Yes, there is free money and it belongs to you

 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?'

What is an Acceptable National Deficit?

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There is such a thing as Conservative virtue signaling and much of it revolves around statements of 'fiscal responsibility'. In the U.S., the periodic calls for a balanced budget amendment is an example. It is, in fact, a really bad idea.  As the economy grows, one can accept an increased amount of national debt.  However, while some deficit spending is OK, how do we determine how much is prudent and how much is too much? That is actually not as hard to compute as it may initially seem. It does require some basic competence in Economics, but, if you don't have it, you really should 'bite the bullet' and acquire it.  It will be a basic InfoAge survival skill. This article will do two things. First, we will demonstrate that deficit spending is OK and that there is a way to calculate how much is appropriate. Second, we will see how increasing money supply creates wealth out of thin air and that distributing it through 'general welfare' (a constitutional term) expenditures has both practical and ethical advantages. 

Debt as a Percent of Income
We will begin with the well established and easily understood fact that wealthy people tend to owe more than poor people. That is because of simple principles such as the usual requirement that one's total house payment should be no more than 28% of one's gross income. So, the more you earn, the more debt you can take on in order to buy a larger house. The notion also applies to auto loans.  Bond rating agencies that assess the creditworthiness of corporations and municipalities also rely heavily on the ratio between debt and equity and 'times interest earned' measures. What applies to households, local governments and corporations also applies to nations.

This is why international Economists pay close attention to Public Debt as a percent of nominal GDP. According to the CIA World Fact Book, the world, in total, is at about 60%, with the U.S at slightly over 82% and the EU at 86.9%. While there is not an agreed upon guideline, we may assume that 50% would be a reasonable and achievable ideal goal. As an example, nominal GDP in the U.S. grew by about $1,060 billion in 2018. This would 'earn' $530 billion of deficit spending and the related additional borrowing. Adhering to this guideline would result, both in the U.S. and EU, in the rapid decrease in Debt as a percent of nominal GDP, with a slowing of the annual reduction with an asymptote at 50%. This actually happened in the U.S. between WWII, when Public Debt skyrocketed and around 2000 when it had fallen well below 50%.  It did so, while there was deficit spending in almost all years.  However, the deficits were less than 50% of the nominal increase in GDP.  In other words, this level of deficit spending and increase in Public Debt would not be worrisome.   

Starting with the crisis that began in 2008, Federal Deficits far exceeded nominal GDP growth and the Federal debt started expanding.  Furthermore, the deficit far exceeded 50% of nominal GDP growth.  For example, the economy 'earned' $530 billion of deficit spending, but the deficit was $719 billion.  2019, between lower nominal GDP growth and higher deficit to be much worse.  So, while there is an acceptible degree of deficit spending, at present, the U.S. seems to be exceeding it.  This is also true of the EU.

Before we proceed, there are two important considerations where changes in governmental accounting and, perhaps, structure are needed.  These are in Social Security and Medicare.  In both cases, surpluses or deficits should be segregated from Federal expenditures and serious consideration should be given to treating them as the U.K. does the BBC and as the U.S. has from time to time done with the U.S. Postal Service, as quasi-governmental programs.  Right now is a good time for the U.S. to do this because the Social Security Fund has a close to zero surplus, and, if, as we suggest, Medicare Advantage is made universal it, too, can transition easily to being a discrete entity.  Right now, these programs do not contribute to the deficit, but later they will and it will be more difficult, politically, to segregate them from actual Federal spending.

Intra-governmental Borrowing
Thus far, there does appear to be a legitimate concern since the U.S. Federal deficit spending is exceeding the reasonable guidelines of 530 billion USD.  However, there is another source of funding for deficit financing that is not considered to be Public Debt. specifically Treasury debt purchased by government agencies.  Since it is essentially the government lending to itself, it is typically eliminated from reported Federal Debt.  In the U.S., the borrowing has historically been undertaken primarily by the Social Security Administration, followed by other pension programs. For now, because of growing populations, these funds are generally buying more than selling, thereby creating budget funding that is being transferred to the general fund.

In this way, deficits are decreased without increasing debt.  This will not last forever and will eventually add to the deficit when withdrawals from the pension funds exceeds the contribution.  This became a hot political topic in the U.S. at one point and was referred to as a 'lockbox' approach.  The argument seemed to confuse most voters and so it was dropped as a political issue. However, it is a disguised ticking time bomb that will be discussed in an article on Social Security.  This is defused as a problem if the Social Security Administration is turned into a self-financing quasi-governmental organization.  However, of course, doing so will raise other issues.

Quantitative Easing
There is a third, critical consideration for calculating acceptable deficits which is referred to as Quantitative Easing or QE.  Central Banks must increase the money supply each year to accommodate the cash requirements of a growing GDP and to force their targeted inflation rate.  If nominal GDP is 20 trillion, about the sum of both the U.S. and the EU, and M2 is 14 trillion (approximately correct in the U.S.), it means that for every trillion USD that the nominal GDP increases, M2 needs to increase by 700 billion.  

Historically, this has been done by the Fed lowering interest rates which, in theory, should increase loan demand.  Member banks lend out 100 USD, supplying 10 USD from their own funds. This 10USD out of every 100 USD is called a reserve requirement.  This 90 USD is essentially created out of thin air.  Eurozone Central Banks have different reserve requirements but nearly always less than the U.S. 10%.  Also, they are inclined to change the reserve percentage in order to stimulate or depress borrowing while the U.S. tends to leave it constant.

This is something that is widely misunderstood.  Banks print money, not the government.  The currency is printed in the U.S. by the U.S. Treasury, but the bills themselves are actually owned by the Federal Reserve.  But, of course, today most 'money' is electronic and is not really printed. 

There is, however, an alternative way to create money supply.  This is for the Federal Reserve to purchase Treasury debt using 'created money'.  This puts the needed 700 billion USD in the hands of the Federal government which can either increase spending or decrease taxes or some combination thereof.  In one round of QE, the Federal Reserve bought mortgage backed securities from the large securitizers, which lowered mortgage rates and increase availability of mortgages.  This demonstrates that QE can provide the Fed with the ability to better target its stimulus.

The Fed prefers using the reserve lending approach to managing money supply.  However, from time to time, it does engage in QE.  It was heavily relied upon during the financial crisis of 2008, when businesses would not borrow money at any interest rate.  The Fed lowered the discount rate to near 0% and still had not 'rescued' the monetary system.  Then Quantitative Easing was used and it was effective.  The Federal Reserve Bank bought Treasury debt, mortgage backed debt and some bank debt using created money.  While the Fed has done some 'run off' which is lowering the total debt purchased, it still holds about 4 trillion USD of Treasury debt and the has not ruled out increasing that over time.

The member banks like fractional reserve because they only commit 10% of their reserves to lending but collect interest on all 100%.  This allows them to enjoy a very high return on their investment.  There is more than a little question about the ethics of it.  Simply put, should the 700 billion USD that must be printed to avoid deflation be a benefit that enriches the banks or should it enrich the population as a whole?  While it seems obvious that the latter is more easily justified, ethically, it is the former that is supported by nearly the whole business community.  They usually just state that QE is inflationary.  That is a duplicitous claim, because it is to be discussed about the 700 billion USD of M2 that needs to be created.  If they are pushed beyond that they will claim that it will do irreparable harm to the banking industry.  The real reason, however, is that the prime interest rate is currently 5.5% and big businesses believe that if the banks had their reserve requirements increased from 10% to something higher, that their 5.5% would increase, too.  It is, in reality, not that simple.

In addition, many in the investment community are concerned that without a 10% reserve requirement, the banking industry would collapse.  It is true that if the reserve requirement was raised so fast that the banking industry could not secure replacement financing they would see a substantial reduction in the market capitalization.  In reality, an expert and unbiased analysis would conclude that a mixture of increased quantitative easing and a measured increase in the reserve requirement would give the Central Bank the greatest flexibility and tools to manage the components of the domestic economy that have been charged to them.

This means that the Federal Government could spend 700 billion USD more than it takes in by issuing debt to the Federal Reserve. However, this debt is not counted in the National Debt, and correctly so. The principle will never be paid back. It is where M2 comes from and must remain or M2 shrinks and deflation would result. Even the interest is invisible. That is because while the Treasury will pay the Federal Reserve interest, that interest, by law is paid back to the Treasury as a dividend of excess earnings. The expense is directly offset by the interest income. If it seems as if it means that it is free money, you are correct. But it is not a shell game.  It is, in reality, a dividend related to economic growth. There literally is no downside.

If the reserve lending percent is 100% all increases in M2 would be done in the form of quantitative easing.  However, there would certainly be value in retaining interest rate manipulation as a tool in monetary policy.  So, although 700 billion USD  is theoretically available for QE, it is more likely to fall between 50% to 75% depending upon the Economic measures at any point in time.  So, in the above example, the Federal Government can have 530 billion USD + 350 billion USD = 880 billion USD deficit spending with no deleterious effects. It could be as much 530 billion USD + 525 billion USD = 1,055 billion USD.  The 530 billion USD will carry real interest and be counted in the Public Debt. However, the 350 billion USD to 525 billion USD is completely invisible.  With proper structure, amounts similar as a percent of nominal GDP is available to nearly all nations. 

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There is a fundamental, theoretical difference between this 1.055 trillion USD (or equivalent for EU countries) and the rest of the national budget.  Most of the budget is funded through taxes which are taken from citizens.  However, this 1.055 trillion USD is simply the result of the economic operation of the nation and, theoretically, is a dividend shared by every citizen equally.  One could simply provide a dividend to every adult in the country.  That has advantages and disadvantages over just lowering taxes.  Income taxes are progressive and somewhere between 40% and 50% of U.S. households pay no taxes at the Federal level. Consequently, their taxes would not be lowered and they would get none of the dividend.  The remainder of taxes are related to purchases, either directly or indirectly, which would also cause the tax reduction to be regressive.

One could place it in the Medicare and Social Security funds, if, as is the case in the U.S., the program is underfunded.  While better than reduced income taxes, this would help with Social Security liquidity, it would tend to favor the elderly, often more affluent, and, therefore, would also be regressive.  So, it seems appropriate that the funds simply be given to each adult equally.  This would be neither progressive nor regressive. Also, one can make a fairly strong ethical argument for the practice.  In the U.S. by the above example, each adult would receive about 4,200 USD per year.  One could make it progressive by taxing it away from the more affluent and use the additional funds for social safety net expenditures. However, I believe that this will likely be a question that will be more relevant after it is used to deal with the coming wave of technological unemployment.  As that hits, it all will likely be needed for extended unemployment and retraining costs.

Once this is properly understood, most politicians will support it, because the voters will support it.  The traditional Conservative objection made over 'safety net' expenditures that they are funded with money earned by others doesn't apply.  This money is not being taken from other taxpayers; it is being created by the monetary requirements of a growing economy.  Conservatives will likely still be against this use, because Conservatives are generally pro business and will react to financial interests that will not support taking this windfall away from the banking industry.

Specifically, the creation of money has nearly a 100% profit and right now, with interest rate manipulation, that ends up on the balance sheets of banks.  The banking industry has been very vocal about not supporting QE and has been actively pressuring the Federal Reserve to divest of Treasury instruments. They understand that this will lower M2 and require the Fed to increase it through lowering interest rates, thus increasing banking profits.  Their argument is that it is inflationary.  However, the above calculations are specifically driven by nominal GDP targets that are set to the optimal inflation rate.  It is a spurious argument.

The 'Balanced Budget' argument has been primarily a political battle line in the U.S.  However, because the U.S. constitutes over 40% of the EuroCulture GDP, how it handles its fiscal and monetary policy will affect the whole.  I advocate that the U.S. fiscal policy be trifurcated and sequestered into General Funds, Social Security and Medicare Funds and Monetary and GDP Dividend Funds. On a long term basis, the total should not create a deficit larger than the Monetary and GDP Dividend Fund.  Rather than a per capita dividend, at this point, I advocate that this last fund be dedicated to dealing with the impending wave of Technological Unemployment.  While a 'political' assessment, I do believe that it is one grounded in valid political and ethical principles.

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