Friday, May 14, 2010

Functional finance.

I think advocates of Modern Monetary Theory (aka Functional Finance) need to get more articles into newspapers etc putting their case. I’ve penned a draft article below – 1,100 words. Comments welcome. Feel free to plagiarize and present it as your own (though I prefer credit where credit is due).


Economists and economic commentators are currently split into two camps. First there is what might be called the conservative or traditionalist camp: those who believe government deficits are undesirable if not an abhorrence. Secondly there are those who believe that without deficits, long periods of excessive unemployment will ensue.

Functional finance is a set of ideas that belong to the “pro deficit” camp. But more than that, functional finance advocates a very different view of deficits, national debts and the money supply from that set out in the economics text books. An alternative name for functional finance is “Modern Monetary Theory”.

If there is one basic point underlying functional finance, it is the inescapable reality that money for a government which issues its own currency is a very different from money as viewed by households or firms. A government that issues its own currency can print and spend money at will. Likewise, it can do the opposite, that is, raise taxes and extinguish the money collected.

For a firm or household, money inflows and outflows are a measure of earnings and expenditure and households and firms need to ensure that earnings are equal to or exceed spending, else they go bust, or become poorer. In contrast, for a government, there is no merit whatsoever in balancing the books. The sole objective of income and spending by a government should be “functional”: that is, to bring about the maximum level of employment that is consistent with acceptable inflation.

For reasons given below, normally government spending will exceed income, though occasionally the reverse will obtain.

Moreover, when it looks like spending should exceed income, there is not much point in borrowing to cover the difference: that is, governments (at least those that issue their own currencies) should simply print extra money to cover the difference. Borrowing is particularly nonsensical given that when a government borrows, it borrows “stuff” (i.e. money) which it can produce an infinite supply of at no cost. A government borrowing money is a bit like a dairy farmer buying milk at the supermarket when there is a thousand gallon tank of milk a few yards from his house.

A second nonsensical aspect of government borrowing is that when government borrows and spends, the object of the exercise is often to bring economic stimulus or “reflation”. But borrowing as such has the opposite effect: it’s deflationary. So why not just spend and forget all about the borrowing? “Borrow and spend” is a bit like throwing dirt over your car before cleaning it!

Various economists over the decades have advocated functional finance, and one of the more significant was Abba Lerner, who was much admired by Keynes. As Keynes said, “Lerner's argument is impeccable, but heaven help anyone who tries to put it across to the plain man at this stage of the evolution of our ideas." Keynes was right: functional finance can be a shock for those tutored in conventional economics.

There are three reasons why a deficit will be the norm, that is reasons why government spending will normally exceed government’s income from tax. These three reasons stem from the fact that it is generally accepted nowadays that the optimum rate of inflation is around 2% p.a.

So let’s assume 2% inflation and assume the money supply needs to remain constant in real terms. This means the Fed will have to print an additional amount of money each year equal to 2% of the money supply (or monetary base, to be more exact).

Second, assuming the economy expands in real terms by a small amount each year, (let’s say 1.5% just for illustration), then the monetary base will have to be expanded by another 1.5% p.a. That is a total of 3.5% a year, assuming the above percentages. Now that is several billion worth of deficit! But I haven’t finished.

The third point relates to the national debt. As intimated above, I think that national debts are near pointless and should be drastically reduced, but I won’t go into that. Instead, let’s just assume the national debt is to remain constant as a proportion of GDP (say 50% for the sake of argument). Much the same point applies here as applied above to the monetary base. That is, to keep the latter proportion constant, the Fed is just going to have print even more money (and borrow it back, thus creating “debt”) just to keep the national debt constant as a proportion of GDP.

Indeed, taking the above illustrative figures (2%, 1.5% and 50%), the annual unfunded deficit or amount of additional monetary base that needs to be printed each year would be about $300bn (calculations below).

There is a fourth and less common reason for deficits, which has to do with deleveraging by the private sector. Deleveraging consists of trying to pay off debts and/or accumulate a larger stock of cash. And this is exactly what the private sector has been trying to do over the last two years or so.

When one person or firm switches from spending money to trying to hoard it, that means less demand for goods and services. And that in turn means unemployment for those who would have produces these goods and services.

There is only one solution to this problem: print yet more money so as to fulfil the saving desire of the private sector. Conversely, if the private sector is trying to dissave money (the opposite of deleveraging) then to that extent the deficit will need to be reduced. Indeed, on occasions, this reduction may be so extreme as to cancel out the above mentioned first three factors which tend to bring the deficit into being. I.e. on occasion, a surplus is called for. But to repeat, given inflation of around 2%, a deficit will be the norm.

Having given four reasons that justify money printing or deficits, conservatives and those with concerns about inflation will now be seething. I admit their concerns have some justification.

Given an omniscient and omnipotent government (or even moderately intelligent government), such a government ought to be able to expand the money supply during a recession by enough to bring a quick end to the recession. And if and when this money supply looks like causing excess inflation, such a government ought to be able to rein in the additional money or take other deflationary measures so as to prevent excess inflation.

However the big problem, as Milton Friedman pointed out, is that governments are so incompetent and chaotic that the above “moderately intelligent” behaviour is unlikely. Indeed, Friedman’s conclusion was that governments are so incompetent, that it would be better if they didn’t even try to deal with recessions or inflationary booms.

Perhaps Freidman’s pessimism was justified. But I cannot just sit back while millions of lives are ruined by unemployment. I feel we’ve just got to try. We may fall off the bike twenty times before learning to ride it, but I think we’ll eventually learn.

And finally, having argued for deliberate money supply changes designed to deal with recessions and inflationary booms, I am not suggesting that economic conservatives are totally wrong to claim that economies self correct in the long run. It’s just that this self correction is too slow. Or as Keynes put it, “In the long run we are all dead”. Also, conservatives are correct to point out that the recent boom was based on artificially high house prices, which in turn distorts the entire economy, and this distortion cannot be removed instantaneously.



GDP taken as $14,000bn. Source:
Mononetary base as £2,000bn. Source:
Annual unfunded deficit under normal circumstances (i.e. absence recessions or inflationary booms) will be:
((2 + 1.5)/100) x ($14,000bn/2 + $2,000bn) = $315bn.

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