The Principles of Functional Finance

[William Hummel]

In 1941, Abba Lerner outlined the three fundamental rules of functional finance:

1. The government shall maintain a reasonable level of demand at all times.  If there is too little spending and thus excessive unemployment, the government shall reduce taxes or increase its own spending. If there is too much spending that threatens inflation, the government shall reduce its own expenditures or by increasing taxes.

2. By borrowing money when it wishes to raise the rate of interest, and by lending money or repaying debt when it wishes to lower the rate of interest, the government shall maintain that rate of interest that induces the optimum amount of investment.

3. If either of the first two rules conflicts with the principles of ‘sound finance’, balancing the budget, or limiting the national debt, so much the worse for these principles.  The government press shall print any money that may be needed to carry out rules 1 and 2.

Lerner noted that conventional fiscal wisdom was based on the principles of good household management, i.e. don’t spend what you don’t have.  However he argued that governments using an inconvertible fiat money regime should only consider the results of their actions. The aim of government spending and taxing should be to hold the economy’s total spending at a level compatible with, and conducive to, full employment at current prices.  In doing this the government should not be concerned with deficits or debt.  The government should borrow or repay only insofar as it wants to change the proportions in which the public holds securities or money.  Changing this proportion will raise or lower interest rates and hence discourage or promote investment and credit purchasing.  If the only question then was how to finance a deficit, Lerner advocated printing money.  

[Jean Erick]

----- Original Message -----

From: William Hummel

To: Google Group

Sent: Sunday, April 24, 2011 3:55 PM

Subject: The Principles of Functional Finance

In 1941, Abba Lerner outlined the three fundamental rules of functional finance:

1. The government shall maintain a reasonable level of demand at all times.  If there is too little spending and thus excessive unemployment, the government shall reduce taxes or increase its own spending. If there is too much spending that threatens inflation, the government shall reduce its own expenditures or by increasing taxes.

2. By borrowing money when it wishes to raise the rate of interest, and by lending money or repaying debt when it wishes to lower the rate of interest, the government shall maintain that rate of interest that induces the optimum amount of investment.

     I think I have seen you state that investment is currently from earnings.  If Hudson's paradigm is accepted (it agrees with your statement), #2 misses the cycle of inflation and deflation and the upward and downward swing of interest rates therein.  So it would tend to answer questions in the first part of the cycle, but not after money changing from going into investment to go into rentals had gone far enough to change the dynamics away from #2's paradigm.  MPATT.

3. If either of the first two rules conflicts with the principles of ‘sound finance’, balancing the budget, or limiting the national debt, so much the worse for these principles.  The government press shall print any money that may be needed to carry out rules 1 and 2.

     I think the arguments for balancing the budget, etc. are politically based and I see little evidence of sound princples expressed.

Lerner noted that conventional fiscal wisdom was based on the principles of good household management, i.e. don’t spend what you don’t have.  However he argued that governments using an inconvertible fiat money regime should only consider the results of their actions. The aim of government spending and taxing should be to hold the economy’s total spending at a level compatible with, and conducive to, full employment at current prices.  In doing this the government should not be concerned with deficits or debt.  The government should borrow or repay only insofar as it wants to change the proportions in which the public holds securities or money.  Changing this proportion will raise or lower interest rates and hence discourage or promote investment and credit purchasing.  If the only question then was how to finance a deficit, Lerner advocated printing money.

     I just posted, a few days ago, my understanding of use of the "good household management" idea.  It's bogus.  Everybody and every business will, hopefully, make a decision about how much debt they can afford to carry.  Everybody spends what they don't have.  They spend what they have and some of what they think they are going to have.  Except for those to dumb to feed.

     As far as the rest, again, I have to mention Hudson.  If he is correct, his analysis must be looked at.  In a sence, I see the above, and explanations like it, provide "mini-wave" views, without noting the overall movements.  It describes the way the economy would work,and does in mini wave terms, and would work continuously if the Hudson paradigm didn't exist.

James

 

[Hugo Heden]

William,

This would be worth posting as an article on your site, in my opinion. Very useful.

[Jean Erick]

     So, government is to conduct itself as a "good household" but is also to ignore any debt they carry.  I find that to be a condradiction.

James

[Hugo Heden]

You're misreading it, I think. Lerner is challenging the household analogy (the "conventional fiscal wisdom"). 

[Joe Leote]

In this long (1.5 hours) but worthwhile video economist Jeffrey Sachs advocates raising taxes to provide necessary public goods with a budget gap (deficit) no larger than 2% of GDP in the out-years. He says government budgeting should be 10 year process, and is more serious business in a democratic society than our current politicians seem to recognize:

 

http://vimeo.com/23280737

 

I think William mentioned the 2% budget gap way back in a thread as in line with economic growth to keep ratio of debt/GDP roughly constant? I know 2% inflation rate is a number thrown out for steady/optimum GDP growth when the economy is expanding.

 

In contrast to the Modern Monetary Theory advocates (or perhaps I've misread some of their ideas) both Hyman Minsky and Jeffrey Sachs suggest that a small deficit or balanced budget is preferred, but I suspect for slightly different reasons. Minsky says credibility of Treasury bond sales requires at least the notion that taxes could go into surplus, and he says a small deficit is better in case government needs to run a surplus to curb inflation, if government were to also promote operation closer to a full employment (writing in the 1980s I recall he set 6% unemployment as a full employment target, I think published number was closer to 4-5% unemployment in some Clinton years, and one MMT author says 2% unemployment is an achievable level of full employment with government programs setting a wage floor).

 

I think Minsky and Sachs are close to Lerner's idea of Functional Finance in that both recognize fiscal tools are the more powerful in managing the economy for the public good, but they are more cautious about running large deficits than MMT proponents seem to be. I am not sure the deficit level should be ignored to the degree suggested by Lerner since Minsky is concerned that government must be able to force a surplus or swing from deficit to surplus effectively under inflationary conditions, and this is not easy to do with a large deficit.

 

Joe

[William Hummel]

On 5/9/2011 12:19 PM, Joe Leote wrote:

In this long (1.5 hours) but worthwhile video economist Jeffrey Sachs advocates raising taxes to provide necessary public goods with a budget gap (deficit) no larger than 2% of GDP in the out-years. He says government budgeting should be 10 year process, and is more serious business in a democratic society than our current politicians seem to recognize:

http://vimeo.com/23280737

Without having viewed Sachs' video, I wonder how he proposes to set a limit on deficit/GDP of some arbitrary amount like 2% in the out-years.  It's OK to set targets 10 years ahead, but actual results depend on economic factors which no one can accurately forecast, let alone control.  Functional finance would have little use for such planning.  Fiscal policy should be guided mainly by current conditions and near-term forecasts of unemployment and inflation.

I think William mentioned the 2% budget gap way back in a thread as in line with economic growth to keep ratio of debt/GDP roughly constant? I know 2% inflation rate is a number thrown out for steady/optimum GDP growth when the economy is expanding.

I don't recall having said that. You may be thinking of my comments regarding the asymptotic behavior of the debt/GDP ratio.  For a fixed deficit/GDP ratio, the debt/GDP ratio will approach an asymptote equal to the ratio of the deficit/GDP to the GDP growth rate.  In other words, as long as the average GDP growth rate is positive, the debt/GDP is bounded for any fixed deficit/GDP.  For example, if the nominal GDP growth rate is 5%, and the deficit/GDP is 4%, the debt/GDP will not exceed 80%.  Of course we don't know how high the debt/GDP ratio can grow before something very awkward happens.  But its worth noting the Japan's debt/GDP ratio is over 200% and 10-yr bonds currently yield 1.3%. and have not exceeded 2.0% for at least ten years.

In contrast to the Modern Monetary Theory advocates (or perhaps I've misread some of their ideas) both Hyman Minsky and Jeffrey Sachs suggest that a small deficit or balanced budget is preferred, but I suspect for slightly different reasons. Minsky says credibility of Treasury bond sales requires at least the notion that taxes could go into surplus, and he says a small deficit is better in case government needs to run a surplus to curb inflation, if government were to also promote operation closer to a full employment (writing in the 1980s I recall he set 6% unemployment as a full employment target, I think published number was closer to 4-5% unemployment in some Clinton years, and one MMT author says 2% unemployment is an achievable level of full employment with government programs setting a wage floor).

MMTers argue that a Federal deficit is the norm for a growing economy, and the credibility of Treasury bond sales is not an issue.    

I think Minsky and Sachs are close to Lerner's idea of Functional Finance in that both recognize fiscal tools are the more powerful in managing the economy for the public good, but they are more cautious about running large deficits than MMT proponents seem to be. I am not sure the deficit level should be ignored to the degree suggested by Lerner since Minsky is concerned that government must be able to force a surplus or swing from deficit to surplus effectively under inflationary conditions, and this is not easy to do with a large deficit.

I'm surprised that Minsky thinks the government could force a surplus, and certainly not without having achieved full employment.  Everything must come together nicely for that to happen, and a democracy is an unlikely place for that to happen, especially with divided powers where everything is a compromise of competing interests.

[Joe Leote]

William,

 

Thanks for your comments. I am a bit surprised at Minsky's view that national government must be able to force cash inflow (taxation T) sufficient to cover its debts, which is similar to the theory of the long term intertemporal budget constraint, or a balanced long term budget concept. But he does discuss this in the chapter on policy recommendations.

 

I would summarize Minsky's view as follows. Let GDP = C (consumption) + I (investment) + G (Gov spending) + NX (net exports).

 

To stabilize the economy, which varies due to financial instability in the investment spending cycle I, the government spending component G must be of the same order of magnitude as I, say I = G = 20% of GDP. That leaves 60% for consumption and trade balance spending.

 

Increases in the government spending component G put upward pressure on consumption goods prices, particularly if government institutes an jobs or full employment program per his recommendation, then deficit spending can become a cause of inflation because it fuels aggregate demand near the full employment boundary. Government must be ready to force a tax surplus via a properly structured tax policy when inflation threatens to occur due to too much aggregate demand caused by government. Sachs does not discuss these matters in the Minsky context.

 

I agree with you that deficits are not the problem until it comes to a full employment economy and then government spending and transfer payments should become inflationary according to Minsky's model, per my best understanding, and at that point either spending must go down or taxes that stabilize rising prices must kick in "automatically." Whether such "automatic stabilizers" as Minsky envisions can be implemented in practice, I am not sure, but it seems to me the MMTers are combining the Lerner view on deficits with the Minsky view on spending and tax stabilization at the full employment inflation boundary, without making the case clearly and concisely enough in one place.

[Jean Erick]

         Well, am I mis reading IT or am I misreading your COMMENTS on IT?  ;-)

     Well, I agree that the "household" argument is in error and I also think it is a product of the rightest propaganda.

I just have a tendency to think that we are wasting time when we go over these "I've got an answer" guys who talk about a "workable" system.

My position tends to be that we have a workable system, capitalism, but we're just not "working" it.  The problem, MPATT, is well stated in the Hudson article.

But then, I seem to be in the minority on that.

 

Link to Hudson article.

 

http://www.itulip.com/forums/showthread.php/891-Saving-Asset-Price-Inflation-and-Debt-Induced-Deflation

 

James

[Jean Erick]

     A few things that have sunk in, over time, is that break downs are caused by (1) revenues based on foreign conquest dimishing due to dimishing returns (Rome, etc.)  (2) debt gowing out of hand (the rest).  Note that debt problems predate fiat money.

     In our situation, the private debt created a problem which O'bama mis handled into a public debt.  Debt has been the problem and, therefore, there is the solution to be found.

     At this point, as you may or may not have noticed. I am drawing the distinction between mercantalisms profits from rentiers (modern conservatives, in power since Reagan); and Adam Smith's capitalism, profits from private production.  Hudson's article laid out the basic theory on modern rentier scenario.

 

James

[Joe Leote]

Obama's time would be better spent herding cats than organizing Democrats in Congress to get the spending and tax policy "right" in this crisis, but increasing the deficit and debt is not the problem, it is the components of tax and spend policy in the "stimulus" which Obama cannot control all by his lonesome, which would either expedite or delay economic recovery. Streamlined bankruptcy rules during debt-deflations would be also be a good legal reform in the future.

 

Glad to hear your definition of mercantilism and capitalism explained, since I had no idea what you meant by these terms in the past.

 

Joe

 

----- Original Message -----

[Jean Erick]

     It was kind of surprising to see Sachs view the deficit as a problem.  He says it's to high for peace time.

[Joe Leote]

From what I recall of the video, Sachs wants to tax the rich to close the deficit gap, reduce military spending, and increase social spending programs in line with what other civilized first world countries spend on social welfare programs. He is in favor of closing the deficit by taxing the income of the most wealthy few.

[Jean Erick]

     :-)