Friday, 14 May 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.


  1. Good job, Ralph.

    A couple of suggestions:

    1. A sentence explaining how the present misconceptions are based on a failure to take into account the transition from a convertible fixed rate monetary system characteristic of the gold standard to a nonconvertible flexible rate system.

    2. I would lose "printing money." It is inaccurate, has derogatory connotations, and reinforces misperceptions. Try, "The government issues currency without financial constraint, neither having to tax in order to fund itself or needing to issue debt to finance itself."

    3. I would counter Freidman by noting that he preferred monetary policy under the central bank owing to its independence from political influence and pointing out that this gives enormous power to a small group of unelected bureaucrats, especially the Fed chairperson. Not only is fiscal policy more effective in achieving full employment with price stability, appropriations and taxes re also in the hands of elected representatives accountable to the people at the voting booth.

  2. Tom: thanks for the comments. I’ll take them in turn.

    1. I’ve no strong feelings on this.

    2. I think the problem with omitting the phrase “print money” is that the opposition will spot that effectively this is what is being advocated. They’ll then say something like “You’re advocating money printing and either you’re too stupid to realise it, or too dishonest to admit it.” So I’m in favour of the “full frontal”, blunt, direct approach.

    3. There is a big “checks and balances” problem here. The beauty of an independent central bank is that it helps to stop politicians accessing the money printing press. Even democratically elected politicians are an irresponsible bunch. So even in a “functional finance economy” I would favour a role for an independent central bank. But I’m not sure what the rules of the game would be. I’ll think about that.

  3. Ralph, the politicians access the printing press through appropriations. While the Fed can increase the monetary base by increasing reserves, the Fed cannot "print money" into the economy, in that they cannot increase the endogenous money supply which is controlled by bank lending and banks lend against capital, not reserves. The enormous pool of excess reserves created by QE should forever bury forever the myth that reserves create loans.

    The budget is what creates nongovernment financial assets through currency issuance, and taxes withdraw nongovernment financial assets. The budget balance is the only way that nongovernment net financial assets can be affected, since bank credit extension nets to zero.

    When Congress appropriates funds and the Treasury expends them, the Fed supplies the necessary reserves. The Treasury and central bank functions of the sovereign state are complementary. However, neither the Fed nor Treasury act to issue currency through expenditure without authority from Congress and approval by the president.

  4. Tom: Thanks for the second comment. I’m not an expert on the rules governing the U.S. appropriations committee or the Fed. My points are about central banks in general. And you are right: I overstated the extent to which central banks control the printing presses.

    I realise that elected politicians in most countries can do some money printing when they vote to spend more than they collect in tax. On the other hand given an independent or reasonably independent central bank which is told to control inflation by altering interest rates, the central bank can nullify politicians’ money printing activities if the latter get excessive. This amounts to joint control of the press, doesn’t it?

  5. This amounts to joint control of the press, doesn’t it?

    The problem is that the Fed's control over the short term rate is a form of price control. Interest rates represent the price of money, and interest rate increases add to costs, decreasing demand for loans, and depressing both consumption and investment while increasing saving. But controlling prices is a blunt instrument that interferes with normal market operation. This is giving a very small group of "experts" control over the free market -- not exactly in the spirit of capitalism and very close to the definition of a command economy.

    More significantly, increasing rates to control inflation increases unemployment, But managing unemployment is a mandated target of the Fed, along with managing inflation. So in targeting inflation with rate hikes, the Fed is using one of its targets, unemployment, as a tool,, in violation of its mandate. Here a very small group of people hods the destiny of millions of workers in the palm of its hand to use as a tool. Even though this is contrary to law, there is no political remedy because of Fed independence and the lack of penalty in the law or other legal recourse. This is undemocratic.

    The effective way to deal with inflation is to reduce net nongovernment net financial assets through increasing taxes. Only Congress can do this. If employment and price stability were handled by Congress and the president through the budget, then there would be full political recourse for budgetary outcomes and justifiably so since our elected representatives would have the tools they need to manage utilization of capacity, employment, and price stability.

    Of course, to make informed political choices, the media and general public would have to understand the basics of national accounting identities and sectoral balances. But all they would have to know is this:

    The government as monopoly currency issuer has the sole prerogative and corresponding sole responsibility to provide the correct amount of currency to balance spending power (nominal aggregate demand) and goods for sale (real output capacity). If the government issues currency in excess of capacity, demand will rise relative to the goods and services available, and inflation will occur due to a glut of money. If the government falls short in maintaining this balance, recession and unemployment result, due to a glut of goods and services. The government attempts to achieve the correct balance through fiscal policy (currency issuance and taxation) and monetary policy (interest rates), based on data and its analysis in terms of sectoral balances.The federal budget affects nongovernment net financial assets through expenditure and taxation, while Interest rates affect the supply of money created by banks through loans, which is the bulk of the money supply.

  6. Tom: I don’t agree with the way you split responsibilities as between elected politicians, central banks and others. Seems to me the basic principle underlying all this should be one that is widely accepted in economics, as follows.

    The free market should allocate resources except where it is clear that there is market failure. E.g. it is widely agreed that market failure occurs in relation to monopolies, distribution of incomes, provision of education etc. That is why we have anti trust legislation, income tax and free schooling for kids, and so on. Elected politicians assisted by experts frame the relevant legislation, but lead detailed administration of the legislation to experts.

    The above principle applies to central banks. The latter exist amongst other reasons because the free market is obviously an unstable system, with the credit crunch being only the most recent of a very long line of examples of this. Central banks are full of economics PhDs and if anyone can make economies more stable, its them, not elected politicians.

    E.g. Bill Mitchell recently described the new British prime minister David Cameron as economically illiterate, or words to that effect. I agree with Bill. See

    Most elected politicians are equally illiterate and would make a hash of doing what central banks do (and even the latter are badly flawed).

    Re your para starting “More significantly.....”, I don’t think the fact that the Fed uses unemployment as a tool to control inflation is a good criticism of the Fed because whatever the economic system, there will be a trade off between inflation and unemployment. I bet the nearest planet with a money based economy, has the same problem.

    In the planned economies of Eastern Europe prior to the collapse of Communism, the same problem arose, but they solved it differently. They had an excessive money supply which resulted in plenty of demand and plenty of employment. But the inflation which market forces were trying to bring about was suppressed by price controls. These price controls were not entirely effective though. For example on building sites in the old USSR it was common for managers to carry large stocks of cash and pay workers a wage which was way above the official rate (inflation in effect). Moreover, while the communist authorities claimed very low unemployment levels, this claim was very debatable.

    There is a large amount of anti-central bank sentiment in the U.S. which you echo and which I don’t agree with. In Germany prior to the Euro, Germans were pleased with the job the Bundesbank did. In the U.K. since Gordon Brown made the Bank of England independent (at least nominally), the general view is the B.of E. does the best it can (not that that stops me criticising it).

    You seem to suggest that if control of the money supply or “net financial assets” shifts away from the private sector and is put more into the hands of government, this will improve the inflation unemployment trade off. This position (private sector control of money) actually obtained in the 1800s and 1700s, that is before central banks existed or played any significant role. The extent of booms, slumps and average employment levels were not much different then (though I admit that comparing the UK economy as of 1700 to that of 2010 is comparing chalk to cheese).

    Having said that I don’t see big benefits coming from reducing “non government net financial assets”, I AM sympathetic towards abolishing the fractional reserve system, i.e. going for “full reserve” banking. But the arguments here are complicated. No room for them here!

  7. I agree with much of what you say, Roger, but the fact is that the folks running the Fed are not on the people's side but rather the bankers, on the ground that finance is the foundation on which the economy is built. Apparently, President Obama agrees with this position, too.

    History shows that neither politicians nor the elite can be trusted to act in the best interest of the people. So this debate is really about how one trusts more to do the least harm — the elite that has a vested interest in wealth and influence, or the politicians, who have a vested interest in power. Obviously, both are seriously compromised by self-interest and class interest, too.

    But the beauty of democracy is that politicians are accountable to the people, and they can use power to bridle the elite. If I have to trust my fate to one or the other, I'll take the politicians, who at least can be removed at the voting booth. I can appreciate how others might feel differently. But it's a matter political decision (preference), not an economic truth (fact).

    It was the elite that created the Great Depression, and it is the elite that is doing it again.

  8. What do you think about this Financial Times article on reforming the Fed?

  9. Given the Republican Party's recent "hostage" taking of the unemployed benefit's extension in order to maintain tax breaks for the rich (the elite)the likelihood of their agreement to increasing taxation for the rich to deal with inflation is pretty much a hostage to fortune if you'll excuse the pun! This would strongly suggest that until the corruption is taken out of democracy it is not a very effective way of controlling an economy.

  10. Anon, Yes – raising taxes from the rich so as to deal with inflation is difficult in a system where the elite won’t part with any money. On a slightly different but related point, the fact that a regime is corrupt would not prevent it being run on functional finance (FF) lines. As Abba Lerner said, FF can work in any old regime: democratic, non-democratic, communist, you name it. See final paragraph here:

    I.e. the reason FF won’t be adopted for a few years yet is not so much the corruption of the elite, but their ignorance: not helped by the mixed messages they get from economists!

  11. Critique of Functional Finance:

  12. Anon: Thanks. The "egolessdebate" article is poor quality. I just sent a very critical reply.


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