Wednesday, June 9, 2010

Functional finance.

According to Wikipedea there are three basic principles in functional finance, the second of which is, “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.”

If Abba Lerner actually said the above, I suggest he was wrong. The idea that governments (politicians in particular) can gauge the rate of interest that will bring the “optimum amount of investment” totally unrealistic.

Moreover, given the huge range of returns that come from investments (anything from plus 100% or more a year to minus 100% or more a year) does it really make a blind scrap of difference whether the official central bank base rate of interest is 2% or 4%?

That is not to say that in a functional finance regime government should not use interest rate changes as a macro economic tool. The main tool under functional finance is changing government income and expenditure. But there would be nothing to stop a "government – central bank machine" changing interest rates as well, so as to influence aggregate demand, inflation and so on.

Update (25th June). Though on second thoughts there is much to be said for the argument that a government - central bank machine can control the quantity of money or the price but not both. Thus under functional finance, possibly a government - central bank machine cannot control interest rates.

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