Your mistake is to consider the Fed profits instead of the profits derived by the private sector from money lent to the government.

The government is running a deficit, but the law (treaties in Europe) forbid it to fund itself by printing money. So it needs to reduce expenses and/or increase taxes, but in the meantime it has to borrow from the market (whether that happens through the central bank like in the US is irrelevant). Borrowed money is not free at all as you say, it comes with an interest that is paid to the private lender, not to the Fed. The interest adds to the deficit, increasing the drive for higher taxes (hence the burdening of the tax payer) and lower expenses (hence the austerity).

This mode of funding often amounts to a tax on the poor (through spending cuts in social programs for example) and to a lesser extent a tax on the rich (through tax hikes). A government funded directly through printed money is more of a tax on the rich, due to the loss of value of their savings and assets. It also makes it much easier to run an irresponsible budget.

Why do we have the treasury market at all with the government paying interest to private individuals who do nothing and have no risk when the government could just print the money like China? People who own government bonds (the ones that are not the fed) are getting paid an enormous amount of risk-free interest courtesy of the taxpayer.

My admittedly poor understanding is, because printing money increases inflation. You can't just print more money because people will stop believing in the value of the currency, which destroys any holdings of owners of large capital.

The United States is a bit of a special case; the dollar is the world's reserve currency. For starters, as a large business you have a big need to stash your money into some kind of ultra-safe vehicle with lots of liquidity. Lots of companies sink their payroll into Treasuries because a) they know they can sell them when the time comes and b) they're basically guaranteed to never lose value.

Secondly, It's the currency of international trade; if I live in Brazil and want to sell my coffee to Russians, we will exchange dollars. As a result, there is a constant demand for lots of dollars.

Finally, US Treasuries are currently set at negative real interest rates. If I were to buy a Treasury today, after inflation, I am paying the US Government for the privilege of lending it money. See for yourself: http://www.treasury.gov/resource-center/data-chart-center/in... (As for today, a 5 yr bond is going for -1%).

This is to say, no one is getting paid an enormous amount of risk-free interest. You only invest in Treasuries if you have absolutely nowhere else to put your money. No one likes having their money in Treasuries, because while the nominal value is basically guarantee, you lose money by holding them.

Edit: as a final aside, some commentators have gone as far to say that the current crisis in Europe stems from German hatred of inflation; they could easily solve the problem by having the ECB guarantee EU sovereign bonds, but that would probably cause the inflation rate to rise above 2%.

To expand on what phillmv said a bit, printing money generally tends to increase inflation. I say tends to, because there are a lot of factors that change that. For instance, in 2008 when most people though we were facing a more supply driven recession with a possible spike in inflation[1] but the Fed wanted to put a lot of money into banks. What they did was institute a policy called Interest on Reserves, where they would pay banks to sit on the money they were giving them and not lend it out. This policy worked remarkably well at what it was intended to do, and the US money supply increased by a huge amount even while the country was suffering from deflation. Whether it worked in light of what was actually needed is another story.

Another big complication in the relationship between printing money and inflation is expectations. If the Fed gave everyone in the US $1000 but said that anyone who didn't return it in a month would go to jail, then inflation would go up very little because most people would save the money. Conversely, if people were absolutely convinced they were going to get $1000 in a month inflation would go up a bit right now as people made purchases in expectation of their future windfall.

This makes printing money as a way to finance the government very dangerous, though. If the government is printing money to finance its spending, people know the money is going to keep coming into the economy, so prices go up even in advance of the money arriving. But this inflation forces the government to print even more to match the increased prices, and you've got a positive feedback loop and then you get hyper-inflation. Which really sucks for the economy. So though you want a central bank that can print money to do macro-stabilisation, you don't want to have the people in charge of the budget able to print money to make ends meet.

[1] The governments numbers on inflation take months to calculate, inflation was already crashing at this point but the Fed Open Market Commission didn't know it.

>This makes printing money as a way to finance the government very dangerous, though.

Well… It depends, is what I hear.

If you use debt to finance economic stimulus (i.e. World War 2) then you're making a bet that the amount of money you spend now will be offset by the jumpstart in economic growth you're creating. A crazy amount of things affect the economy.

The catch is is that there is a lot of money printing going on, it's just all going on in the banking system via the money multiplier. I'm sure you've seen the M1/M2/M3 Graphs. Why not let the government create that money instead of the banks?