ECB will sterilize bond purchases. Right.

The European Central Bank announced this weekend that they would begin printing Euros and buying up the besieged debt of various EU governments. At the same time, in an attempt to allay inflation fears, they said they would sterilize those money flows to prevent a sharp increase in the money supply and thus inflation. That statement is almost certainly a lie. To understand why, here's a little primer on monetary sterilization.

Occasionally an economy is faced with rapid increases in currency inflows, for example due to increased foreign investment or trade flows. If left to slosh around in the economy, that increased money supply can lead to a spike in inflation. Central bankers have a way to take some excess money out; they sell various debt instruments to the banks, and then either hold the resulting funds or exchange them in the foreign exchange markets. The relevant point is that the central bank is selling something, almost always debt instruments.

In their new bailout plan, the ECB has pledged to lower funding costs for over-indebted EU governments by buying their debt. So then, to sterilize they do what? Turn around and sell bonds or bills to remove that excess capital that they just injected? Whose debt do they sell? Where do they sell them? Will they buy Greek bonds and then immediately sell German debt to Greek banks, or French banks, or Spanish banks? While that may lower Greek debt costs, it's basically exchanging German debt for Greek debt. I don't believe that will be acceptable for Germans.

Practically speaking, any attempt at sterilization will end up being some kind of debt swap. The end result will be a convergence of interest rates across the EU, punishing the countries that have been better stewards of their economies, rewarding those who have spent themselves into insolvency. That will not work on anything other than a token scale. It is only there as a figleaf to cover the looming inflation risk of this debt monetization plan, in hopes the market continues to ignore obvious fiscal and monetary insanity.

Gold investors see through the whole charade. The price of gold in Euros has gone vertical in recent weeks hitting new highs nearly every day. The German delegates to the ECB can not be happy with this. They understand gold's message; once the printing starts, it can never stop and it cannot be sterilized. The Euro is headed the way of the German Papiermark.