And that, my friends, is that! Victor is spot-on!

      Understand this one point by Victorthecleaner, and you will understand the whole tamale.

      Gold trumps all suits...gold crosses every sovereign border with impunity...gold speaks every language.

      You just can't eat gold nuggets, coins or ingots...but you can trade them for food and other creature comforts almost everywhere.

      I expect the banksters and politicians will be very soon be asking (or ordering) people turn in their gold. I predict it will happen in my lifetime and I am seventy.

      So there you go pilgrims...there is no safe harbor from the storm...just more turmoil is a'coming down the pike.

      However, if a person can adapt, and can zigzag, and has good "beach sense" (like a castaway needs) and can protect themselves and their physical holdings from the predators, there is a bright future coming our way as well...in time.

      For the time being, be it a bond, or a note of currency, or a title to a property, or an equity, or anything made of paper bearing inked words and/or images…or be it an electronic journal entry -- all of these decrees, of worth and worthiness must have trustworthy people to make them good…lots of luck on that one!

  14. http://www.zerohedge.com/contributed/2012-09-07/draghi-acts-it-inflationary

    Doesn't sound much different to QE to me.

  15. Dan, the mechanism has been clearly summarized, and so far it's working. But it is NOT sterilization. I blogged about it recently: http://laurencehunt.blogspot.ca/2012/09/mr-draghi-is-sterilizing-his-purchases.html

    Also, the WSJ has explained it in detail:


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