Functional Finance versus Sound Finance

[Joe Leote]

According to Mathew Forstater interpreting Abba Learner's Functional Finance (8 page pdf):

 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=174849

 

there are three pairs of fiscal tools identified as spending and taxing, borrowing and lending, buying and selling. These tools should be used along with monetary tools to help manage a stable price full employment economy, without regard to a self-imposed requirement to balance the federal budget.

 

Sound Finance is contrasted with Functional Finance in this excellent 5 page pdf:

 

http://community.middlebury.edu/~colander/articles/functional%20finance%20article.pdf

 

In the context of both positions the identity called the Combined Government Budget Constraint identifies the change in money supply due to operations of Fed and Treasury. A version which incorporates Fed activity called Quantitative Easing would have three stock variables that I call "financial floats" held outside the Fed/Treasury and Federal agency balance sheets.

 

The three financial floats are money supply M (currency plus bank deposits), Treasury bills and bonds B, and all kinds of private financial securities P. An increase of each float is written dM, dB, or dP. A decrease in each float is written -dM, -dB, or -dP. The minus signs in the GBC equation thus show that money dM is drained from bank deposits or currency in circulation by an increase of floats dB or dP:

 

dM = (G - T) - dB [Treas] - dB [Fed] - dP [Fed]

 

where historically the economy operates primarily under deficit spending G - T > 0, Treasury is operationally constrained to replenish its account at Fed by collecting taxes T or net increasing the float of bills and bonds dB on average over some period, and Fed regulates interest rates by open market operations dM = - dB [Fed sells bills to drain money] or dM = + dB [Fed buys bills to add money]. Quantitative easing is the purchase or sale of private securities by Fed +/- dP, an historic drastic measure undertaken in the recent crisis, However Fed ordinarily permits similar Lender of Last Resort activity on a much smaller scale at its discount window where a borrower posts collateral against a Fed loan.

 

Using its authorized monetary policy tools Fed attempts to maintain maximum employment and stable prices, which it does by adjusting interest rates, theoretically the target of monetary policy transmission is aggregate demand. Fed loses control over interest rates at the zero limit bound and perhaps it loses control over inflationary pressure (except to cause a recession) at the full employment boundary.

 

Fiscal policy tools are more powerful control variables to stabilize an unstable economy (Keynes, Learner, and Minsky are advocates), and more difficult to fine tune due to operational and political factors. For example, Mosler proposes using the buying and spending powers of government to promote a full employment jobs program at a non-inflationary wage floor. Minsky argues that inflation is a long term concern only because of government deficit spending preventing periodic debt-deflations and central bank activity intervening as lender of last resort. Stagflation is possible if government transfer payments support rising prices in pockets of the economy where consumer goods are scarce relative to purchasing power. To promote full employment and prevent inflation government must allocate its spending and tax policy in proportion to demand for consumption goods based on installed capacity according to Minsky using policies within components of G and T that act as "automatic stabilizers."

 

Joe 

[William Hummel]

On 5/19/2011 10:32 AM, Joe Leote wrote:

Sound Finance is contrasted with Functional Finance in this excellent 5 page pdf:

 

http://community.middlebury.edu/~colander/articles/functional%20finance%20article.pdf

David Colander first came to my attention when I read his book "Why Aren't Economists as Important as Garbagemen?" [1991].  The title is only flippant part of the book.

I agree with Colander's basic thesis about Lerner's functional finance, namely that it is too simple as a policy prescription.  It assumes that government can easily change taxes and spending as needed to steer a path to full employment without inflation.  However it fails to deal with the fact that policy is made by a diverse group of elected representatives each with his own agenda. Even if all could agree on well-conceived policy, the lag in implementation is usually too long. Conditions can change in the meantime and the result is often counter-productive.  In brief, fiscal policy is a blunt tool, which is why we often find ourselves looking to monetary policy to deal with problems in the economy.

That doesn't mean functional finance as a theoretical guide is not valuable.  Its real importance is in the recognition that full employment and low deficit/GDP ratios can be achieved when the functionality of deficits and the money supply rather than "sound finance" is the driving principle.

William

[Jean Erick]

     Neat article.  I'll have to read it better later.

     Just as a note, the forum keeps talking about a workable system.  We MIGHT (I say might because this whole debt as money thing looks crazy)

have had a workable system.  But the reality of the system seems to be that crazy Jefferson inflation/deflation cycle.  I am subdued by that 60 year dome of interest rates.  That has to be explained.  Also, a look at the FRED PPI chart indicates there is no "formula" for inflation.  Over time it appears, at first glance, as chaotic.  The first jump is, I think, due, to the first oil  embargo but jumps after that don't have such a clear coincidence accompanying them.

 

James