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You are oversimplifying a bit:

I didn't, I gave the full equation, mv=pq. If you don't understand it, you should go look it up right now.

His point is that mv=pq is a very simplified equation which makes numerous false assumptions. It is good for a ECON 101 class to explain the basics, but it doesn't cover the entirety of what affects the CPI. Some basic problems with the equation include:

M = Money Supply -> This is a very complex topic as there are many forms of money supply with very different characteristics, such as liquidity. This is one way wages enter into inflation figures, because more liquid forms of money supply in the hands of people who spend most of their money on goods and services (such as minimum wage workers) have a higher effect on inflation.

V = Velocity -> In this equation V is not well defined. I'm not going to write a paper about it on Slashdot, but you can read this for a little more info.

P = Price of Goods and Services -> This equation also doesn't take into account how inflation can hit different types of goods and services very differently. The type of Money Supply has a strong effect on this.

I was going to type more but have a meeting to get to. I'm not saying that MV=PQ is a meaningless equation, it just doesn't encompass all economic theory on inflationary pressures. Think of it as F=MA before Einstein and quantum mechanics.

Tax's dont fund spending. Haven't since we came off the gold standard. Instead, this research gives jobs to people qualified to do so, extending human knowlege.

With the scale of unemployment, would you rather they sit on social?

http://www.pragcap.com/ama/wha...

Once you start dealing with a deficit that's bigger than what you can reasonably expect to grow, you're in deep trouble.

You're taking the wrong metric here. When it comes down to it, the deficit is simply equal to the net imports plus the saving of the private sector. That is not a theory, by the way, it is a simple consequence of proper book keeping. So whether a government deficit is big or not really needs to be seen in relation to the desires of the private sector and the behaviour of the rest of the world.

What you are seeing in the US is simply that the crazily low savings rate of the private sector is returning back to normal now. Where before, consumption has been financed by easy credit, this access to credit has now dried up and everybody is scrambling to get their balance sheet in order - a balance sheet recession. This increase in private saving needs to be supported by a government deficit. If the government withholds the assets that the private sector needs, this will result in less spending, i.e. a lower path of GDP, and a lot of pain for private individuals especially via higher unemployment.

All that has been known for a long time, see e.g. here. Modern Monetary Theory also explains the connections quite well, and can perhaps help you calm down in general.

To anybody who reads the parent: yes, those debt numbers sound impressive. However, ultimately they are just the necessary counter-part to giving the private sector the monetary assets that it desires. This was understood a long time ago, see e.g. here. More recently, Modern Monetary Theory economists have been pushing the same point. If you haven't yet, I recommend you set aside some time to read introductory explanations e.g. here and here and here.

The bottom line is this: targeting a specific size of the budget is bad policy. The budget will be whatever it has to be to match the behaviour of the private sector. Artificial austerity, as is being proposed these days, is coercion of the private sector to go against its natural behaviour, even when that natural behaviour is benign. In other words, austerity actually means an oppressive and draconian government. Deal with it.

This is simply not true. Banks cannot issue money they don't have, either physically or electronically.

You don't have to take it from me. Here is a nice visualization of what happens when a bank makes a loan. You can let economist Bill Mitchell explain it to you. Or you can read between the lines in the Basel accords, which define how much leverage a bank can have. Of course, "leverage" is the key word here - banks normally create money when they increase their leverage (technically speaking, they can also increase their leverage by changing their position to be riskier according to the Basel rules, but that is an exception rather than the rule). If you speak German, you might also want to look at this explanation of the German central bank, in particular the section on "Giralgeld". More generally, if you want to understand how money works, the best sources are the writings of Modern Monetary Theory economists, simply because they place value on explaining the down-to-earth mechanisms underlying all the fancy talk. I suggest you start here or here.

If I were you, this cross section of sources from all over the economics spectrum (from ultra-orthodox to highly unorthodox) would convince me.

Seriously, if every loan a bank made "magically created money", we'd be in such runaway inflation it would cost billions for a gallon of milk.

Since the premise of that implication is true without there being runaway inflation (though I want to emphasize that there still is no magic involved), it seems you also have to work on your understanding of how inflation works.

Look, I understand where you're coming from, and I understand you find it hard to believe the things that I'm writing. But consider the possibility that I'm right. Can you risk being wrong about that?

Two years ago, I probably would have reacted like you did (although I hope that I would have better estimated my own lack of knowledge in the matter). The fact of the matter is that, unfortunately, the macroeconomics education sucks everywhere around the world, and unless you study economics at university you never normally come across all these things. That's not your fault. In the context of the financial crisis I've become curious to understand more, and I've read up on all these things. I've come across a lot of unintuitive things along the way, and it takes time to digest everything. It took me at least a year, and I'm still learning new things.

I sincerely hope you will set aside some time to follow some of the links I listed above. It can be an amazing intellectual experience.

Of course this site doesn't go into too much detail but 95% of our money is magically created out of debt.

Actually, it's 100%, and there's nothing magic about that. Just as a matter of accounting, every from of monetary assets is actually somebody else's liability, i.e. debt. Those physical dollar bills in your wallet? They are a liability of the US government.

But that's no reason to go insane about it. Calm down, set aside a few hours, and read the Modern Money Primer by UMKC economist Randall Wray, or, if you don't have quite that much time, this summary on PragCap.

US national debt is over 100% of GDP. It's banana republic time from this point on.

Given that they don't even have the same dimensions, I fail to see why some arbitrary and suspiciously round (in decimal) value of their ratio has such magical significance.

You're right to be sceptical about this. All these debt limit numbers, whether it's the GP's 100%, or the Maastricht treaty 60% for the Eurozone are really just pulled out of thin air. There is no solid research to substantiate them. For a bit of perspective, consider that Japan has been running with a debt level of way more than 100% of GDP for over a decade, and they haven't fared worse than most Western countries.

The key thing that people need to understand in this debate is how currencies even work. This is amazingly badly understood, even by academic economists (this is very slowly changing, but as they say, progress in the sciences happens one funeral at a time). If you have some time, you may be interested in this Modern Money Primer, or the somewhat shorter article of PragCap.

The tl;dr version is this: monetary sovereignty matters. The US federal government, being a currency issuer, simply cannot be reasoned about in the same way as we reason about our own personal, currency user, finances. In particular, the US federal government will never be unable to make US$ payments, and it will never be unable to service its debt obligations. In fact, it could start deficit spending immediately without even issuing matching treasury bonds, and nothing much at all would happen.

Most honest people accept that after a while, but the implications always take a while to sink in. There are no free lunches, but the current austerity obsession is needlessly throwing away lots of food that's on the table. It's also an uphill battle because there are so many misconceptions on how inflation works. Food for thought: the highest rate of inflation in the US in the last 80 or so years was in a year when the government ran a surplus!

Actually, the US Federal government is also only a currency user, ever since 1913. The US Dept of the Treasury has no legal authority to create new US Dollars

The so-called independence of the Fed is all smoke and mirrors. The Fed was created by Congress, it has to operate under the rules set by Congress, and it can be undone by Congress. More importantly, even today the Fed does not operate independently from the Treasury. The Fed and Treasury coordinate their transactions to enable the Fed to manage the bonds market. Seriously, read up on it.

a pseudo-private/public institution whose owners are US banks but who is somewhat answerable to the US Congress and the President

That is quite misleading. Outside of regulatory capture (which is unfortunately a very real thing), the banks have exactly zero influence over the politics of the Fed. They are formally owners, but even the profit of the Fed is largely paid out to the Treasury.

This last point highlights just how absurd the institutional setup is, by the way. The profit of the Fed is in large part due to interest that the Treasury pays to the Fed for the bonds that the Fed owns. The profit is then paid back to the Treasury. Hooray for smoke and mirrors bureaucracy!

should Congress remove that authority from the Federal Reserve (...) in the middle of the mess we're seeing, it would bring about an economic panic that would dwarf any we've heretofore witnessed.

Oh, really. Never mind the fact that such an action wouldn't even be necessary, what form do you imagine this economic panic would take? I assume it'll be like the panic that happened after Treasuries were downgraded to AA+?

Greece, Ireland, and others are all perfectly able to coin their own money at will. They need only abdicate treaties prohibiting it and fire up the printing presses. The reason they haven't done so is that it's economic suicide.

Bad comparison, because Greece and Ireland are in a very different situation. Their problem, especially in the case of Greece, is that its currency should have devalued significantly relatively to currencies of the rest of the world, but that was prevented because Greece tied itself to the Euro. Countries that do not have pegged currencies don't suffer from the same problem, because their exchange rates never go that far off-kilter.

That said, I would say that reintroducing their own currency is in fact the best thing Greece can do economically. Better to have a very painful but short cut followed by a swift recovery, than to suffer many years of economic depression. Argentina is a good example that this can work.

We've seen in Germany, Zimbabwe, and many others what happens when you attempt to coin your way out of a massive fiscal debt.

I was wondering when the inflation bogeyman would show up. Hyperinflation in Germany and Zimbabwe was never about printing too much money; that was just the spectacular side effect of other, very different problems. This is a good introductory paper. Tl;dr: in both cases, a collapse of productive capacity combined with foreign currency-denominated debts created an impossible situation. Printing money was a symptom rather than a cause.

What happens when the US pays more in debt servicing than its entire annual revenue combined and we begin borrowing for 100% of spending plus x% of the debt servicing?

Since that can only happen due to the interest that the government pays on the debt, the answer is very simple: decrease the interest rate. The interest rate is a political choice set by the Fed, after all.

If the decreasing interest rate should cause people to buy and invest instead of saving, even better: This will cause tax r

Welcome to topsy-turvy land. We've actually been here for awhile, with "fiscal conservative" presidents and legislatures growing the national debt and supposedly "tax and spend liberal" presidents actually shrinking debt.

It's bizarre how perverted the discussion has become due to the focus on deficit and debt. There is a reasonable political debate to be had on the question of whether government should be small or large. Should the government be responsible for maintaining basic infrastructure? For education? And so on.

But these questions should not be confused with discussions about the deficit and debt, at least on the federal level. The deficit is mostly endogenous. That is economist-speak for saying that the deficit is not directly controlled by political decision. Instead, it is largely the result of what happens in the private sector. If the private sector produces a lot of activity, this automatically results in higher tax payments and therefore a lower government deficit. If the private sector is running idle, tax revenue drops while at the same time federal outlays in social programs increase, hence the government deficit increases. Therefore, it is best to just let the deficit be whatever it needs to be. That is the approach of Functional Finance, which greatly influenced Modern Monetary Theory.

Stop worrying about the deficit or the debt. They are meaningless, red herrings. Start worrying about real things instead, like crumbling infrastructure or high unemployment - both are things that can very easily be fixed simultaneously at the federal level, if the deficit terrorists are finally silenced.

You're committing the fallacy of composition, which is a cardinal sin in economics. Macroeconomic debt is categorically different from private sector debt, and means something completely different. US government debt is enumerated in a currency of which the US is the monopoly issuer. It can always be monetized. Much of this debt is held at the Fed, and indeed all of it could be--that some is public and international borrowing is merely a political decision, and there is no constraint in terms of the monetary system being used that this should be so. http://pragcap.com/resources/understanding-modern-monetary-system

You haven't the foggiest clue what you are talking about. Money in a fiat system is backed by virtue of the requirement that taxes can only be paid in said currency. (the other reason for taxes is to remove excess currency from circulation). Please read this carefully: http://pragcap.com/resources/understanding-modern-monetary-system

Cutting taxes won't increase production. Deficit spending will. Taxes are a monetary tool, not an economic one (they remove excess currency from circulation). http://pragcap.com/resources/understanding-modern-monetary-system

Your argument is easy to obliterate:
1. The US can easily monetize its debts.
2. Economy can be sustained through deficit spending regardless of foreign exchange-implied value of dollar (government is not revenue constrained so the only limit to deficit spending is political).
3. Greece... LOL are you serious? the whole problem with Greece is that it's part of the Euro countries and no longer a monopoly issuer of its own currency. Kind of hard to fight back against Germany's "beggar-thy-neighbor" huge trade imbalance with the Euro countries when you've given up a major component of your sovereignty.
PUBLIC BORROWING IS NOT NECESSARY FOR THE GOVERNMENT TO FUND ITSELF. The US doesn't have to sell treasury debt instruments to the public or other countries. That's a purely political choice, and an obviously wrong one.
http://pragcap.com/resources/understanding-modern-monetary-system
http://bilbo.economicoutlook.net/blog/?p=11218
http://bilbo.economicoutlook.net/blog/?p=5098

The government can run a deficit without public (or international) borrowing, and the "debt" registered between the Treasury and the Fed is an accounting fiction. It's as simple as that. It can simply credit accounts and hire people to create a net amount of money in the system, then when there is recovery and the private sector picks up the slack, increase taxation to remove the excess money. http://pragcap.com/resources/understanding-modern-monetary-system

Mod parent down for perpetuating the myth of the money multiplier. "When banks create money by extending credit (loans create deposits), this occurs completely within the banking system and results in a liability for the bank (the deposit) and a corresponding asset (the loan). The customer has an asset (the deposit) and a corresponding liability (the loan). This nets to zero." Get it? You completely forgot that any money banks loan out are deposited at other banks. Deposits are a liability for the bank, and cancels out the lent out money exactly. Only government deficit spending creates a net amount of money (and taxation creates a net negative amount). http://pragcap.com/resources/understanding-modern-monetary-system

This is about as rigorous as the Zeitgeist movies *rolleyes*
If lazy slashdotters insist on videos rather than a rigorous description, a place to start would be http://pragcap.com/resources/media-section
Also, a summary by one of the core experts on modern monetary theory in an interview: http://hir.harvard.edu/debt-deficits-and-modern-monetary-theory
And how to fix things: http://bilbo.economicoutlook.net/blog/?p=5098 and http://bilbo.economicoutlook.net/blog/?p=4656
Note that MMT is pretty much the only rational approach and is derived mathematically.

Absolutely the wrong way to look a this. Macroeconomic debt does not mean what you think it does; it's not real, just an accounting fiction registered between the Treasury and the Fed. And banks don't really create money, since any money loaned out are deposited in other banks, and the latter is a liability that precisely cancels out the debt of the former. Only government creates net money through deficit spending, and removes it through taxation. http://pragcap.com/resources/understanding-modern-monetary-system

Your comment makes no sense because macroeconomic debt is categorically different from private sector debt. You're committing the fallacy of composition, one of the most basic in economics, and your analogy is a cardinal sin in economics. The government is not revenue constrained and doesn't have to borrow from the public or other countries in order to spend. http://pragcap.com/resources/understanding-modern-monetary-system

Government debt doesn't mean what you think it does, since government is the monopoly issuer of its own currency. Government debt is an accounting fiction. Unlike private debt, government debt doesn't really have to be repaid; that's a common fallacy. http://pragcap.com/resources/understanding-modern-monetary-system

The ones that best predicted it, and the failings of attempts at corrections (quantitative easing, etc.), are the ones that understand MMT/neo-Chartalism. http://pragcap.com/resources/understanding-modern-monetary-system

Bailing out the banks failed to help overall for the same reason the "quantitative easing" programs failed. No net money was created in the system (since the injections were offset by matching liabilities). Only government deficit spending creates net money, and that's what should have been done. Worrying about government insolvency is silly, since why would a sovereign worry about debt enumerated in a currency of which it is the monopoly issuer? The government doesn't need to borrow money to fund itself. http://pragcap.com/resources/understanding-modern-monetary-system

While that is useful for individuals and corporations, Austrian economics is useless on a macroeconomic level and is part of the shit that has gotten us in the current mess. Austrian theory was developed when the world was on a gold standard, and so it is unsurprising that while it is invaluable in understanding markets and the dangers of an unconstrained fiat monetary system, it is incomplete as a description of the monetary system that we have today. Austrian thinking results in nonsense claims such as that the government needs to borrow to fund itself or that it is revenue constrained. The fact is, Austrian economics is as failed a model as Keneysian economics. http://pragcap.com/resources/understanding-modern-monetary-system

Oops, this one fell through the cracks. Apologies for the delay in replying.
Modern Monetary Theory (MMT) is a type of modern monetary theory. Does this clear up my use of terminology? By Chartalism I mean neo-Chartalism, which is essentially synonymous with MMT.
I can clearly see that in part our disagreement has to do with you not being familiar with MMT. I highly recommend this concise but complete summary http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1905625 I know you're not likely to read it (and I understand as we are all busy), but that would be a shame. Also, take a look at an MMT proponent's comments on Austrian economists http://pragcap.com/the-austrians-are-intrigued (to an extent he sympathizes with them). Without this background to frame the discussion, there can't be much of a discussion.
PS You misread my comment on the correlation between employment and inflation. I know very well that long term correlation has been disproved. My point is that there is far more ignorance of that fact among the, for lack of a better term, elites, than you allow for.

besides, you are misrepresenting the way the USD system works; it does not turn physical USD into a larger amount

I chose my words very carefully. I never implied that physical USD can be turned into larger amount. Please read what I said again.

If the fractional reserve banking system can make $980 billion physical USD bills into $9.5 trillion dollars, then the very same system will make 7.2 million bitcoins into 72 million bitcoin credits.

Obviously physical USD bills != USD dollars, and in the same sense, bitcoins != bitcoin credits. I made the distinction very clear by my choice of words.

Right back to you ;)

The banking system does not turn an amount of physical bills into a larger amount of dollars. This view of the banking system is shared by nobody. Most economists would say you are wrong because s/physical bills/reserves/. But that's a distortion of the truth, too ;)

In fact, as Modern Monetary Theory clearly illustrates, it would be more accurate to say that the banking system maintains a very large amount of dollars in deposits, most of which originated in loans, which in turn are backed by the regulatorily mandated amount of bank capital (as per the Basel accords). In addition, the system keeps a significantly smaller amount of reserves at the central bank as part of the payment settlement system. In most countries, the regulatory rules demand that the amount of reserves is somehow tied to the amount of deposits, so that an increase in deposits also causes an increase in reserves. However, not all countries have such a rule. In those latter countries, the amount of reserves is determined entirely by the liquidity preferences of banks.

This is only true if people replicate the existing system of bank money on top of Bitcoin

Sorry but that's not my assumption. Fractional reserve banking is not just a property of the current banking system. It's a fact of life.
(...)
Regardless of how bitcoins are marketed or how it works, a bitcoin banking sector will develop, and everyone will start using it because the people who boycott the banking system will not be able to compete with those who do. The market will eventually weed them out just like how it weeded out Bob's two inefficient businesses in the above examples.

Ah yes. You're right: if bitcoins were widely adopted, then such a banking sector would develop. Still, it's ironic, don't you think? People who have an ideological distaste for the existing system invent something to replace it. Then, assuming they win, they will proceed to reinvent (over time, of course) the existing system on top of their replacement.

It's the old "Those who don't know history ..." thing all over again.

> it is not determined by the government, and therefore
> defining inflation in terms of the money supply is
> simply pointless.

I don't follow. Why does it matter who inflates the supply?

It matters for policy discussions. In the gold standard world, expanding the money supply (and base) is something that governments did. Inflation, in the gold standard sense, was something that governments did. So it made sense to argue for or against certain government action.

In our modern world, money supply changes and inflation are things that are almost entirely done by the private sector. The implication for policy debates is huge.

Either way, supply/demand still works: supply of money goes up, price of money goes down.

Uh, no. The term "money supply" is really very misleading. Just because the "money supply" (i.e. M2) increases, that doesn't mean that money somehow "becomes cheaper". There is not a market like for commodities. In fact, there is no robust causality from a growth of the money supply to anything else. The only causalities there are is that some third type of event causes both the money supply to grow and something else to happen.

For example, increasing consumer credit can cause the money supply to grow and also aggregate demand to grow, which in turn can grow the economy, or, if the economy hits supply side constraints, cause inflation. So in the latter case, it is not the growth of money supply that causes inflation; instead, it is a third event (more consumer credit) that simultaneously causes inflation and a growth of the money supply. Similarly, in the first case it is not the growth of money supply that causes growth of the economy; instead, it is a third event that simultaneously causes growth of the economy and of the money supply.

Sorting out those causalities is kind of important.

> There are really two big classes of loans in
> our society:

I believe you are leaving out the federal debt, which at 14 trillion dollars accounts for somewhere in the neighborhood of 100% of the money supply.

I was talking about private sector loan activities, which are what really affects the money supply the most. Also, don't delude yourself: outstanding mortgage debt is on the same order of magnitude as total government debt, and that's just one type of private debt.

Besides, it's not like government needs you to loan it money. Government debt is really a tool of monetary policy. Read about how our monetary systems actually work.

The technical definition of inflation is an increase in the money supply. And as it turns out, that was indeed just around the corner.

Rising prices are really just a symptom (money supply goes up, money value goes down, you need more money to buy stuff).

You have it backwards, unfortunately. Inflation is defined to be an increase in price levels. This increase in price levels can indeed cause the money supply to grow, but more on that in two paragraphs.

The longer story is that your definition of inflation is simply outdated. It used to be used for gold standard currencies, where "inflating the money supply" was something that a government actively chose to do, and so it was reasonable to talk about it. In our modern monetary systems, the size of the money supply is endogenous, i.e. it is not determined by the government, and therefore defining inflation in terms of the money supply is simply pointless.

The size of the money supply is mostly determined by the credit creation of banks. When a bank makes a loan, the money supply increases. When the loan is retired, the money supply shrinks. There are really two big classes of loans in our society: mortgages, and loans to cover production costs of firms. The first class grows when house prices rise: increasing prices in houses causes the size of mortgages to go up, which expands the money supply. The second class grows when general price levels increase: firms have larger production costs, which means they're taking out larger loans, which grows the money supply.

Of course there are other factors driving the money supply as well, such as Minsky-type cycles in how banks assess the credit-worthiness of their customers, but there is certainly a causal link from price levels to the size of money supply that people don't seem to be aware of.

Google's worth as a bookmark system has seriously dropped with the way they're handling links now. Obviously, the links in my post are messed up, they should be: #1 and #2.

Do we need to carry on that "risk of default"-bullshit? The US never were in any economical risk of default, given their top credit rating. Debt/GDP ratio has been worse in history and is worse in countries working just fine right now.

You can go even further. There is never any economical risk of default for a government that issues its own currency and only issues debt that is denominated in that currency. In fact, it is even misleading to think of US government bonds as debt. It's more like a savings account (as opposed to the reserve accounts at the Fed, which are like checking accounts). You can read more about the basic observations of Modern Monetary Theory (MMT) here. Debt/GDP ratios or anything like that really don't matter: the US government cannot go bankrupt.

(Note that of course, hypothetically, the US$ as a currency could be rejected by the US citizens, in which case the government would still be solvent, it just couldn't buy anything with its US$. However, then we're talking about what causes hyperinflation, and some insight into that can be found here)

The only possibility has ever been that the government voluntarily defaults (in the current case, due to the craziness of the Tea Party types).

Do we need to carry on that "risk of default"-bullshit? The US never were in any economical risk of default, given their top credit rating. Debt/GDP ratio has been worse in history and is worse in countries working just fine right now.

You can go even further. There is never any economical risk of default for a government that issues its own currency and only issues debt that is denominated in that currency. In fact, it is even misleading to think of US government bonds as debt. It's more like a savings account (as opposed to the reserve accounts at the Fed, which are like checking accounts). You can read more about the basic observations of Modern Monetary Theory (MMT) here. Debt/GDP ratios or anything like that really don't matter: the US government cannot go bankrupt.

(Note that of course, hypothetically, the US$ as a currency could be rejected by the US citizens, in which case the government would still be solvent, it just couldn't buy anything with its US$. However, then we're talking about what causes hyperinflation, and some insight into that can be found here)

The only possibility has ever been that the government voluntarily defaults (in the current case, due to the craziness of the Tea Party types).

The crucial thing that all the talking heads are missing is that you and I are users of money. We have to get money before we can spend. The US federal government, on the other hand, is an issuer of money. They have to spend money before they can get it back.

We are the players of World of Warcraft, and the US federal government is Blizzard. Everything else follows from this when you think about it logically (and are prepared to challenge everything you've known so far about macroeconomics).

If you want to really challenge your understanding of all this, I suggest you read about Modern Monetary Theory. Some initial pointers are: this overview, the book 7 Deadly Innocent Frauds, and the blog of economics professor Bill Mitchell - for your particular question particularly the series Deficit Spending 101: #1, #2, #3.

The Cliff Notes version is that because - in the long run - the private and external sectors save in financial assets, the currency issuer must run a deficit to maintain aggregate demand at a level where the economy does not tank - after all, the money that is being saved by the private and external sectors has to come from somewhere. The government surplus under Clinton was only possible due to the financial engineering that allowed the private sector to accumulate massive debts. These debts ultimately were not sustainable, and so it is quite reasonable to say that the Clinton surpluses are one of the causes of the global financial crisis. What we are seeing now is that the private debt burdens are shifted back to the government.

The Republicans are debating plans to cut spending. This is unlikely to reduce the budget deficit, and if it does reduce it, it will do so at a high cost in real terms, especially unemployment.

What you have to understand is that there is a discretionary budget - what politicians aim for - and then there is an actual budget outcome that is largely driven by automatic stabilisers. In particular, when the economy is going badly, tax revenue will drop and welfare payments will go up, and thus the actual budget outcome will be different from the discretionary budget. This causes attempts to reduce a budget deficit to often be self-defeating. This can be observed nicely in the various Euro countries that are forced to implement austerity measures.

What people need to understand is that achieving a balanced budget is not a reasonable political goal. At any point in time, if the budget deficit is too high, so that it drives aggregate demand beyond productive capacity, it will cause inflation. If the budget deficit is too low, so that firms lay off workers due to a lack of aggregate demand, it causes unemployment. The high unemployment is evidence that the budget deficit in the US is too low at the moment.

This is not surprising, because the government balance is the counter-part of the private sector balance plus the external sector balance. Since the US is a net importer, and the private sector is saving (it is paying down debts at an incredible rate), the budget deficit must be high.

A reasonable political goal is something like "achieve full employment", because employment allows people to have meaning in their life. "Increase real living standards" is a reasonable political goal for obvious reasons. Having "balance the budget" as a political goal is just plain stupid.

Once you define your political goal, you need to take an unideological look at how to to achieve that given the economic reality. If that means maintaining a high budget deficit, then you maintain a high budget deficit.

As for "the federal government drives the economy", well, federal spending is a significant chunk of GDP.

Where does it get that money to spend?

The federal government gets the money that it spends from the same place where Blizzard gets the gold in World of Warcraft. In other words, whenever the federal government spends, money is created out of thin air. It does not come from taxes. The accounting that creates this illusion is just a historical vestige from the distant gold standard past.

I understand that Modern Monetary Theory is hard to swallow at first, because at first sight it appears as if MMT were claiming that there is a free lunch. And in fact there is something as close to a free lunch as you can get at this point in time, however it is not an unlimited free lunch in any way.

What MMT observes is that the federal government has no financial constraints. However, there are real constraints. The two main points are the following:

1) If the government's discretionary budget deficit is too big, then it pushes aggregate demand beyond the productive capacity of the economy, which leads to inflation. On the other hand, if the government's discretionary budget deficit is too small, then the lack of aggregate demand causes mass unemployment. So how big is too big, and how small is too small? The answer is that it depends on the private sector's decisions. Most of the time, a budget deficit is necessary to accomodate the private sector, though very occasionally, a budget surplus may be appropriate (this must be a very rare event though: six out of seven times that the US government ran a budget surplus in its history, a recession followed, and the seventh time set the stage for the global financial crisis).

2) Irrespective of the discretionary deficit that politicians desire, the actual budget outcome may be very different due to automatic stabilisers (tax revenue and welfare payments). Example: the discretionary budget deficit in the US at this point in time is too small, causing unemployment. The resulting lack of tax revenue and the increased welfare payments cause the actual budget outcome to be bigger than desired. The interaction of discretionary and actual budget lead to the (initially) counterintuitive situation where the discretionary deficit needs to be increased so that the actual deficit can become smaller.

lets take your theory to its extreme conclusion. The government takes 100% of all financial transactions and then spends it. Under your theory our GDP is now 200% of what it was.

Disregarding for a moment that you clearly don't understand how government spending works, this is true. And it's not actually a theory, it's simply the definition of GDP. If the government were somehow to spend that much additional money, the nominal GDP would in fact double (let's ignore multiplier effects for now). Look up the definition of GDP.

Now refer to what I wrote above: while there is a lot of idle capacity in the economy right now, I don't think there's that much spare capacity. As a result, the increased aggregate demand would cause inflation, and therefore the real GDP would not double (it would still likely increase, just not by that much).

However, if the economy really were below 50% capacity utilisation, then yes, the government could really spend that much without causing inflation (with the caveat that the distribution of the additional spending matters: the type of spending must match the type of available capacity, otherwise there may be inflation until the market adjusts to restructure the economy to match the demand).

So let's go back to the "free lunch" thing for a moment. Right now, an unusually large part of the US economy's productive capacity is idle. The most obvious indicator of that is the extremely high rate of unemploymen

Once that happens, the rough outline for what needs to be done is that somebody needs to start spending again. ...
I am not against that on principle, but you have to realize that when people who are deep in debt get a tax break, they're probably going to use it to pay down their debt.

But doesn't that give the debt owners more money that they can then spend on other stuff, or loan out to other people to spend on stuff?

Not necessarily. What we're talking about here is people paying debt back to their bank. The bank will be very happy about that, but being repaid won't make them give out more loans directly, because bank loans are not limited by the amount of money available to the bank anyway. So debts being settled will just cause the money supply to shrink - the M1-M3 type of money supply, not the monetary base; the latter is still very high in the US due to the Fed's monetary policy, but ultimately it's the private sector that determines the size of M1-M3, and the Fed's quantitative easing has demonstrated spectacularly that the orthodox theories about how those quantities are related are just plain wrong. You'll find a little more on this - light on the theory, but with pretty graphs - here.

This is one of the things that I had the most problems understanding, asking myself the "is it really like this?" question more than a few times. But a number of sources agree that at an operational level, the decision by the bank to give out a loan has nothing to do with how much money (reserves, to be more precise) the bank has. The people who make those decisions don't even know how much money the bank has. They just make the decision based on creditworthiness and interest rates, and then a different department at the bank worries about getting the money - if necessary - after the fact. This liquidity management is entirely separate. It takes a while to unlearn the incorrect elementary school picture of banking that we are all told.

So the total amount of debt, and therefore the size of the money supply, grows and shrinks based on changes in the demand for debt and the risk-averseness of the banks. Currently, the US economy is still settling debts, and the money just "disappears". In the accounting sense of assets and liabilities, the corresponding assets and liabilities (money and anti-money) cancel each other out and that's it, the balance sheet shrinks and nothing replaces the lost volume.

Unfortunately, it seems like these days, government spending never really seems to do much good. Instead of building roads (we don't really need a lot of new highways or the like, but we do need to fix up the ones we have, especially bridges), sending men to the moon and developing new technologies to do so, investing in fundamental research, etc., all I ever see is spending money on military hardware, sending money to other screwed-up nations like Mexico for them to waste, spending money on poorly-designed social programs that don't do anything to relieve poverty, etc. If they cut a lot of that stuff out, and spent the money instead on lots of medical research, a space elevator, a personal rapid transit system, etc., we'd put lots of people to work, create lots of very useful new technologies, and become a world leader in many things again. But we don't seem to want to do that.

It does seem like a kind of vicious cycle:

The almost inquisition-like hatred of everything to do with government spending prevents politicians from pushing for visionary projects like the ones you mentioned. As a result, only two kinds of government spending happen: the boring things that people just take for granted (and that are probably efficient as often as they are inefficient), and the ugly back room deals that continue precisely because they are ugly and dominated by ruthless vested interests. The latter is correctly identified as inefficient and wasteful,