Primer: What Is Functional Finance?

Functional Finance is a body thought that was originally proposed by the economist Abba P. Lerner. Functional Finance was associated with the “Keynesian” policies of the post-war era, but its influence eroded as “Keynesian” policies fell out of favour with the mainstream. The idea is that one looks at the function of fiscal policy (what it does), and you ignore the form (such as the amount of budget balances, or how deficits are “financed”).

(UPDATE): A modified version of this article is found in Understanding Government Finance.

Functional Finance is a key component of what is now referred to as Modern Monetary Theory (MMT). (This theme article has links to my other writings about MMT.) In particular, MMT pays particular attention to monetary operations; the exact mechanisms of government finance. A central government that controls the currency it issues debt in has a very different perspective on financing than a user of the currency, and this difference of perspective opens up the range of policies that may be attempted.

Functional Finance And The Federal Debt

The principles of Functional Finance evolved over time, with developments added in response to the economic debates of the day. Since my objective is to explain the theoretical concepts, and not provide a history of economic thought, I will not attempt to cover the whole history of Functional Finance. Rather, I will focus on what I see as a defining work – Functional Finance And The Federal Debt (Abba Lerner, 1943, published in Social Research 10: 38-51).

Lerner summarises the philosophy of Functional Finance as:

 The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy, and not to any established traditional doctrine about what is sound or unsound. The principle of judging only by the effects has been applied in many other fields of human activity, where it is known as the method of science as opposed to scholasticism. The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance.

When Lerner refers to “sound finance” is also known as The Treasury View, or the loanable funds doctrine. (The name The Treasury View came from the fact that it was best summarised the staff of the British Chancellor of the Exchequer, the equivalent of the U.S. Treasury, when they explained why counter-cyclical fiscal policy was futile during the Great Depression.) I do not want to attempt to cover the debate around loanable funds, other than saying that the most naïve form involves comparing the central government to a household. Government borrowing will replace private sector borrowing within an allegedly fixed stock of loanable funds available, so increasing government spending will just “crowd out” private investment. There are more sophisticated defences of the loanable funds theory, but such a discussion is too broad to be attempted here. Rather, I raise this point to explain what Functional Finance rejects.

Although Functional Finance is controversial within economics, I assert that its viewpoint is effectively the mainstream amongst fixed income rates investors, based on my experience. This is the subset of investors who have to be right about the direction of interest rates as part of their job description, as opposed to market economists, government finance analysts at rating agencies, equities strategists or even fixed income participants in spread markets. Since those other branches of finance (broadly defined) are not marked to market on their views on interest rates, they are free to embrace sound money doctrines without risking their careers.

As an extreme example, take Japan. There have been repeated calls for the collapse of the JGB market for decades, based on theories around “unsustainable” debt/GDP ratios. But those ratios are almost completely ignored by Japanese fixed income strategists. They have figured out that those ratios have no functional impact on the economy, and so they are dropped from the analysis framework.

Two Laws Of Functional Finance

Within the article Functional Finance And The Federal Debt, Lerner describes two laws of Functional Finance. (I am summarising these laws using more familiar terms, which perhaps is dangerous from the point of view of an economic historian.)

1. The first responsibility of the government is to adjust aggregate demand with either taxes or spending so that the economy is running at potential without causing inflationary pressures.
2. The government should only issue debt if it is desirable to change the mix between money and government debt holdings within the non-government sector. This is done to adjust rates of interest.

The second law is the source of the viewpoint that states “government bonds are a reserve drain”. An implication of this law is that a government that controls the currency it borrows in cannot default for financial reasons. And it defines the relationship between fiscal and monetary policy, which matters for understanding what determines bond yields. Although there are some arcane debates about this stance, it is compatible with most modern analysis of monetary policy in practice. Roughly speaking, if there is a counter-example to the second law, we never arrive at such a situation in the real world. This is an important topic, but I am focussing here on the first law, and its relevance to the analysis of fiscal policy.

One implication of the first law is that “taxing is never to be undertaken merely because the government needs to make money payments.” In other words, citizens do not pay tax because the money is needed to pay for government services, rather they are taxed to reduce aggregate demand. I am somewhat cautious in advancing this interpretation. This does not mean that taxes can be abolished; they are needed to contain inflationary pressures. But it does point us in an interesting direction – since different taxes have a different effect on demand for the same dollar amount of taxes raised, you cannot assess the stance of fiscal policy solely by looking at the aggregate amount of taxes raised. Instead, the mix of taxes matters.

Additionally, the first law implies that inflation is heavily influenced by fiscal policy. I believe that this is largely correct in terms of the broad trend in inflation, but it does not mean that we can look at fiscal policy and use it to forecast the wiggles in inflation. Since the early 1990’s, fiscal policy settings in most countries have been relatively stable, and so the business cycle (and inflation) has largely reflected shifting confidence within the private sector.

I view that the most important implication that he drew within the paper is that “Functional Finance rejects completely the traditional doctrines of ‘sound finance’ and the principle of trying to balance the budget over a solar year or any other arbitrary period.” Given the fad for embracing balanced budgets on either an annual basis, or using vague periods like “across the cycle”, this is an important part of Functional Finance that mainstream thought appears to have rejected.

However, even this rejection is less than it appears. Most observers discuss the value of stabilising debt/GDP ratios at various levels, such as the 60% of GDP level that made its way into the Maastricht Treaty. There is little discussion of driving debt/GDP ratios to zero, other than by a small fringe who insist that government debt “must be paid back”. But as long as nominal GDP is rising, simple mathematics tells us that balanced budgets across any fixed cycle would in fact drive the ratio of debt plus the monetary base over GDP to zero. As a result, most “balanced budget” proposals contain holes that exclude “good” categories of spending from the balance constraint, such as “investment”. Since practically any government spending can be reclassified by a good spin doctor as being “investment”, there is no real constraint on net government spending.

We’re All Lernerians Now

The economist Milton famously remarked “In one sense, we are all Keynesians now; in another, nobody is any longer a Keynesian.” I would argue that this applies to Functional Finance, at least amongst those who spend time analysing fiscal policy. In practice, anyone who wants to correctly analyse government finance has to embed Functional Finance principles, even though most analysts would reject the label. But at the same time, the philosophy for policy is different; there is little appetite amongst mainstream economists and politicians to engage in discretionary fiscal policy, most of the time. (During the financial crisis, politicians fearing their re-election chances let loose a torrent of stimulus spending.)

But is clear that Functional Finance principles are not accepted by the public at large. For example, balancing the budget is often found to be popular in polling data. But at the same time, the constituency for the policies that might balance the budget are generally small. Additionally, politicians appear to realise that policy stances that contradict Functional Finance are not feasible politically. This causes frustration amongst the public, who realise that politicians are not doing anything useful to reduce debt levels.

Take an example from the United States – The National Commission on Fiscal Responsibility and Reform (also known as the Simpson-Bowles Commission) of 2010. This commission was created in an atmosphere of media-generated panic over the levels of U.S. Federal Government debt. And despite the apparent momentum to reduce debt levels, the centerpiece of the plan proposed by the co-chairs of the committee was to reduce income tax rates. This plan was so unserious that it was not even able to win the support of the 18 person committee (it only received 11 of the 14 needed votes). The commitment to debt reduction only held to the extent that it fit in with prior political beliefs.

As always, the Euro zone is somewhat of an exception (after the financial crisis). But even there, the functional economic principle is that it is necessary to toe the line of the European Central Bank (ECB). As long as Euro periphery countries put in austerity policies that please the ECB, we can ignore the form of government finance. For example, Spanish bond spreads over German bunds have tightened to low levels at the time of writing. This is not because of any material “improvement” of Spanish government finances, rather it is the result of the ECB being apparently willing to defend the Spanish bond market. Why an unelected independent central bank is setting fiscal policy is a mystery to me, but that is what is happening. In any event, the bottom line is that we need to look at the underlying economic principles (keep the ECB happy), and not superficial form of government finance.

Finally, I feel that it is impossible to “prove” that Functional Finance is correct. It is actually a fairly minimal set of observations about fiscal policy that holds up to analytical scrutiny. Rather than being able to demonstrate Functional Finance is the true description of fiscal policy, it is necessary to look at alternative analytical frameworks, and show how they break down when they contradict Functional Finance. That examination is lengthy, and has to be done elsewhere.

Note: This article is a modified excerpt from a first draft of a small book that I have just started writing. The book will be an introduction to understanding fiscal policy. Since this is my first attempt at writing a book (other than my thesis), I do not have a firm deadline. Feedback would be greatly appreciated, including questions that I can address within the book.

See Also:

• Understanding Government Finance (book).
• Government bonds as a reserve drain - Lerner's second law.
• Applying Functional Finance to government pensions. I show why it is pointless for a central government to "capitalise" its pension schemes, such as Social Security.
• The Wikipedia Functional Finance entry. Includes links to Lerner's article, as well as a comprehensive article by Stephanie Bell.

(c) Brian Romanchuk 2014