Chapter 04 · How money really works

Who broke the engine?

6 min
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This chapter builds on the ones before it. You can read it now, but it will not count towards your progress until the earlier chapters are done.

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Ever wondered why your banker gives you a funny look when you mention financing a real project, but rolls out the red carpet the moment it's a mortgage or an investment product? It's not (necessarily) you. It's their engine running on fumes. And the Central Bank has a lot to do with it.

Up to now, the Central Bank has come to the rescue of commercial banks by flooding the system with liquidity. The problem is that, in doing so, it jammed the engine.

To understand why, you first need to know how a bank actually makes money.

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By buying bonds on a massive scale, the Central Bank mechanically pushes their price up (the law of supply and demand). And as bond prices rise, their interest rate falls at the same time.

Want a hands-on example to make this click? OK, let's go!

You're now a central bank, and you're about to run a quantitative easing operation. Watch what it does to bonds.

Government Bond Coupon

The bond's coupon (its annual payment) is fixed at €40 (4% of €1,000).
Bond price
1 000 €
Yield (Interest rate)
4%
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And since the government rate (the loan considered the safest) serves as the benchmark, it drags down pretty much every other type of loan with it (mortgages, business loans, and so on).
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At which point you'll probably go: "OK, great... so what? Is it serious, Doctor?" and I'll tell you straight away: "Yes, because it breaks how commercial banks make their money."

Remember: a commercial bank earns its keep on the gap between long-term rates (what it lends at) and short-term rates (what it borrows at).

Try it yourself! Move the long-term rate on the chart below to feel just how much damage rates that are too low can do.

Simulation of commercial bank profitability based on the long-term rate

Short-term rate : 0.5%
Long-term rate4%
The engine is running! The margin is sufficient to cover risks. The bank lends to the real economy with a smile.
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Here's what happens: with rates this low, financing the Productive Economy (creating value, launching projects by funding entrepreneurs, hiring) becomes far less profitable for banks. Too much risk for such a thin margin.

But banks have to survive! So they pull off a major strategic turn. They walk away from production and pour their efforts into financing the Asset Economy instead.

Instead of lending to those who build, they'll lend . And that's exactly what's coming up next!

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