Chapter 03 · How money really works

The Central Banks' Nuclear Option

7 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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A bank runs short of money. No problem: the central bank presses a button, and the money appears. Magic, right? You can probably guess there's a catch. It's called Quantitative Easing.

We've seen two key principles:

Most of the money in circulation (M2) is a promise of repayment.
Commercial banks absolutely must hold enough reserve money (M0) to settle their accounts with one another.

And if a bank were to run out of M0, what would happen?

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Central Bank money: the pillar holding up the whole structure

If Nicolas's Bank couldn't pay its debt to Ms. Smith's Bank, then Ms. Smith's bank might in turn fail to pay all its own debts to other third-party banks, and so on. Through a domino effect, banks could become unable to honor their debts. And that would be catastrophic.

M0 money is what guarantees that M2 payments (which are promises) rest on an asset nobody can dispute: Central Bank money itself. Without it, the whole payment system seizes up: promises aren't worth much if no one can keep their own.

So you can see that no longer being able to pay in M0 is the start of the spiral: a liquidity crisis, then failure, then a chain freeze of the economy.

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So how does a commercial bank end up short of M0?

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Let's go back to Nicolas's bank from . Everything was fine - until the day several Nicolas-types (let's call them the Nicolas-bis) stop repaying their loans. Here's the chain reaction:

The bank's claims shrink every time a loan goes unpaid.
Equity shrinks in turn, so the bank's balance sheet stays balanced.

ILLUSTRATION OF POINTS 1 AND 2 ON THE BANK'S BALANCE SHEET

ASSETS	LIABILITIES
€500,000,000 (all claims on customers, including that of Nicolas)	€440,000,000 (all customer deposits, except Nicolas who transferred his money to Ms. Smith)
€9,800,000 (M0 Reserves)	€20,000,000 (debt to the Central Bank)
	€49,800,000 (equity)

Other banks watch the bank's equity melt away and start to panic.
Panicked, banks stop lending M0 to the struggling bank: the confidence crisis hits.
The bank no longer has access to M0 and can't settle its debts with other banks: the whole system is paralyzed.

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Facing the risk of total collapse, the Central Bank pulls out its monetary nuclear weapon to save the system: Quantitative Easing⁠(opens in a new tab).

What is Quantitative Easing?

Quantitative Easing is an operation run by central banks that consists of massively buying back bonds (mainly government bonds, in other words debts contracted by the State) held by commercial banks short on M0.

It's a genuine sleight of hand: commercial banks get bailed out in M0, as if by magic, thanks to central banks that conjure this M0 out of almost nothing. In return, they take in the bonds and park them on their own balance sheet. In other words, the counterpart backing all that freshly created M0 is government debt (reassuring, isn't it?).

And this isn't science fiction: the Bank of Japan first pulled out this "weapon" back in 2001, the US Fed and the Bank of England used it massively after the subprime crisis of 2008, and the ECB joined in by 2015. Then everyone did it again, together, during the pandemic crisis of 2020. If you want to check for yourself, the Banque de France⁠(opens in a new tab) lays it out plainly.

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All of this sounds wonderful, doesn't it?

We've FINALLY solved every monetary problem by printing M0 by the truckload (what's called running the printing press).

You can probably tell this is all too good to be true. And you're right: these maneuvers have heavy consequences for the economy. For many critics of the monetary system, they're even at the very heart of today's financial problem - and after what you're about to read, you might well agree. That's what you're going to see next: .