FUNCTIONAL FINANCE AND THE FEDERAL DEBT

FUNCTIONAL FINANCE AND THE FEDERAL DEBT

A Part from the necessity of winning the war, there is no task facing society today that is as important as the elimination of economic in­security. If we fail in this after the war the present threat to demo­cratic civilization will arise again. It is therefore essential that we grapple with this problem even if it involves a little careful thinking and even if the thought proves somewhat contrary to our precon­ceptions.

In recent years the principles by which appropriate government action can maintain prosperity have been adequately developed, but the proponents of the new principles have either not seen their full logical implications or shown an over-solicitousness which caused them to try to save the public from the necessary mental exercise. This has worked like a boomerang. Many of our publicly minded men who have come to see that deficit spending actually works still oppose the permanent maintenance of prosperity   be­cause in their failure to see how it all works they are easily fright­ened by fairy tales of terrible consequences. •

As formulated by Alvin Hansen and others who have developed and popularized it, the new fiscal theory (which was first put for­ward in substantially complete form by J, M. Keynes in England) sounds a little less novel and absurd to our preconditioned ears than it does when presented in its simplest and most logical form, with all the unorthodox implications expressly formulated. In some cases the less shocking formulation may be intentional, as a tactical device to gain serious attention. In other cases it is due not to a desire to sugar the pill but to the fact that the writers themselves have not seen all the unorthodox implications - perhaps sub­-consciously compromising with their own orthodox education. But now it is these compromises that are under fire. Now more than ever it is necessary to pose the theorems in the purest form. Only thus will it be possible to clear the air of objections which really are concerned with awkwardness’s that appear only when the new theory is forced into the old theoretical framework.

Fundamentally the new theory, like almost every important dis­covery, is extremely simple. Indeed it is this simplicity which makes the public suspect it as too slick. Even learned professors who find it hard to abandon ingrained habits of thought have complained that it is "merely logical" when they could find no flaw in it. What progress the theory has made so far has been achieved not by simpli­fying it but by dressing it up to make it more complicated arid accompanying the presentation with impressive but irrelevant sta­tistics.

The central idea is that government fiscal policy, it’s 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. This principle of judging only by 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.

The first financial responsibility of the government (since no­body else can undertake that responsibility) is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate which at the current prices would buy all the goods that it is possible to produce. I£ total spending is allowed to go above this there will be inflation, and if it is allowed to go below this there will be unemployment. The government can in­crease total spending by spending more itself or by reducing taxes so that the taxpayer* have more money left to spend. It can reduce total spending by spending less itself or by raising taxes so that tax­ payers have less money left to spend. By these means total spending can be kept at the required level, where it will be enough to buy the goods that can be produced by all who want to work, and yet not enough to bring inflation by demanding (at current prices) more than can be produced.

In applying this first law of Functional Finance, the government may find itself collecting more in taxes than it is spending, or spend­ing more than it collects in taxes. In the former case it can keep the difference in its coffers or use it to repay some of the national debt, and in the latter case it would have to provide the difference by borrowing or printing money. In neither case should the gov­ernment feel that there is anything especially good or bad about this result; it should merely concentrate on keeping the total rate of spending neither too small nor too great, in this way preventing both unemployment and inflation.

An interesting, and to many a shocking, corollary is that taxing is never to be undertaken merely because the government needs to make money payments. According to the principles of Functional Finance, taxation must be judged only by its effects. Its main effects are two: the taxpayer has less money left to spend and the govern­ment has more money. The second effect can be brought about so much more easily by printing the money that only the first effect is significant. Taxation should therefore be imposed only when it is desirable that the taxpayers shall have less money to spend, for example, when they would otherwise spend enough to bring about inflation.

The second law of Functional Finance is that the government should borrow money only if it is desirable that the public should have less money and more government bonds, for these are the effects of government borrowing. This might be desirable if other­wise the rate of interest would be reduced too low (by attempts on the part of the holders of the cash to lend it out) and induce too much investment, thus bringing about inflation. Conversely, the government should lend money (or repay some of its debt) only if it is desirable to increase the money or to reduce the quantity of government bonds in the hands of the public. When taxing, spend­ing, borrowing and lending (or repaying loans) are governed by the principles of Functional Finance, any excess of money outlays over money revenues, if it cannot be met out of money hoards, must be met by printing new money, and any excess of revenues over outlays can be destroyed or used to replenish hoards.

The almost instinctive revulsion that we have to the idea of printing money, and the tendency to identify it with inflation, can be overcome if we calm ourselves and take note that this printing does not affect the amount of money spent. That is regulated by the first law of Functional Finance, which refers especially to inflation and unemployment. The printing of money takes place only when it is needed to implement Functional Finance in spending or lend­ing (or repayment of government debt).'

In brief, 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. In their place it prescribes: first, the adjustment of total spending (by every­body in the economy, including the government) in. order to elim­inate both unemployment and inflation, using government spend­ing when total spending is too low and taxation when total spend­ing is too high; second, the adjustment of public holdings of money and of government bonds, by government borrowing or debt re­payment, in order to achieve the rate of interest which results in the most desirable level of investment; and, third, the printing, hoard­ing or destruction of money 3* needed for carrying out the first two parts of the program.

In judging the formulations of economists on this subject it is dif­ficult to distinguish between tact in smoothing over the more staggering *Borrowing money from the banks, on conditions which permit the banks to issue new credit money based on their additional holdings of government securities, must be considered for our purpose us priming money. In effect the banks are acting as agents for the government in issuing credit or bank money.

Statements of Functional Finance and insufficient clarity on the part of those who do not fully realize the extremes that are implied in their relatively orthodox formulations. First there were the pump-primers, whose argument was that the government merely had to get things going and then the economy could go on by itself. There are very few pump-primers, left now. A formula similar in, some ways to pump-priming was developed by Scandinavian econ­omists in terms of a series of cyclical, capital and other special budg­ets which had to be balanced not annually but over longer periods. Like the pump-priming formula it fails because there is no reason for supposing that the spending and taxation policy which main­tains full employment and prevents inflation must necessarily bal­ance the budget over a decade any more than during a year or at the end of each fortnight.

As soon as this was seen - the lack of any guarantee that the main­tenance of prosperity would permit the budget to be balanced even over longer periods - it had to be recognized that the result might be a continually increasing national debt (if the additional spending were provided by the government's borrowing of the money and not by printing the excess of its spending over its tax revenues). At this point two things should have been made dear: first, that this possibility presented no danger to society, no matter what             unimagined heights the national debt might reach, so long as Func­tional Finance maintained the proper level of total demand for current output; and second (though this is much less important), that there is an automatic tendency for the budget to be balanced in the long run as a result of the application of Functional Finance, even if there is no place for the principle of balancing the budget. No matter how much interest has to be paid on the debt, taxation must not be applied unless it is necessary to keep spending down to prevent inflation. The interest can be paid by borrowing still more.

As long as the public is willing to keep on lending to the govern­ment there is no difficulty, no matter how many zeros are added to the national debt. If the public becomes reluctant to keep on lending, it must either hoard the money or spend it. If the public hoards, the government can print the money to meet its interest and other obligations, and the only effect is that the public holds government currency instead of government bonds and the government is saved the trouble of making interest payments. If the public spends, this will increase the rate of total spending so that it will not be neces­sary for the government to borrow for this purpose; and if the rate of spending becomes too great, then is the time to tax to prevent inflation. The proceeds can then be used to pay interest and repay government debt. In every case Functional Finance provides a sim­ple, quasi-automatic response.

But either this was not seen clearly or it was considered too shock­ing or too logical to be told to the public. Instead it was argued, for example by Alvin Hansen, that as long as there is a reasonable ratio between national income and debt, the interest payment on the national debt can easily come from taxes paid out of the in­creased national income created by the deficit financing.

This unnecessary "appeasement" opened the way to an extremely effective opposition to Functional Finance. Even men who have a clear understanding of the mechanism whereby government spending in times of depression can increase the national income by several times the amount laid out by the government, and who understand perfectly well that the national debt, when it is not owed to other nations, is not a burden on the nation in the same way as an individual's debt to other individuals is a burden on the individual, have come out strongly against "deficit spending."* It has been argued that "it would be impossible to devise a program better adapted to the systematic undermining of the private-enter­prise system and the hastening o£ the final catastrophe than 'deficit spending.''*

These objections are based on the recognition that although every dollar spent by the government may create several dollars of income in the course of the next year or two,

*An excellent example of this is the persuasive article by John T, Flynn in Harper's Magazine (for July 1948,

*Flynn, ibid.

Years, the effects then dis­appear. From this it follows that if the national income is to be maintained at a high level the government has to keep up its con­tribution to spending for as long as private spending is insufficient by itself to provide full employment. This might mean an indefinite continuation of government support to spending (though not nec

neces­sarily at an increasing rate); and if, as the "appeasement" formulation suggests, all this spending comes out of borrowing, the debt will keep on growing until it is no longer in a "reasonable" ratio to income.

This leads to the crux of the argument. If the interest on the debt must be raised out of taxes (again an assumption that is un­challenged by the "appeasement" formulation) it will in time con­stitute an important fraction of the national income. The very high income tax necessary to collect this amount of money and pay it to the holders of government bonds will discourage risky private in­vestment, by so reducing the net return on it that the investor is not compensated for the risk of losing his capital. This will make it necessary for the government to undertake still more deficit financing to keep up the level of income and employment. Still heavier taxation will then be necessary to pay the interest on the growing debt - until the burden of taxation is so crushing that private investment becomes unprofitable, and the private enter­prise economy collapses. Private firms and corporations will all be bankrupted by the taxes, and the government will have to take over all industry.

This argument is not new. The identical calamities, although they are now receiving much more attention than usual were prom­ised when the first income tax law of one penny in the pound was proposed. All this only makes it more important to evaluate the significance of the argument.

III

There are four major errors in the argument against deficit spend­ing, four reasons why its apparent collusiveness is only illusory.

In the first place, the same high income tax that reduces the re­turn on the investment is deductible for the loss that is incurred if the investment turns out a failure. As a result of this the net return on the risk of loss is unaffected by the income tax rate, no matter how high that may be. Consider an investor in the $50,000 - a-year income class who has accumulated $10,000 to invest. At 6 per­ cent this would yield $600, but after paying income tax on this addition to his income at 60 cents in the dollar he would have only
$240 left. It is argued, therefore, that he would not invest because this is insufficient compensation for the risk of losing $10,000. This argument forgets that if the $ 10,000 is all lost, the net loss to the investor, after he has deducted his income tax allowance, will be only $4,000, and the rate of return on the amount he actually risks is still exactly 6 percent; $840 is 6 percent of $4,000. The effect of the income tax is to make the rich man act as a kind of agent work­ing for society on commission. He receives only a part of the return on the investment, but he loses only a part of the money that is invested. Any investment that was worth undertaking in the absence of the income tax is still worth undertaking.

Of course, this correction of the argument is strictly true only where 100 percent of the loss is deductible from taxable income, where relief from taxation occurs at the same rate as the tax on returns. There is a good case against certain limitations on permis­sible deduction from the income tax base for losses incurred, but that is another story. Something of the argument remains, too, if the loss would put the taxpayer into a lower income tax bracket, where the rebate (and the tax) is at a lower rate. There would then be some reduction in the net return as compared with the potential net loss. But this would apply only to such investments as are large enough to threaten to impoverish the investor if they fail. It was for the express purpose of dealing with this problem that the cor­poration was devised, making it possible for many individuals to combine and undertake risky enterprises without any one person having to risk all his fortune on one venture. But quite apart from corporate investment, this problem would be met almost entirely if the maximum rate of income tax were reached; it a relatively low level, say at $25,000 a year (low, that is, from the point of view of the rich men who are the supposed source of risk capital). Even if all income in excess of $25,000 were taxed at go percent there would
be no discouragement in the investment of any part of income over this level. True, the net return, after payment of tax, would be only one-tenth of the nominal interest payments, but the amount risked by the investors would also be only ten percent of the actual capital invested, and therefore the net return on the capital actually risked
by the investor would be unaffected.

In the second place, this argument against deficit spending in time of depression would be indefensible even if the harm done by debt were as great as has been suggested. It must be remembered that spending by the government increases the real national income of goods and services by several times the amount spent by the gov­ernment, and that the burden is measured not by the amount of the interest payments but only by the inconveniences involved in the process of transferring the money from the taxpayers to the bondholders. Therefore objecting to deficit spending is like argu­ing that if you are offered a job when out of work on the condition that you promise to pay your wife interest on a. part of the money earned (or that your wife pay it to you) it would be wiser to con­tinue to be unemployed, because in time you will be owing your wife a great deal of money (or she will be owing it to you), and this might cause matrimonial difficulties in the future. Even if the in­terest payments were really lost to society, instead of being merely transferred within the society, they would come to much less than the loss through permitting unemployment to continue. That loss would be several times as great as the capital on which these interest payments have to be made.

In the third place, there is no good reason for supposing that the government would have to raise all the interest on the national debt by current taxes. We have seen that Functional Finance permits taxation only when the direct effect of the tax is in the social interest, as when it prevents excessive spending or excessive investment which would bring about inflation. If taxes imposed to pre­vent inflation do not result in sufficient proceeds, the interest on the debt can be met by borrowing or printing the money. There is no risk of inflation from this, because if there were such a risk a greater amount would have to be collected in taxes.

This means that the absolute size of the national debt does not matter at all, and that however large the interest payments that have to be made, these do not constitute any burden upon society as a whole, A completely fantastic exaggeration may illustrate the point. Suppose the national debt reaches the stupendous total of ten thousand billion dollars (that is, ten trillion, $10,000,000,000,000), so that the interest on it is 300 billion a year. Suppose the real national income of goods and services which can be produced by the economy when fully employed is 150 billion. The interest alone, therefore, comes to twice the real national income. There is no doubt that a debt of this size would be called "unreasonable," But even in this fantastic case the payment of the interest constitutes no burden on society. Although the real income is only 150 billion dollars the money income is 450 billion - 150 billion in income from the production of goods and services and 300 billion in income from ownership of the government bonds which constitute the na­tional debt. Of this money income of 450 billion, 300 billion has to be collected in-taxes by the government for interest payments (if 10 trillion is the legal debt limit), but after payment of these taxes there remains 150 billion dollars in the hands of the tax­payers, and this is enough to pay for all the goods and services that the economy can produce. Indeed it would do the public no good to have any more money left after tax payments, because if it spent more than 150 billion dollars it would merely be raising the prices of the goods bought. It would not be able to obtain more goods to consume than the country is able to produce.

Of course this illustration must not be taken to imply that a debt of this size is at all likely to come about as a result of the application of Functional Finance. As will be shown below, there is a natural tendency for the national debt to stop growing long before it comes anywhere near the astronomical figures that we have been playing with.

The unfounded assumption that current interest on the debt must be collected in taxes springs from the idea that the debt must be kept in a "reasonable" or "manageable" ratio to income (what­ever that may be). If this restriction is accepted, borrowing to pay the interest is eliminated as soon as the limit of "reasonableness" is reached, and if we further rule out, as an indecent thought, the possibility o£ printing the money, there remains only the possibility of raising the interest payments by taxes. Fortunately there is no need to assume these limitations so long as Functional Finance is on guard against inflation, for it is the fear of inflation which is the only rational basis for suspicion of the printing of money.

Finally, there is no reason for assuming that, as a result of the continued application of Functional Finance to maintain full em­ployment, the government must always be borrowing more money and increasing the national debt. There are a number of reasons for this.

First, full employment can be maintained by printing the money needed for it, and this does not increase the debt at all. It is probably advisable, however, to allow debt and money to increase together in a certain balance, as long as one or the other has to increase.

Second, since one of the greatest deterrents to private investment is the fear that the depression will come before the investment has paid for itself; the guarantee of permanent full employment will make private investment much more attractive, once investors have got over their suspicions of the new procedure. The greater private investment will diminish the need for deficit spending.

Third, as the national debt increases, and with it the sum of pri­vate wealth, there will be an increasingly yield from taxes on higher incomes and inheritances, even if the tax rates are unchanged. These higher tax payments do not represent reductions of spending1 by the taxpayers. Therefore the government does not have to use these proceeds to maintain the requisite rate of spending, and it can devote them to paying the interest on the national debt.

Fourth, as the national debt increases it acts as a self-equilibrat­ing force, gradually diminishing the further need for its growth and finally reaching an equilibrium level where its tendency to grow conies completely to an end. The greater the national debt the greater is the quantity of private wealth. The reason for this is simply that for every dollar of debt owed by the government there is a private creditor who owns the government obligations (pos­sibly through a corporation in which he has shares), and who re­gards these obligations as part of his private fortune. The greater the private fortunes the less is the incentive to add to them by saving out of current income. As current saving is thus discouraged by the great accumulation of past savings, spending out of current income increases (since spending is the only alternative to saving ' income). This increase in private spending makes it less necessary for the government to undertake deficit financing to keep total spending at the level which provides full employment. When the
government debt has become so great that private spending is enough to provide the total spending needed for full employment, there is no need for any deficit financing by the government, the budget is balanced and the national debt automatically stops grow­ing. The size of this equilibrium level of debt depends on many things. It can only be guessed at, and in the very roughest manner. My guess is that it is between 100 and 300 billion dollars. Since the level is a result and not a principle of Functional Finance the latitude of such a guess does not matter; it is not needed for the application of the laws of Functional Finance.

Fifth, if for any reason the government does not wish to see private property grow too much (whether in the form of govern­ment bonds or otherwise) it can check this by taxing the rich in­stead of borrowing from them, in its program of financing govern­ment spending to maintain full employment. The rich will not reduce their spending significantly, and thus the effects on the economy, apart from the smaller debt, will be the same as if the money had been borrowed from them. By this means the debt can be reduced to any desired level and kept there.

The answers to the argument against deficit spending may thus be summarized as follows:

The national debt does not have to keep on increasing;

Even if the national debt does grow, the interest on it does not have to be raised out of current taxes;

Even if the interest on the debt is raised out of current taxes, these taxes constitute only the interest on only a fraction of the benefit enjoyed from the government spending, and are not lost to the nation but are merely transferred from taxpayers to bond­holders;

High income taxes need not discourage investment, because appropriate deductions for losses can diminish the capital actually risked by the investor in the same proportion as his net income from the investment is reduced.

iv

If the propositions of Functional Finance were put forward with­out fear of appearing too logical, criticisms like those discussed above would not be as popular as they now are, and it would not be necessary to defend Functional Finance from its friends. An especially embarrassing task arises from the claim that Functional Finance (or deficit financing, as it is frequently but unsatisfactorily called) is primarily a defense of private enterprise. In the attempt to gain popularity for Functional Finance, it has been given other names and declared to be essentially directed toward saving private enterprise. I myself have sinned similarly in previous writings in identifying it with democracy,* thus joining the army of salesmen who wrap up their wares in the flag and tie anything they have to sell to victory or morale.

*In "Total Democracy and Full Employment," Social Change (May 1941).

Functional Finance is not especially related to democracy or to private enterprise. It is applicable to a communist society just as well as to a fascist society or a democratic society. It is applicable to any society in which money is used as an important element in the economic mechanism. It consists of the simple principle of giving up our preconceptions of what is

proper or sound or tradi­tional, of what "is done," and instead considering the functions performed in the economy by government taxing and spending and borrowing and lending. It means using these instruments simply as instruments, and not as magic charms that will cause mysterious hurt if they are manipulated by the wrong people or without due reverence for tradition. Like any other mechanism, Functional Finance will work no matter who pulls the levers. Its relationship to democracy and free enterprise consists simply in the fact that if the people who believe in these things will not use Functional Finance, they will stand no chance in the long run against others who will.

Government borrowing is near pointless

Government borrowing is near pointless

Ralph S. Musgrave

Abstract:

The currently larger than normal national debts in numerous countries

makes this a good time to look at the rationale behind government debt. Four

of the main reasons are considered here. The conclusion is that they range from

hopeless to unimpressive. First there are political reasons which can be

demolished in a few sentences. Second there is having government ‘borrow

and spend’ with a view to stimulus. The main flaw in this policy is that where a

government issues its own currency and borrows units of its currency, it is

borrowing something which it can create itself in limitless quantities: similar

to, and as pointless as a dairy farmer buying milk in a shop. In relation to

stimulus, a zero borrowing system was set out long ago by Karl Marx, Milton

Friedman, and others: it is called ‘Functional Finance’. This is a viable

alternative to borrow and spend. Moreover, quantitative easing amounts to a

move in the direction of functional finance and an admission of the weaknesses

in borrow and spend.

Third there is borrowing with a view to the purchase of assets, like

infrastructure investments. The arguments for borrowing here are passable.

Fourth there is borrowing to smooth out the erratic timing of government

expenditure and income from taxation. The arguments for borrowing here are

poor.

On balance, the arguments for government debt are not impressive.

Hopefully the arguments below will assist those trying to curb such debt.

Note:

Athens Institute for Education and Research (ATINER) July 2010 Conference,

except for the last sentence of the conclusion (i.e. last sentence of the paper).

This sentence is a more recent addition, and it has two references to works by

William Mitchell which have been added to the list of references.

Copyright 2010 by Ralph S Musgrave. Excerpts of up to a thousand words

may be reproduced without permission as long as the source of such excerpts is

made clear.

2

This version of this paper is identical to the version submitted to the

Introduction

Four of the more important reasons for government debt are examined here.

The first reason, or set of reasons, is political. Second there is having

government borrow and spend with a view to economic stimulus, which

occupies the bulk of the paper. Third there is borrowing to fund the purchase of

assets, e.g. infrastructure investments. Fourth, is borrowing with a view to

smoothing out the erratic timing of government expenditure and receipts from

tax.

The political reasons are dealt with in a few sentences below, while the

others are considered in more detail.

The second reason, borrowing with a view to stimulus, is written just with

countries that issue their own currencies in mind. Thus care must be taken in

applying the points here to the Eurozone as a whole or to individual Eurozone

countries. The other three reasons are applicable to both countries which issue

their own currencies and those which are part of a common currency system.

The word government is sometimes used below to refer to ‘government and

central bank combined’. In contrast it is sometimes used to refer to politicians

and the bureaucracy as distinct from the central bank. The change in use is

indicated where it is not obvious from the context.

The words stimulus and reflation are used as synonyms: they refer to raising

aggregate demand.

1. Political reasons for borrowing

Politicians tend to think they can win votes by borrowing rather than raising

taxes. Amongst other reasons this is because it is obvious to voters who to

blame when taxes rise but less obvious when interest rates rise as a result of

increased government debt. This reason for debt is clearly unjustified.

A second political motive with ostensibly more justification because it

seems to involve social justice is that politicians probably think that when

borrowing rises it is the cash rich who supply the funds. Actually the evidence

is that funds become available primarily because debtors and potential debtors

reduce the amount they borrow thus releasing funds for government to borrow

(Musgrave (2010:9-11). This is just another way of saying that when

governments borrow, crowding out occurs.

Objections to crowding out

Some readers may object to crowding out for the following reason. Many

governments have substantially increased their borrowing in the last year or

two, yet their interest rates have declined rather than increased.

The answer to this is that crowding out as interpreted here is based on the

‘other things being equal’ assumption. That is, if government borrows and

3

spends the relevant money but makes no other changes, an interest rate rise (or

a reduced availability of funds for private sector borrowers) is almost

inevitable: government out-bids the private sector for funds.

In contrast, over the last year or two, governments have both borrowed more

and flooded the market with liquidity. In this instance, other things are not

equal.

2. Borrow and spend with a view to stimulus

A conventional view is that governments should borrow and spend so as to

bring stimulus. In contrast, there is a set of ideas called ‘functional finance’

which objects to the borrow part of borrow and spend. ‘Modern monetary

theory’ is a more recent name for functional finance. (The word government is

used in the sense ‘government and central bank combined’ here.)

Karl Marx was the first to set out the basics of functional finance, though

there is nothing left wing about it. The next and much the most influential all

time advocate of functional finance was Abba Lerner (born: 1903, died: 1982).

Keynes said of Lerner, ‘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’. (See Landes (1994:220). Friedman (1948) also backed functional

finance, though he did not often use the phrase functional finance. Another

economics Nobel Laureate who advocated functional finance was William

Vickrey: see Colander (2003).

The basic idea behind functional finance is that the fact of government

spending exceeding income (or vice versa) is not important. (The word

government is used here in the sense ‘government and central bank combined’)

That is, there is no merit in government balancing the books just for the sake of

it.

Under functional finance, the only important considerations are the

‘functional’ effects of government income and expenditure, much the most

important being the effects on inflation and unemployment. That is,

governments should use their income and expenditure to bring the maximum

level of employment that is compatible with acceptable inflation. For example,

given high unemployment and subdued inflation, government spending should

exceed income. To that extent functional finance is similar to conventional

policies. But the big difference is that functional finance says governments

should not borrow to make up the difference between income and expenditure.

One reason for not borrowing is that when government borrows, it borrows

something (money) which government itself has created and which it can

create in limitless amounts. Thus for a government which issues its own

currency to borrow units of its currency is similar to, and as pointless as a dairy

farmer buying milk in a shop.

A second objection to borrowing is that borrowing involves crowding out.

Crowding out would not matter if there were agreement on the extent of the

problem. But there is a lack of agreement. Thus introducing crowding out

4

firstly introduces uncertainty. Secondly, if crowding out is a serious problem -

say 90% of borrow and spend is nullified by crowding out - the expansion in

the national debt for given stimulus will be about nine times the expansion in

the monetary base required for the same stimulus. The latter outcome is hardly

desirable, particularly in view of recent concerns about the size of national

debts. Indeed, it is possible that the recent large increases in national debts

combined with resulting increases in demand which have been scarcely enough

to counter the recession are explained by crowding out.

Incidentally, Friedman (1948) dismissed the need for government debt in

about two hundred words. The main valid reason for government borrowing he

could think of was a scenario where there was a sudden and large need to

constrain private sector spending, like in war time. In contrast, as he rightly

pointed out, in peace time, government spending is more or less constant from

year to year. In the latter case, there is little need for government borrowing.

To summarise, functional finance essentially consists of government

creating and spending extra money when unemployment is excessive and doing

the reverse when inflation looms. By ‘reverse’ I mean destroying money, that

is raising taxes and extinguishing the money collected.

The irrelevance of the structural deficit

A nice example of the irrelevance of the actual size of the deficit is the socalled

structural deficit: much discussed recently, at least in the U.K.

Government net spending in 2012 or thereabouts will clearly be less than

was planned prior to the recession, even if an economy returns to near normal.

The difference between the deficit in these two scenarios is the structural

deficit. But what is the practical relevance of the structural deficit concept?

Suppose that in 2012 the private sector is still deleveraging. That would

justify a larger deficit than normal. Conversely, if the private sector is

exhibiting irrational exuberance, to use Alan Greenspan’s phrase, that would

justify a smaller deficit, or even a surplus.

To summarise (and repeat) the size of the deficit or surplus in any given

year should be whatever looks like optimising the inflation unemployment

relationship. The actual size of the deficit or surplus is almost irrelevant.

Advocates of functional finance disagree with each other

Economists are famous for disagreeing with each other, a fault found

amongst functional finance advocates as much as with any other group. Thus

the version of functional finance set out here inevitably has the author’s stamp

on it. So for those new to functional finance, this paper should be taken as an

introduction to the subject, with further reading required.

5

The advantages of functional finance

Functional finance has several advantages over conventional policies. One

is simplicity: it cuts out some well-paid middlemen in the world’s financial

centres and for the following reasons.

Conventional stimulus consists of the following. 1. Treasury borrows $X. 2.

Treasury gives $X worth of securities to lenders. 3. Treasury spends $X. Under

functional finance, stage 1 and 2 become obsolete. (This simple illustration

assumes that the Treasury incorporates central bank functions, of course.)

A second advantage of functional finance is that the likelihood of owing

money to other countries is reduced. Third, less national debt means less

interest paid to creditors. Fourth, and to be cynical, the simplicity means fewer

economic illiterates in high places talking nonsense about national debts, and

doing immense economic damage in the process. Fifth, government is less in

thrall to ‘bond vigilantes’ because there are fewer government bonds or none at

all.

Quantitative easing is a move towards functional finance

Returning for a moment to the above three stage illustration in which the

Treasury borrows $X, if it then quantitatively eases the $X worth of securities,

this amounts to reversing stage 1 and 2. That is, assuming it is government debt

rather than private sector debt that is quantitatively eased, then QE comes to

the same thing as stimulus functional finance style. Indeed, QE amounts to an

admission of the limits of borrow and spend and the merits of functional

finance. And just to rub it in, borrowing combined with dropping interest rates

(mentioned above) amounts to a similar admission, because to force interest

rates down, the central bank may well have to engage in QE.

Inflation

The inflationary dangers of functional finance are obvious, but this is not a

strong criticism because conventional policies, if taken too far, can be just as

inflationary. Four reasons are set out below for discounting inflationary

dangers.

1. Dollar for dollar, ‘print and spend’ is doubtless more potent than ‘borrow

and spend’. But that does not of itself mean inflation. If a more potent fuel is

fed to a car engine but constant power output is required, it does not take a

genius to work out what to do: use less fuel! Similarly for given stimulus, print

and spend requires less expenditure than borrow and spend. Incidentally and in

relation to money creation, the word ‘print’ is used in this paper as a synonym

for ‘create’: that is, it is not just the physical printing of say dollar bills that is

referred to.

6

2. It is debatable as to how big a difference there is between what might be

called ‘formal’ money (monetary base, M1, etc) and various assets which are

effectively used as money, like government debt, as Klein (2009) makes clear.

3. There is the argument that expanding the monetary base enables

commercial banks to then lend some multiple of the monetary base expansion.

This sort of idea still appears in some text books, but it is obsolete and for the

following reasons.

i) One of the main constituents of commercial bank reserves is monetary

base and there are no reserve requirements at all for Canadian banks.

ii) There was an astronomic and unprecedented increase in the monetary

base of the U.S. and U.K. in 2009. The effect was certainly not a dramatic

increase in bank lending.

iii) If commercial banks do lend more simply because they have money to

lend, that suggests that banks are lacking in competence. It suggests they are

not too good at performing one of their basic functions: distinguishing between

credit worthy and non credit worthy customers. This calls for tighter bank

regulation e.g. banning 100% or 90% mortgages.

iv) Plenty of articles and papers which explain the unimportance of reserves

can be found by typing the phrase “banks are capital constrained not reserve

constrained” into a search engine.

4. On converting national debt to monetary base, there is no reason it has to

be done on a dollar for dollar basis. Indeed, a dollar for dollar conversion

would probably be too stimulatory, and thus inflationary. But the solution is to

obtain some of the money for buying back the debt from increased tax (or

reduced government spending) the effect of which is deflationary. (The word

deflation is used in this paper to refer to damping economic activity rather than

to falling prices – though of course the former sometimes causes the latter.)

This means there are two methods of buying back, one being stimulatory

and/or inflationary, and the second deflationary. They are respectively ‘buy

back with printed money’ and ‘buy back with money from tax or reduced

spending’.

This in turn gives two levers which can be adjusted to bring any rate of

national debt repayment desired, plus any stance on the reflation – deflation

scale that is desired. For example, for a faster rate of national debt reduction,

apply more of both levers. And for a more deflationary method of debt

reduction, apply more of the second relative to the first.

Extreme circumstances

The differences between functional finance and conventional policies are

more pronounced in extreme circumstances (e.g. a recession) than in normal

circumstances.

For example, given the extensive deleveraging and cash hoarding by the

private sector that has taken place in the aftermath of the recession, there is no

alternative, if demand is to be maintained, to a

7

That is if households hoard cash instead of spend it, then total spending

declines, which raises unemployment. The authorities, certainly in the U.S.

have failed to grasp this point. They expanded the monetary base by around a

trillion dollars in 2009, but as Galbraith (2009) pointed out, a trillion was not

enough.

This difference between normal and extreme scenarios may help explain

why Keynes and Milton Friedman approved of functional finance, but did not

devote huge efforts to advocating it: they may have thought that the sort of

credit crunch we have recently experienced was unlikely.

very large deficit.

Central banks under functional finance

The rules governing central banks under functional finance would be similar

to those that currently obtain. The rules would be approximately as follows.

(Government and central bank are treated as separate entities here.)

Rule 1. Politicians must work on the assumption that a small annual deficit

is permitted. The reason for this stems from the widely held view that inflation

of around 2% is optimum. The reasons are thus.

i) 2% inflation means a 2% reduction in the real value of the monetary base

per year other things being equal. Thus to maintain the value of the base in real

terms, a deficit equal to 2% of the base per year is required.

ii) Where an economy expands by X% a year in real terms, and assuming

the value of the base relative to real GDP is to be maintained, a further amount

of deficit is required equal to X% of the base.

iii) A very similar point applies to the national debt, if there is one.

The above three items amount to significant amount of annual deficit: a

deficit required even where neither stimulus nor deflation is required.

(Incidentally, exactly the same deficit is required under conventional policies:

it is just that, to be impolite, advocates of functional finance are clearer on what

size deficit is required and why than those with more conventional views. Put

another way, the contribution to the debate from some conventional sources

has consisted, at worst, of little more than getting hysterical about the large

numbers involved.)

Rule 2. The central bank shall be responsible for holding employment as

high as is consistent with acceptable inflation. If unemployment is too high and

there is room for reflation (i.e. stimulus), the central bank shall inform

government of what extra sums it (the central bank) will allow government to

spend without any corresponding tax collection or borrowing. Conversely, if

inflation looms, the central bank may have to inform government that the latter

rein in spending or collect more in tax, or even collect more in tax than it

spends. This surplus money collected is remitted to the central bank where it is

extinguished.

8

‘Borrowing’ so as to extinguish money

Under functional finance, where inflation looms, government (in the sense

that includes central banks) needs to rein in money either by raised taxes or

reduced spending.

However the purpose of this so-called borrowing is definitely not to

spend

the money: the objective is to extinguish or shred the money, or render it

temporarily inoperative. This activity is not borrowing in any normal sense of

the word.

Abba Lerner favoured borrowing, while Friedman (1948) did not and nor

does Mosler (2010 – see second last paragraph). However, Lerner did not

favour ‘borrowing as a source of funds’ (Lerner (1943:355). His attitude to

borrowing was the same as his attitude to government income or spending, that

is, ‘functional’. In other words, the only important question for him was ‘what

is the effect of borrowing?’. He favoured an interest rate policy so as to bring

about the optimum level of investment. But that is a very questionable idea and

for several reasons.

i) Does anyone actually know the optimum level of investment?

ii) Investment suffers from diminishing returns. In other words the most

worthwhile investments in any economy have been made long ago. While the

additional investment that comes from dropping interest rates from say four

percent to two percent brings negligible benefits.

iii) The returns on investments vary from plus a hundred percent and more

p.a. to minus a hundred percent and more p.a. Again, in the light of this, the

above change of interest rate from four to two percent is of negligible

importance.

iv) There is the argument that government can control the price of money

or the quantity, but not both. Lerner seems to think governments can control

both. The view taken in this paper is that governments can control only one,

and that should be the quantity. (As to interest rates these would tend to be near

zero - as obtains at the time of writing. See Mosler (2005) for more on this.)

To summarise, to the extent that Lerner favoured borrowing, it was

borrowing not in any normal sense of the word. And even this latter form of

borrowing is questionable because the aim is near impossible: optimising the

amount of investment.

Is monetary base a debt owed by central banks?

A possible criticism of functional finance is that it involves replacing

national debt at least to some extent with monetary base, and the latter appears

on the liability side of central banks’ balance sheets. Thus it could be argued

that not much has changed in that monetary base is borrowing or a central bank

liability of sorts, much like the securities that governments issue.

One answer to this was given by Buiter (2008) who said ‘These monetary

base ‘liabilities’ of the central bank are not in any meaningful sense liabilities,

9

because they are irredeemable.’ (Willem Buiter is a former member of the

Bank of England Monetary Policy Committee.)

Does borrow and spend increase private sector assets?

In the above illustration where the Treasury borrowed $X, the net result

appears to be that the private sector is $X better off, which should be

stimulatory. However part of the reason that Treasury securities have value is

the interest they earn. But this interest comes out of the pockets of taxpayers,

thus the creation of these securities involves the creation of a liability as well as

an asset! Thus the size of the net increase in private sector assets is debatable:

yet another uncertain aspect of borrow and spend.

In contrast, print and spend undoubtedly gives the private sector additional

assets.

Borrow and spend with a view to stimulus: the conclusion

Borrow and spend involves uncertainties of which crowding out is just one.

For this is and for other reasons given above the zero borrowing alternative,

functional finance, should be given serious consideration.

3. Borrowing to purchase assets

A third reason governments borrow is to purchase assets, for example

infrastructure investments. The points made here apply both to countries which

issue their own currency and to countries that are part of a common currency

area.

The first flaw in this form of borrowing is that governments just do not need

to borrow in order to fund capital projects. This is for two reasons. First, the

total of all such investments in any given country is much the same every year.

Thus if a country

devoting much the same proportion of its budget to these investments every

year (in the form of loan repayments, interest, etc) as if it pays for the

investments out of income.

Second, governments do not face a problem that micro economic entities

like firms or households often face. This is that the latter sometimes make

investments worth several times their annual income. A family buying a house

is an example. Here, there is normally no alternative to borrowing.

Conclusion: the need to fund capital projects does not justify government

borrowing. However, the case for borrowing here is stronger than is the case

with the other reasons for borrowing considered in this paper. Indeed, there is

not much difference between funding a public sector investment and debiting it

10

with a nominal sum for interest, and on the other hand, actually borrowing the

capital sum and paying interest to lenders.

does borrow, to fund this expenditure, it will just end up

Spreading the cost across generations

A plausible sounding argument for government borrowing to fund capital

projects is that this spreads the burden across generations because future

generations ostensibly have to repay some capital and/or pay some interest.

The flaw in this argument is that while various members of the next generation

inherit the above liability, others inherit a corresponding asset, namely

government debt or bonds. These two net to nothing.

Put another way, the brute physical reality is that it is impossible to build a

road this year (2010) without diverting concrete, steel and so on from other

uses in 2010 (assuming constant aggregate demand). That is, people living in

2010 have to sacrifice the consumption of other products to have the road built.

Or put a third way, it is a physical impossibility to build a road in 2010 with

concrete produced in 2050.

The only way to have future generations in one country to pay for today’s

investment is for the country to borrow the capital sum from some other

country, and gradually pay the money back, as pointed out by Musgrave (1939:

269). But if every country adopts the latter policy, it becomes self-defeating.

Moreover we all benefit from investments made by previous generations

where the relevant debt has long been paid off. An example is education:

capital costs apart, these costs are normally born and paid off annually (e.g.

teachers’ salaries). Thus allocating the costs of investments to each generation

in any sort of accurate way is a bureaucratic nightmare. It is probably simpler

just to accept that each generation inherits huge benefits from previous

generations, and that each generation should ‘leave the world as it found it’,

that is fund and pass on a roughly equivalent amount of investment to

succeeding generations.

To summarise, having future generations pay for the investments they

inherit is, first, almost a physical impossibility, and second, even were it

possible, the idea is more trouble than it is worth. Thus government borrowing

aimed at the latter objective is also more trouble than it is worth.

4. Does the erratic timing of tax receipts and expenditure within each

year justify borrowing?

The quick answer to this is that given a short term lack of income,

government can easily print money; then, a few months later, when income

exceeds spending, government can do the opposite, that is rein in money and

extinguish it. It could be claimed that the latter money printing would be

inflationary. However, there are flaws in the latter claim.

11

First, inflation is unlikely to take off just because the money supply is more

than optimum for three months and then an equivalent amount below optimum

for the next three months.

The next flaw involves Ricardian equivalence of a sort: that is, where a

private sector entity knows there is a $Y tax liability in the pipeline and has

sufficient cash to meet this liability, that entity is almost certain to use the cash

to meet the liability, rather than spend the cash on something else in the

interim.

This argument gains support from examining what might be called the

counterparties to the regular annual government shortages and surpluses of

income. These counterparties are very definitely not the sort of people who

might blow a temporary excess of cash.

For example a significant proportion of people living on social security

might spend any temporary excess cash; however a large majority of these

people (at least in the UK - pensioners or those on invalidity benefit) receive a

fairly regular income from the state and thus do not cause erratic changes in

government net income.

As to a more responsible or talented or lucky section of the population,

employees, this section of the population also has a regular income. As to

income tax, this is deducted from wages and salaries, both where wages are

paid weekly and where paid monthly (at least in the UK). Thus this section of

the population does not contribute much to changes in government income

either.

Finally, the sections of the economy which really cause the irregularities in

government income are corporations and the self employed. These sections of

the economy (at least in the UK) pay tax on profits once or twice per year.

However, it is precisely this section that is least likely to blow a temporary

excess of cash. Any corporation or self employed person with a propensity for

this sort of behaviour will not last long in business.

Conclusion: the variations in government net income through the year are

not a reason for governments to borrow.

Main conclusion

Of the four alleged justifications for government borrowing examined here,

three are feeble. The only one without serious flaws is borrowing to fund

capital projects like infrastructure investments. But even here, the merits of

borrowing are debatable.

But that is not a message that Goldman Sachs, other banks or the well-paid

employees in the world’s financial centres want broadcast. They have an

interest in seeing governments heavily in debt. They devote millions and will

devote further millions to furthering their interests: foisting debt on

governments. Hopefully the arguments in this paper will help governments

counter banks’ sales pitch. Indeed there was one particularly odd case in

Australia in 2002 where banks managed to foist extra debt on the Australian

12

government despite the fact that the latter was running a surplus and happily

paying off its national debt – see Mitchell (2002 and 2010).

References

Buiter, W. (2008). ‘Wanted: tough love from the central bank.’

Times,

Colander, D. (2003). ‘William Vickrey’s Contributions to Economics.’

Middlebury College Economics Discussion Paper No. 03-23. Vermont, U.S.A.

Friedman, M. (1948). ‘A monetary and fiscal framework for economic

stability.’

Galbraith, J.K. (2009). ‘Navigating the Jobs Crisis: Old Mistakes Die Hard.’

Franklin and Eleanor Roosevelt Institute. Available at

http://www.newdeal20.org/2009/11/23/navigating-the-jobs-crisis-old-mistakesdie-

hard-6556/ [23

Klein, M., Lantz, C., Sweeney, J., & J. Wilmot, (2009). ‘Long Shadows,

Collateral Money, Asset bubbles, and Inflation.’ Credit Suisse.

Landes, D.S. (1994). ‘Abba Ptachya Lerner.’ In:

Volume 65,

Lerner, A. (1943). ‘Functional Finance and the Federal Debt.’

Research,

Mitchell, W. & Mosler W. (2002). ‘Public Debt management and

Australia’s macroeconomic priorities - Submission to the Review of the

Commonwealth Government Securities Market.’ Newcastle, Australia: Centre

for Full Employment and Equity.

Mitchell, W. (2010). ‘Market participants need public debt.’

http://bilbo.economicoutlook.net/blog/?p=10404#more-10404

Mosler, W. & M. Forstater (2005). ‘The natural rate of interest is zero.’

Financial22nd March.American Economic Review, 38(3): 245-264.rd November 2009].Biographical Memoires,208-231. Washington: National Academy of Sciences.Social10: 38-51.

Journal of Economic Issues

Mosler, W. (2010). ‘Proposals for the banking system.’

, 39(2): 535–542.Huffington Post,

21

13

Musgrave, R.A. (1939). ‘The Nature of Budgetary Balance and the Case for

the Capital Budget’.

Musgrave, R.S. (2010). ‘Government borrowing is pointless where a

country issues its own currency.’ Munich Personal RePEc Archive paper No.

20057.st January.The American Economic Review, 29 (2): 260-271.

Functional Finance: What, Why, and How?

Functional Finance: What, Why, and How?

by

Stephanie Bell

University of Missouri at Kansas City

November 1999

In 1943, Abba Lerner wrote an essay entitled

fourteen pages, the principles that Lerner believed should guide the government's budgetary policies. It opens with a

recognition that "[a]part from the necessity of winning the war, there is no task facing society today so important as

the elimination of economic insecurity" (1943, p. 38). Aware that what was to follow would strike his readers as

fantastically naive, he cautioned that it was essential to "grapple with this problem even if it involves a little careful

thinking and even if the thought proves somewhat contrary to our preconceptions" (1943, p. 38). The purpose of the

essay was to set out the principles by which the government could use its fiscal powers to maintain prosperity.

Lerner referred to "the new fiscal theory", which was "formulated by Alvin Hansen . . . and put forward in substantially

complete form by J.M. Keynes" as a somewhat less audacious rendition of his own theory (1943, p. 38). Thus, Hansen,

who argued that deficit spending was appropriate so long as the ratio of debt to national income remained at some

tolerable level, did not support the use of fiscal policy as unabashedly as Lerner did. From Lerner's more fearless

perspective, the government's budget was to be used to

Hansen of "appeasing" the opposition and claimed that in so doing, he "opened the way to an extremely effective

opposition to Functional Finance" (1943, p. 43). Rather than trying to appease his opponents, Lerner forcefully applied

his purely logical analysis, unleashing "all the unorthodox implications" which followed from it (1943, p. 39).

Functional Finance and the Federal Debt . The essay elucidates, in justpermanently maintain economic prosperity. Lerner accused

An Unstable System: Causes, Consequences and Solutions

One of the more unorthodox implications to emerge from Lerner's analysis was his indictment of the economic system

as inherently demand-constrained. Although he did not delve too deeply into the factor(s) causing the insufficient

demand until his 1951 book,

Institutionalists, Marxists, etc. -- The tendency for money-using (in particular, capitalist) economies to be plagued by

chronic deficiencies in aggregate demand derives from the inherent characteristics of such a system. This, as Keynes

(1946), Minsky (1986), Davidson (1982), and others have recognized is due to the existence of fundamental

uncertainty (a nonergodic world, in Davidson's terminology) and its implications for the financing of positions in capital

assets. Dudley Dillard recognized not only the reason for this instability but also its social consequences. Commenting

on these, he maintained:

[T]he motivation to production derives from the expectation of profit. Business men have the power, the

legal right, and often the incentive to withhold from use the means of production to which the labor of

the community must be applied in order to produce the goods and services that provide the basis of

community welfare. When businessmen decide to let their factories remain idle, they serve their own

interest but they do not serve the interest of the community. This is perfectly "natural." It is not in the

nature of business accounting to be directly concerned with what happens to the national income when

wages and salaries fall because of unemployment. (Dillard, 1948, p. 104)

Thus, it is in the "nature" of business enterprise to generate two related sources of instability: First, as a

consequence of the whims of the business man, the system tends to generate unemployment. Second, this

unemployment is likely to persist, because it is not in the nature of business accounting to generate self-correcting

forces.

Unemployment could persist, in Dillard's view, because of a persistent gap between total income and total spending by

the private sector. The reason for the gap, he opined, was the following:

At a level of income corresponding to full employment, the gap between total income and total

consumption is so great in advanced industrial economies that private investment is inadequate to fill it.

If unemployment is to be avoided, the gap must be bridged either by filling in with government expenditure

or by reducing the size of the gap by increasing the propensity to consume. (Dillard, 1948, p. 102)

Keynes was not optimistic about the likely success of policies designed to raise the propensity to consume. In

specifying the factors responsible for determining the propensity to consume, he distinguished the objective from the

subjective. The latter, he maintained "include those psychological characteristics of human nature which, though not

unalterable, are unlikely to undergo a material change over a short period of time except in abnormal or revolutionary

circumstances" (Keynes, 1964, p. 91). Although Keynes also recognized six objective factors, capable of altering the

propensity to consume, he did not believe that they could be manipulated easily enough to make targeting them an

efficient means of closing the gap. Thus, as Dillard notes, Keynes concluded that "the chief burden for maintenance of

high levels of employment falls on

consumption at full employment. (Dillard, 1948, p. 103; my emphasis).

It might be thought that simply 'priming the pump' could close the gap. Pump-primers suggested that it might be

necessary for the government to use its fiscal powers to stimulate demand but that

necessary. However, as Dillard noted, pump-priming "rests on the assumption that a

have a lasting tendency to raise the level of economic activity" (1948, p. 106). By the time he wrote the

Theory,

Implicit in the theory that the pump merely needs to be primed is the belief that the system has been in a state of

"

by some fortuitous event" (Dillard, 1948, p. 106). Keynes, of course, recognized that the system was characterized

by

[I]t is an outstanding characteristic of the economic system in which we live that, whilst it is subject to

severe fluctuations in respect of output and employment, it is not violently unstable. Indeed, it seems

capable of remaining in a chronic condition of sub-normal activity for a considerable period without any

market tendency either towards recovery or complete collapse. Moreover, the evidence indicates that

full, or even approximately full, employment is of rare and short-lived occurrence. (GT, pp. 249-50)

Lerner opposed pump-priming, for its formulation often implicitly called for the balancing of the government's budget

as an objective goal: a practice which (as we will see) is fundamentally at odds with the theory of Functional Finance.

Having rejected the use of pump-priming as an appropriate means of eliminating unemployment (i.e. closing the gap

between the full employment and the underemployment levels of aggregate spending), Lerner proposed his two "laws"

of Functional Finance. The first law placed upon the government the responsibility for maintaining the total rate of

spending on goods and services at the level necessary to purchase all of the output that it was possible to produce. In

elucidating this law, Lerner explained that when spending was at the requisite level it would prevent both inflation and

unemployment.

expenditures or reduce taxes so that private spending would increase. Similarly, the government could cut its spending

or raise taxes in order to reduce the total rate of spending:

By these means total spending can be kept at the required level, where it will be enough to buy the goods

that can be produced by all who want to work, and yet not enough to bring inflation by demanding (at

current prices)

The above should not be read as support for a non-accelerating inflationary rate of unemployment (NAIRU). Such a

reading, as Colander argues, would ascribe to Lerner a position which "is not inherent in the functional finance rules"

(Colander, 1997, p. 203).

Indeed, what Lerner advocated, in this essay, was the maintenance of true full employment (i.e. employment for all

who

While his views regarding the conditions under which inflationary pressures might begin to emerge initially differed

from Keynes', Lerner, in his

Keynes' view, inflation was not to be associated with price increases taking place

involuntary unemployment) had been reached. Indeed, expansionary policy was considered inflationary only if it spent

itself entirely on an increase in prices, with no further stimulus to output. In Keynes' words:

When a further increase in the quantity of effective demand produces no further increase in output and

entirely spends itself on an increase in the cost-unit fully proportionate to the increase in effective

demand, we have reached a condition which might be appropriately designated as one of true inflation. Up

to this point the effect of monetary expansion is entirely a question of degree, and there is no previous

point at which we can draw a definite line and declare that conditions of inflation have set in.

303)

Thus, Keynes recognized that prices were likely to rise before labor became scarce or capacity limits began to bind.

While Lerner did not initially believe that inflation would emerge before full employment had been reached, he later

recognized that prices might begin to rise before all resources were fully employed. He noted that:

[A]s long as it is possible for the supply of goods to increase along with the increase in spending, there

will be no (permanent) increase in prices. (Lerner, 1951, p. 8)

Although prices might begin to rise prior to the attainment of full employment, they would not

should not induce an abdication of the government's responsibilities with respect to the first law of Functional Finance.

The first law of Functional Finance is designed to eliminate a shortfall in total spending, while the second decrees the

specific

interest-bearing government debt only in the event that private spending would

aggregate demand. Under ordinary circumstances, Lerner argued, it is expected that capitalist economies will suffer

from insufficient rather than excessive aggregate demand so that it would not be necessary to offer bonds in

exchange for money as a means of tempering inflationary pressures. Instead, Lerner believed that bonds should be

sold to the central bank or to private banks "on conditions which permit the banks to issue new credit money based on

their additional holdings of government securities, [which] must be considered for our purposes as printing money"

(1943, p. 41).

In sum, capitalist economies are typically demand-constrained. This tendency to generate insufficient effective

demand for all output (even when the system is operating at less than full capacity) is the

instability; the

government to cover the shortfall by spending enough to bring about full employment.

Economics of Employment , the reasons are well known among Post-Keynesians,public expenditures designed to fill in the existing gap between income andrepeated stimuli were nottemporary new expenditure willGeneralKeynes, like Lerner, realized that pump-priming was not going to do the trick.unstable equilibrium before the injection of new spending pushes it back on the track from which it has been derailedstable under-employment equilibrium:1 In order to manipulate total spending, he suggested that the government increase its ownmore than can be produced. (Lerner, 1943, p. 40)want to work), which he believed could be attained without setting off inflation.Economics of Employment , appears to have moved closer to Keynes on this matter. Inbefore full employment (i.e. zero2 (GT, p.remain high and, thus,manner in which the deficiency is to be funded. Specifically, the second law calls for the sale ofotherwise generate excessivecause of the system'sconsequence is unemployment. The solution , according to Lerner, was to make it incumbent on the

Covering the Shortfall

The optimal method by which to finance deficit spending remains a controversial topic among many economists (see

Modigliani, 1992; Trostel, 1993; Ludvigson, 1996; and Smith et al., 1998). Although most would agree that

governments can finance their spending by imposing taxes, borrowing from the public, or printing money (or some

combination of these), there is often strong disagreement regarding the macroeconomic

choices.

The Barro-Ricardo thesis, for example, maintains that the financing choice is inconsequential. This, it is argued, is

because the knowledge that bond-financed government spending will require higher taxes in the future simply induces

households to save more now. The induced saving, which is just sufficient to purchase the new government debt,

leaves private net wealth unchanged, and thereby completely neutralizes the stimulative effect of government

spending. Similarly, as Tobin (1998) recognized, spending financed by issuing demand obligations (i.e. printing money)

might lead a monetarist Ricardian to suggest that a "money rain," like a "bond rain," will have no effect on aggregate

private wealth or consumption since adjustments in the price level will prevent the

changing. With the real quantity of money unaffected, decision-makers are said to have no reason to alter their

spending behavior. Thus, the macroeconomic consequences of bond- or money-financed deficit spending are thought to

yield results 'equivalent' with those that would have resulted if all spending had been financed by contemporaneous

taxation. In other words, it just doesn't matter whether the government chooses to tax, sell bonds, or print money;

each will affect the economy in an identical way.

In contrast, 'Keynesians' (Blinder and Solow, 1973, 1976; Buiter, 1977; Tobin, 1961), generally agree that the

economic consequences of borrowing and printing money can differ substantially from those obtained when

government spending is financed solely by contemporaneous taxation. Inspired by Christ (1967, 1968), Blinder and

Solow (1973) investigated the optimal method by which to finance government (deficit) spending, concluding that the

expansionary effects from borrowing would outweigh the stimulative effects of financing by creating new money.

Although 'Keynesians' recognize that there will be different macroeconomic consequences, depending on the

consequences of thesereal quantity of money frommanner

in which the shortfall is made up, they do not generally share Lerner's preference for printing money to finance the

deficit.

Post-Keynesians and Institutionalists, however, tend to be more amenable to Lerner's position. For example, Wray

(1998) discusses at length the possibility (and the desirability) of printing money to finance government expenditures.

Similarly, focusing on the macroeconomic consequences of alternative financing methods, Chick (1983) concludes:

Common sense, superior here, indicates that finance by new money, both because it introduces new

liquidity into the system and because there is no effect from the policy action itself on the rate of

interest, will have a greater expansionary effect than finance by borrowing. (Chick, 1983, p. 321)

On the same subject, Dillard (1948) recognizes that when the government simultaneously spends and collects taxes, it

is simply substituting public for private spending, whereas "the expenditure of funds raised by borrowing represents

mainly new expenditure and therefore an addition to total effective demand" (Dillard, 1948, p. 109). Elaborating on this

point, Dillard maintained that:

The greatest stimulation to employment will result when a public construction program financed by

borrowing replaces a public relief program which was paid for out of taxation. (Dillard, 1948, p. 109)

Thus, while 'Keynesians' typically conclude that the macroeconomic consequences of bond- vs. tax-financed spending

will differ, Dillard goes further, claiming that "there are significant differences between various

taxes" (1948, p. 110; my emphasis). Like Lerner, Dillard recognized that the expansionary effects would be greater

when bonds were sold to banks rather than to the non-bank public (i.e. when spending was financed by printing money):

In the former case, no one need restrict either his consumption or his investment. The bond is purchased

with new money created within the banking system in the form of new check-book money. The total

quantity of money is increased by the lending activities of the banking system. There is no transfer or

giving up of means of purchase by one party for expenditure by the government; there is merely the

creation of additional means of purchase. (Dillard, 1948, p. 110)

The least desirable method for financing spending involved the taxation of funds that would have been spent if left in

the hands of taxpayers. Thus, like Lerner, Dillard recognized that the consequence of taxing or borrowing from the

public was to leave private individuals with less money to spend. Because of this, Dillard proposed that the government

close the spending gap by creating additional money (i.e. a net injection) to finance its spending. Once the gap was

closed, Dillard, again siding with Lerner, maintained that the method of finance should shift in favor of taxation and/or

borrowing in order to forestall inflation (Dillard, 1948, p. 112).

Lerner, anticipating a knee-jerk opposition to his recommendation that the government 'resort' to printing money,

stated that:

The almost instinctive revulsion that we have to the idea of printing money, and the tendency to identify

it with inflation, can be overcome if we calm ourselves and take note that this printing does not affect

the amount of money

Again, the consequence of taxation and bond sales is to leave the public with less money to spend. Such a result would,

from Lerner's perspective, be "desirable . . . when they would otherwise spend enough to bring about inflation" (Lerner,

1943, p. 40). The idea, then, is to allow a private sector, unfettered by taxes, to come as close as possible to

satisfying Say's Law. In the absence of such robust demand conditions, however, Lerner advocated the printing of

money to finance the spending necessary for the maintenance of full employment. Again, the idea is to sell bonds to

banks (private banks or the central bank) as opposed to the non-bank public, so that funds which might otherwise be

spent are not lured away (or "crowed out") by the government. Thus, while most economists would argue that the

government should

excess of spending over taxation, Lerner believed that the government should do this "only if it is desirable that the

public should have less money and more government bonds" (1943, p. 40).

types of loans andspent . That is regulated by the first law of Functional Finance. (1943, p. 41)borrow 3 from the public (i.e. sell bonds in exchange for existing money) in order to finance the

How Can the Government Print Money?

How might a country print money in conformity with Lerner's second law? Economists typically apply the term 'printing

money' to the crediting, by the monetary authority, of the fiscal authority's checking account as a consequence of

purchasing its debt instruments. But Lerner wanted to broaden the application of the term. In his view, if

private

banks are capable of purchasing government debt by crediting a government account, this, too, should be considered

printing money. Thus, when either the central bank or a private bank purchases newly-issued government debt by

issuing credit or bank money, they are, in effect, printing money. Because printing money is essential for the adoption

of the principles of Functional Finance, it is, perhaps, prudent to devote some space to the balance sheet effects of

these two methods for printing money.

First, a government could create its own spendable balance by allowing its monetary authority to credit the account of

its fiscal authority. This, as Figure 1 indicates, can be accomplished through the purchase of the fiscal authority's IOU

(e.g. a government bond) by the monetary authority. Thus, if the central bank purchases a newly-issued security from

the Treasury, it will do so by crediting the Treasury's account. The balance sheet effects of this purchase/sale are

shown in Step A. Once the fiscal authority draws on this account in order to acquire goods and services, it can be said

to have paid for its purchase by 'printing' money. Asterisks indicate, in Step B, the amount of narrow

and

high-powered money that will have been created - both 'inside' and 'outside' money have increased (

Second, the government could sell bonds to a private bank.

printing money. The balance sheet effects of allowing private banks, as opposed to the central bank, to create

deposits for the Treasury are shown in Example 2.

ceteris paribus ).4 Lerner (correctly) characterized this as a means of

Figure 1

The sale of newly-issued bonds to the Central Bank

Step A: The sale of a Government bond to the Central Bank

TREASURY

+ Balance at Central Bank + Government Security

CENTRAL BANK

+ Government Security + Balance owed to Treasury

Step B: Drawing on the newly created balance

BANKS

+ Balance at Central Bank* + Balance owed to Public**

TREASURY

+ Asset - Balance at Central Bank

CENTRAL BANK

+ Balance owed to Commercial Banks - Balance owed to Treasury

* High-powered (or base) money created/'printed'

** Narrow money (e.g. M1) created/'printed'

Figure 2

The sale of newly-issued bonds to Note-Option Banks 5

Step A: The Sale of a Government Bond to a Note-Option Bank

NOTE-OPTION BANK

+ Government Securities + Tax & Loan Account

TREASURY

+ Tax & Loan Account + Government Securities

Step B: Transferring Funds from Tax & Loan Account to Central Bank

NOTE-OPTION BANK

- Balance at Central Bank - Balance owed to Treasury

TREASURY

- Balance at Note-Option Bank

+ Balance at Central Bank

CENTRAL BANK

- Balance owed to Note-Option Bank

+ Balance owed to Treasury

Step C: Spending from Account at Central Bank

BANKS

+ Balance at Central Bank + Balance owed to Public

TREASURY

- Balance at Central Bank

+ Asset

CENTRAL BANK

+ Balance owed to Commercial Banks

- Balance owed to Treasury

In this example, narrow and base money do not each rise by an equivalent amount. In particular, there is no net

increase in the quantity of base money as a consequence of the government's spending.

not generally refer to this form of government finance as having resulted in the printing of money. Under Lerner's

more general definition, however, whenever private or public banks, act "as agents for the government in issuing

credit or bank money," they may be said to be printing money for the purposes of government finance (Lerner, 1943,

fn., p. 41). Not only

Functional Finance, Lerner argues that they

purpose of borrowing existing funds

the adoption of so-called "sound" finance:

In brief, 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. In their place it

prescribes: first, the adjustment of total spending (by everybody in the economy, including the

government) in order to eliminate both unemployment and inflation, using government spending when

total spending is too low and taxation when total spending is too high; second, the adjustment of public

holdings of money and of government bonds, by government borrowing or debt repayment, in order to

achieve the rate of interest which results in the most desirable level of investment; and, third, the

printing, hoarding or destruction of money as needed for carrying out the first two parts of the program.

(1943, p. 41)

As Colander notes, "Lerner's purpose in proposing [the] rules of functional finance was to change the focus of thinking

about government finance from sound finance principles that made sense for individuals -- such as balancing the

budget -- to sound finance principles that made sense for the aggregate economy" (Colander, 1997, p. 202). Lerner

realized that a continually increasing national debt might be a consequence of rejecting the principles of "sound"

finance.

6 This is why economists docan they print money on behalf of the government, but, as dictated by the second law ofshould do so. In precluding the sale of government bonds for thefrom the private sector, Lerner unabashedly denied any intelligent grounds for

The Usual Objections

Today, economists from within and outside the mainstream typically object to a number of the implications that follow

from Lerner's proposal. Even Keynes is said to have initially "recoiled from" some of its more unorthodox implications

(Colander, 1997, p. 202). But he reconsidered his position, stating in a letter to Lerner:

It is a grand book worthy of one's hopes for you. A most powerful piece of well organized analysis with

high aesthetic qualities . . . I shall have to try when I get back to hold a seminar of the heads of the

Treasury on Functional Finance (quoted in Colander, 1997, p. 202).

Lerner dealt with some of the more common objections in his original essay, and a number of others have been

addressed by Wray (1998) and Forstater (1997). Because at least some of these objections are likely to creep into

the current reader's psyche, it is best to address (some of) them here.

First, and probably most obvious, is the belief that implementing Functional Finance will prove inflationary. Indeed, this

is a standard (i.e. mainstream) argument against expansionary fiscal policy. In the textbook story, however, a

employed

adds to a level of aggregate demand which is just sufficient to bring about full employment. As Figure 3 shows, the

result is an outward shift in the aggregate demand curve and a

fullyeconomy is usually taken as the point of departure. Thus, it is usually assumed that the additional spendingpermanently higher price level.

Figure 3

The Inflationary Effects of Deficit Spending 7

From the initial state of full employment equilibrium (point A), then, expansionary fiscal policy shifts the aggregate

demand curve from D

employers begin to adjust to the new (higher) price level, the aggregate supply curve shifts in (and to the left) until it

intersects D

price level has risen a full 12 percent from its original level.

As a basis for a critique of Functional Finance, the above is not very compelling. Indeed, it appears to be wholly

incompatible with the theory of Functional Finance, which precludes

otherwise) once full employment has been attained. Thus, expansionary fiscal policies are to be implemented

0 to D1. At this point (point B), the price level has risen by six percent. As workers and1 at point C, causing the price level to rise further.8 Equilibrium is reestablished at point C, where theany additional spending (government oronly

when the economy is operating

that:

Once full employment is reached, additional deficit spending will generate additional income that is likely

to cause inflationary pressures -- except in the unlikely case that all additional income represents desired

net saving. Beyond full employment, then, any further reduction of taxes or increase of government

spending (increasing deficit spending) is likely to reduce the value of money as prices are bid up. (Wray,

1998, p. 84)

Moreover, even if the CPI (or some other standard price index)

reached, it is not at all clear that the 'costs' associated with

moderate price increases would outweigh the (social and economic) benefits of reduced unemployment. Indeed, there

are even studies that argue that moderate inflation is itself a net benefit rather than a net cost.

below full employment. Echoing Lerner's sentiments on this subject, Wray contendsdid begin to rise before full employment had been9

Second, it might be objected that, owing to the existence of a

run the sort of substantial, persistent deficits that might emerge as a consequence of adopting the principles of

Functional Finance. Thus, it is standard practice to write:

financial (budget) constraint, the government cannot

G

- T = B + M

where

B represents the change in the quantity of outstanding bonds issued by the federal government and M

indicates a change in the quantity of newly-created money and to argue that beyond some point, the deficit (G - T)

cannot be increased further because there is no demand for additional government bonds or money. Equation 1 is

usually referred to as a government budget 'constraint' (or 'restraint').

The equation, itself, is not troubling. Indeed, it holds perfectly well as an

ex post accounting identity. As an ex ante

financial constraint, however, it seems, as Chick noted, "paradoxical," since:

[T]here are the possibilities of borrowing and creating purchasing power simultaneously with the

spending, and when the tax receipts are unknown at the outset: it is either a completely

between inflows and outflows of funds like an income statement . . . or it represents a consistent plan,

where the financial implications are recognised." (Chick, 1983, p. 319)

Thus, as Chick notes, it is awkward to refer to a government which is capable of creating money at will as being

subject to a

Another equation, which might be offered to support the claim that the government's debt cannot increase indefinitely

is given by:

Thus, when the deficit is financed by borrowing, some say that there is a finite limit to the quantity of government

debt that the public will willingly hold. From Equation 2, this "willingness" determines b

ratio, simultaneously constraining deficit spending beyond d

Lerner, while not sympathetic to them, spelled out his opponents' fears regarding 'excessive' indebtedness:

If the interest on the debt must be raised out of taxes . . . it will in time constitute an important fraction

of the national income. The very high income tax necessary to collect this amount of money and pay it to

the holders of government bonds will discourage risky private investment, by so reducing the net return

on it that the investor is not compensated for the risk of losing his capital. This will make it necessary

for the government to undertake still more deficit financing to keep up the level of income and

employment. Still heavier taxation will then be necessary to pay the interest on the growing debt — until

the burden of taxation is so crushing that private investment becomes unprofitable, and the private

enterprise economy collapses. (Lerner, 1943, p. 44).

If the entire system were likely to collapse as a consequence of adopting the principles of Functional Finance, there

would indeed be cause for concern. In response to this charge, three important points should be made. First, as Nell

(1999) notes, if there

debt-to-tax receipts), it is irrelevant, because:

For such upper limits to matter it must be shown that there are plausible and economically meaningful

circumstances in which those upper limits will be reached

1999, p.1)

Second, there can be no burden on society

made. While it is true that choosing among taxes, borrowing, and printing money will have distributional effects, any

burden must be measured "by the inconveniences involved in the process of transferring the money from the

taxpayers to the bondholders"(Lerner, 1943, p. 46). As Baumol and Blinder note, "[t]hese transfers may more may

not be desirable, but they hardly constitute a burden on the nation as a whole" (1997, p. 334).

Third, a growing debt (on which interest must be paid) is not a

But we have already seen that when the deficit is financed either by printing money or borrowing, it involves the sale

of interest-bearing debt, which naturally implies an increase in the quantity of interest-bearing debt outstanding. How,

then, would it be possible to run persistent deficits

deficits without issuing any interest-bearing debt at all? This question was asked by Dillard (1948):

Is not the creation of new money properly a government function, and if so, what is there to prevent the

government from issuing money directly, without paying interest on bonds to commercial banks?" (Dillard,

1948, p. 113)

Of course Dillard was not suggesting that the government should just print up mountains of cash and go around making

purchases with it. What he argued was that the default risk on government debt was so slight that it was unnecessary

to 'compensate' holders of this type of debt for parting with their more liquid (government) liabilities. Although he

recognized that a government's ability to adopt such a scheme depended on the "nature of central monetary

authority," (Dillard, 1948, p. 114), he explained that:

In the United States, the Treasury could issue non-interest bearing notes to the Federal Reserve banks

with instructions to increase the government deposits to the extent of the value of the notes. The

government could then spend its balances in the usual fashion for public works and other expenditures.

(Dillard, 1948, p. 114).

The balance sheet effects of this type of sale/purchase of non-interest bearing notes are shown in Figure 3.

ex post relationfinancial constraint.* , the sustainable debt-to-GDP* .is an upper limit (either of debt-to-GDP or its related ratio of interest payments on publicbefore full employment is reached. (Nell,as a whole as a consequence of the interest payments that have to benecessary consequence of continuously rising deficits.without generating a growing debt? Could the government run

Figure 3

The issue of non-interest bearing notes to the Central Bank

Step A: The issue of non-interest bearing notes to the Central Bank

TREASURY

+ Balance at Central Bank + IOU (non-interest bearing)

CENTRAL BANK

+ IOU (non-interest bearing) + Balance owed to Treasury

Step B: Treasury Spending from Account at Central Bank

BANKS

+ Balance at Central Bank + Balance owed to Public

TREASURY

- Balance at Central Bank

+ Assets

CENTRAL BANK

+ Balance owed to Banks

- Balance owed to Treasury

Figure 3 shows that, like in the example in which the Treasury sold

(Figure 2), the effect of drawing on an account that was credited through the sale of

an increase in both the quantities of narrow (e.g. M1) and base (i.e. high-powered) money.

If the government followed Dillard's proposal, not only would there be no increase in the quantity of outstanding debt

as a consequence of rising deficits, but one could not argue that beyond some point, the Treasury would run into a

financial constraint. Thus, as long as there remained the political will to create Treasury balances in this manner,

there would be no limit to Treasury's ability to acquire credits to its balance sheet. The only limitation to the

government's ability to

willingness to provide goods and services in exchange for government money. A government could, then, undertake

Lerner's Functional Finance, continuously making up a shortfall in aggregate spending,

of outstanding debt (or the interest that must be paid on it).

interest-bearing debt directly to the Central Banknon -interest bearing notes isspend these funds, as Wray (1998) recognized, would depend upon the private sector'swithout increasing the quantity

The Need for Policies Guided by the Principles of Functional Finance

This section is intended to provide a (very) general picture of the unemployment trend in a number of world

economies. It must be said, however, that the need for policies based on the principles of Functional Finance does not

depend on the current economic outlook. Indeed, as we have already seen, money-using economies tend to "suffer

from periodic, if not chronic, unemployment," (Wray, 1998, p. 84) which means that something like Functional Finance

(perhaps the Employer of Last Resort (ELR) program supported by Wray (1998) and Forstater (1997)) is needed as

part of the on-going implementation of fiscal policy, irrespective of the current economic situation.

Below is a sample of unemployment conditions in twenty industrialized countries.

It is clear from the graphs that what Lerner referred to as the 'spending gap' is sizable enough to generate substantial

unemployment in most of the countries sampled here. The nations chosen, it should be noted, hardly comprise a biased

sample. Indeed, all eleven countries participating in European Economic and Monetary Union (EMU), Australia, Canada,

Japan, the United Kingdom and the United States are among those sampled.

At the end of 1997, 80% of the countries included in the sample had annual unemployment rates measuring more than

6%, the rate long-believed to be the 'natural' rate of unemployment (at least in the United States). Of those, half (or

40%) had rates of 10% or more. Moreover, of the eight countries with double-digit unemployment rates at the end of

1997, all but one was a member of European EMU. This, as Modigliani, et al. argued, is probably no coincidence, since

preparation for entry into Monetary Union caused countries to pursue highly restrictive fiscal and monetary policies in

order to meet the convergence criteria established in the Maastricht Treaty.

12

While unemployment is fairly low in Japan, Luxembourg, the Netherlands and the United States, the current

performance in these countries, again, does not excuse the need for something like Functional Finance. Indeed, as

Godley (1999) points out, the US economy, currently the envy of almost all industrialized nations, could face an

"unusually protracted recession with a large rise in unemployment" unless steps are taken to implement a "coordinated

fiscal expansion worldwide" (Godley, 1999, pp. 4-5).

Conclusion

In the final paragraph of his essay, Lerner addresses the prospects for the adoption of the principles of Functional

Finance under various systems of governance. Specifically, he maintained that "Functional Finance is not especially

related to democracy or to private enterprise. It is applicable to a communist society just as well as to a fascist

society or a democratic society" (1943, p. 50). He adds, moreover, that "[i]ts relationship to democracy and free

enterprise consists simply in the fact that if the people who believe in these things will not use Functional Finance,

they will stand no chance in the long run against others who will" (1943, p. 51).

It is important to note that although Lerner appears to have considered the implementation of Functional Finance an

option under any

system of governance, he recognized that not all governments could, under existing institutional

arrangements, practice it. Forstater (1999) has also recognized this point, arguing that the institutional "structure

under EMU makes it nearly impossible for a country to enact a counter-cyclical fiscal policy [e.g. Functional Finance]

even if there were the political will [to do so]" (p. 32). The conditions under which Functional Finance can be undertaken

include: "a government's ability to tax, declare public receivability, create and destroy money, buy and sell bonds, and

administer the prices it pays for goods and services purchased from the private sector" (Forstater, 1999, p. 32).

We might say that those governments that are capable of adopting the principles of Functional Finance are those for

whom the national currency is, as Lerner described it in 1947, 'a creature of the State.' The United States, Canada,

the United Kingdom, and Australia are among such systems. In contrast, countries participating in EMU and those

adopting currency boards or otherwise fixing their exchange rates are examples of governments which, due to their

monetary arrangements, are constrained in their ability to follow the principles of Functional Finance.

APPENDIX

A T-account can be used to reflect the

not the only way to depict this (one could prepare a full balance sheet before, and a full balance sheet after, a

transaction), it is, in most instances, preferable to more time-consuming methods.

A few examples should provide the reader with sufficient conceptual understanding to cope with the T-accounts used

in the paper. Let us begin with Bank "A", whose initial balance sheet is reflected as:

Initial Balance Sheet of Bank "A"

change in a balance sheet as the result of a single transaction. Although it is

(thousands of dollars)

Cash $100 Demand Deposits $4000

Federal Reserve Account 1000 Time Deposits 2100

Loans 3000

Securities 2000

ASSETS = LIABILITIES + NET WORTH = 6100

If we wish to show the effects of a single transaction, say when a customer writes a check (to a friend who banks

elsewhere) for $100 on his checking account, we could laboriously construct an entirely new balance sheet as:

Balance Sheet of Bank "A" After Check Clears

(thousands of dollars)

Cash $100 Demand Deposits $3900

Federal Reserve Account 900 Time Deposits 2100

Loans 3000

Securities 2000

Or we could simply use a T-account to show the transaction:

Bank "A"

Federal Reserve Account - $100 Demand Deposits - $100

When we use T-accounts, only the asset or liability accounts

is preceded by a plus or minus sign to indicate whether the account was increased (credited) or decreased (debited).

Additionally, a T-account must always "balance". In other words, there must be equal pluses (or minuses) on opposite

sides, or offsetting plus-minus entries on the same side.

Continuing with Bank "A" as our guide, let us pursue a few more examples to ensure that the reader is comfortable

with this tool.

1. A depositor withdraws $50 cash from her time deposit:

Bank "A"

Cash - $50 Time Deposits - $50

2. A depositor writes a check for $100 on his checking account and deposits it into his time deposit:

Bank "A"

Demand

Deposits

- $100

Time Deposits +$100

3. The bank borrows $100 of reserves from the Federal Reserve:

Bank "A"

Federal Reserve Account +$100 Loan from Federal Reserve +$100

affected by the transaction are written down, and each

Footnotes

1. A word of caution is in order here. In laying out the theory of Functional Finance in 1943, Lerner clearly

believed that two economic ills -- inflation and unemployment -- had to be repressed if economic insecurity was

to be eliminated. Importantly, he did not believe that there was any inherent trade-off or inverse relation

between these two ills. Indeed, he opined that inflation would set in only after the system was pushed beyond

full employment. Later, however, Lerner recognized that inflation would begin to set in much sooner. In fact,

throughout much of his remaining career, he devoted himself to the study of policies designed to combat

inflation (market anti-inflation plans, incomes policies, wage-price controls, etc.). He even began to talk of

pursuing "high" full employment vs. "low" full employment (Lerner, 1951; Lerner and Colander, 1980), rather

than simply "full employment," which was his stated objective in 1943.

2. Although Keynes, in this passage, focused on the output and price effects following an expansionary monetary

policy, nothing of substance would change if, instead, fiscal policy had provided the stimulus.

3. We must be very clear about the difference between 'borrowing' and 'printing money'. Following Lerner,

'borrowing' will be used to refer to the sale of newly-issued government bonds, purchased by drawing on existing

deposits. 'Printing money', in contrast, will be used to refer to the sale of newly-issued government bonds,

purchased by crediting a government account.

4. If it wishes to finance its spending by 'printing' money, however, it cannot allow the bank to purchase the bonds

by drawing on an account with the monetary authority. But, as explained in Chapter Four, this is something the

Treasury can specify.

5. Note-option banks are private (US) banks in which government funds can be kept. The importance of these

accounts in coordinating the government's spending is described in Bell (1998).

6. Depending on the institutional arrangements, base money may rise in the next 'reserve period'. That is, if

banks are subjected to reserve requirements, additional reserves (i.e. base money) may be required as a

consequence of the government's spending.

7. This example is taken directly from Baumol and Blinder (1997).

8. While the textbooks usually concede that the inflationary effects depend upon the degree of slack present

before the expansionary policy is undertaken, the imagery of the inflationary effects of deficit spending tends

to prevail.

9. See: Schultze (1959); Minsky (1986); and Ackerlof, et al. (1996).

10. Although Ott and Ott (1965) may have been the first to specify the 'budget restraint,' Christ's work received

greater attention (1967, 1968), spawning countless extensions and refinements.

11. Personal notes from Tony Aspromourgos (1999).

12. Particularly troubling is the fact that these countries may now, as a consequence of joining EMU, be unable to

effectively deal with these levels of unemployment.

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