A very good example of why populism doesn't work has to do with the U.S. Federal Budget (this also applies to the Eurozone and most of unaffiliated EUNA) and the common populist position for a balanced budget. The common is line is that families know that they must balance their budgets and so does the Federal government. Say a family's income doubles. They will likely move to a bigger house, taking on a bigger mortgage, buy newer and better cars, taking on car loans. So, in that year, they will actually spend more than they earn through borrowing and they will take on more debt. It is also not a true statement because families do not have control of the currency and, thus, have none of the benefits that can be derived from managing the money supply.
The central government, on the other hand, does have a hand in creating money supply. Generally, the money supply needs to be increased by Real GDP + Inflation target divided by money velocity. This has traditionally been done through fractional reserve lending by banks. In other words, the banks only need to hold 10% of what they lend in the form of various reserves. Another way of looking at that is that the banks are allowed to loan a deposit out ten times and they do this by creating more money in circulation. The profit from doing that accrues to the bank and beneficially to their stockholders.
The Federal Reserve (or other National Banks) does this through manipulating the member banks' cost of money. The logic is that if the central bank lowers interest rates to their member banks, the member banks can lower the interest rates to their customers. From this, it is assumed that the demand for loans will increase and the banks will create more money. It is, however, an imprecise tool. It is conceivable, and in fact has happened, that the central bank will lower interest rates and private borrowers, for other reasons, will decide to deleverage.
This happened during the 2008 financial crisis. Much of this 'deleveraging' was in the form of corporations going bankrupt and massive mortgage defaults. In the face of this massive forced deleveraging, lowering interest rates would accomplish very little in stimulating borrowing. So, the central banks had no choice but to infuse money supply into the system or the whole economy would suffer a catastrophic liquidity collapse. They managed to support the money supply by purchasing bonds with created money. This was called Quantitative Easing. It is very effective and very precise. It managed to keep the recession from becoming a depression.
In the 21st Century, two things have taken place that render the traditional fractional reserve method of managing money supply even less effective. First, banks are losing much of their business to other institutions. For example, a family's mortgage is generally funded by Fannie Mae, Freddie Mac or other securitizing organizations. What this means is that the securitizer will bundle a large number of mortgages and then issue bonds with the mortgages as collateral. By some Accounting legerdemain, the mortgages sort of disappear, with the bonds, referred to as derivatives, remaining. Second, businesses that once was a very significant borrower with banks are using a series of other sources of non-equity financing.
The 'establishment' tends to demonize QE (as quantitative easing is called), not because it has very good reasons for it, but because the financial industry has become dependent upon fractional reserves as a source of income. However, in large part, it is defending a practice that seems to be dying no matter what they do.
One of the major advantages of QE, beyond its effectiveness and precision, is that the profits do not accrue to the member banks, but rather to the U.S. Treasury. In other words, QE kills two birds that we really want dead with one stone. First, Federal deficits are, in essence, free. Yes, the Treasury must pay interest on the debt, but the interest flows right back to it. Second, it is more efficient and effective.
A whole lot of research has shown that a small inflation rate is beneficial to the Economy and, thus, the well being of the citizens. Much is made of the dollar losing 90% of its value over the last 70 years. While true, it is also mostly irrelevant. Unless of course, 70 years ago, your grandparents put their life savings under their mattress and your parents, and now you, left it there. Yes, it lost 90% of its purchasing power. However, most people live 'pay check to pay check', which means that between earning a dollar and spending a dollar the loss in purchasing power amounts to a small fraction of 1%.
So, if the central bank targets inflation at, say, 2.5% and the economy grows at a real rate of 2.5%, money supply will need to increase by 5%. If money supply is, say, $16 trillion, money supply will need to increase by $800 billion. The central bank does this by buying debt, most commonly, government debt. It should be noted that this is not always the case. The U.S. Federal Reserve has bought debt of the government authorized mortgage securitizers to increase money supply while lowering mortgage rates when compared to other debt instruments.
Much has also been made of the very rapid rise in money supply and the demagogues have tried to convince voters that this is unrealized inflation. It may be, but that is unlikely. In February 2020, M2, the most commonly quoted money supply statistic, was at $15,447 trillion. Two years later, in February 2022, it increased to 21,812 trillion. Obviously, the approximately $6.4 trillion increase is much more than the $800 billion X 2 = $1.600 trillion explained in the previous paragraph. Normally, that would spell a very hefty amount of inflation. However, during those two years, the velocity of money fell from about 1.4 to 1.1 and has stayed there since. The Federal Reserve needed to put money into circulation to counteract that drop or substantial deflation would have taken place.
If velocity returns to its previous level, money supply will need to be reduced by about $800 billion. This can easily be done by the Federal Reserve selling that many government bonds. If it is sold to domestic investors, it will put upward pressure on interest rates. If it is sold to international investors, it will increase the value of the dollar in Forex markets. Clearly, there is $4 trillion of money supply not accounted for ($6.4 gross increase - $1.6 trillion 'earned' increase - $800 billion of velocity). Where is the rest? Most of it is the result of increased QE. In other words, it is sitting on the balance sheet of the Federal Reserve. If that is not going to turn into inflation, and it will be a total of $4 trillion / $21.8 trillion = 18%, the Federal Reserve will need to sell $4 trillion of its government bonds. That will ease inflation but increase interest rates. That results in a careful balancing.
As stated earlier, M2 needs to be increased by about $800 billion per year in order for the Federal Reserve to hit their inflation target. If this is done by QE, it literally is 'free money', hence the title of the article. Some of it may or may not be done through fractional reserve. However, with the need to increase interest rates, that will not work. So, the Federal Reserve really has no choice but to buy debt in order to reach the goals. This does not need to be Federal debt. It could be, again, debt issued by the mortgage industry, State and municipality debt or corporate debt. It even could buy equity if it so chose. What they buy really isn't as important as the issuing of new money.
However, and this is the second part of the title, the proceeds from the purchase accrues to you, the tax payer. This logic, that the Federal government can overspend by $800 billion per year and, thereby, either increase spending or lower taxes. If the income explosion that I predict increases Real GDP growth per year by 5% per year, the 'free money' pool will increase to $1.2 trillion. How it should best be spent is a matter of political discussion. However, first it must be recognized as a thing to be discussed. Right now, this piece of Economics is being obfuscated.
The one sentence is a restatement of the title, 'Quantitative Easing creates free money and it belongs to you. What should be done with it?'
