Abba Lerner and the Principles of Functional Finance

Abba Lerner and the Principles of Functional Finance

Introduction

The MMT approach to functional finance as a rule for conducting monetary and fiscal policy is based on the work of Abba Lerner. Lerner enunciated three fundamental rules of functional finance in his 1941 (and later 1951) works:

1. The government shall maintain a reasonable level of demand at all times. If there is too little spending and, thus, excessive unemployment, the government shall reduce taxes or increase its own spending. If there is too much spending, the government shall prevent inflation by reducing its own expenditures or by increasing taxes.
2. By borrowing money when it wishes to raise the rate of interest, and by lending money or repaying debt when it wishes to lower the rate of interest, the government shall maintain that rate of interest that induces the optimum amount of investment.
3. If either of the first two rules conflicts with the principles of ‘sound finance’, balancing the budget, limiting the national debt or other dogmas of traditional economics, so much the worse for these principles.

General framework for Government Policy

Full employment and low inflation (price stability) are, according to Lerner, the fundamental macroeconomic goals, together with a decent standard of living for all. To accomplish this, the following framework for government budget procedure and policy should be used.

1. The government decides how much of the economy's real potential output that is better allocated publicly rather than privately. In financial terms, this becomes the government expenditure, G.
2. Unemployment (caused by the output gap) and inflation is observed. Given G and the existing level of taxes net of interest and transfer payments,
   1. if the unemployment too big and inflation is below target, taxes are reduced or transfer payments are raised.
   2. if the output gap is too small and inflation is above target, taxes are raised or transfer payments reduced.
3. Repeat in the next period.

The actual policy implemented using this framework can be aiming for a small government (G is small), a big government (G is large), or anywhere within that spectrum. That main point is rather that the framework is valid for, and shows how to make proper use of, any fiat monetary system. It is emphasized that using the logic of convertible currency systems for a fiat monetary system does not make sense.

The "Government Budget Constraint" challenged

In mainstream economics, there is often talk about the "Government Budget Constraint" (GBC), that governments should adhere to, often expressed as deficit-to-GDP-ratio or debt-to-GDP-ratio. (Prominent examples are the European Growth and Stability Pact, which specifies such limits for the EMU countries, and the debt ceiling in the U.S) According to this view, the optimal level of today's deficit is lower when the existing stock of debt is higher.
Abba Lerner challenged this view. Beyond the economy wide inflation constraint, there is no constraint on public deficits such that if we act too aggressively to reduce the output gap (or raise the inflation rate) in this period, we will be forced to accept a larger output gap (or lower inflation rate) in some future period. Instead, the optimal level of today's deficit is independent of the existing debt stock.
The procedure outlined by the Functional Finance framework should be followed independently of the existing stock of government debt. In particular, it is never the case that due to a presumably "too large" existing stock of debt, government spending G would be set below the level that is otherwise desirable. Such ideas are appropriate for non-sovereign currency systems (for example gold- or currency-pegged non-fiat systems, or the EMU), but are fundamentally inadequate for sovereign fiat monetary systems.

The role of taxes and issuance of government securities

A monetarily sovereign government does not need to "compensate for" (or "finance") government budget deficits penny for penny by revenue (collecting taxes and fees) or borrowing (issuing government securities). This is completely contrary to what is necessarily the case for households, firms and governments that are not monetarily sovereign, such as eurozone nations, US states, provinces, and municipalities, all of which are currency users instead of issuers.
For a monetarily sovereign government, taxes and fees instead serve to decrease Aggregate Demand from the non-government sector, allowing the government spend on resources without causing inflation. Therefore, taxing is seen as a policy tool for regulating nominal aggregate demand by withdrawing non-government net financial assets instead of a fiscal operation for funding government operations and other expenditure. Taxes and fines are also used to discourage negative externality, which is also separate from funding. On the other hand, taxation is required to generate revenue for governments that are currency users rather than currency issuers.
For a monetarily sovereign government, the issuance of government securities drains reserves from the interbank settlement system. Treasury issuance is issued to maintain a desired interest rate (and to provide investors with a risk free interest carrying savings alternative), not to fund budget deficits in lieu of taxation. Debt issuance is therefore, just like taxing, a monetary tool rather than a funding operation. On the other hand, for governments that are currency users rather than currency issuers, borrowing through debt issuance is required to generate revenue in lieu of taxes.
For a monetarily sovereign government, government expenditure, including spending and transfer payments, can be seen as injecting net financial assets (NFA) into non-government, and taxing as removing NFA. The issuance of Treasury securities does not affect non-government NFA; it simply changes the composition of assets in non-government portfolios by exchanging government liabilities of non-zero maturity for zero maturity, as reserves are used to purchase Treasury securities .

Non-government Net Financial Assets

In a growing economy, total government expenditure will likely exceed taxation, thereby increasing total non-government net financial assets (NFA). An increase in non-government NFA increases nominal aggregate demand (NAD) and a decrease in NFA results in a decrease in NAD. Non-government NFA are held as physical currency (cash), bank reserves and Treasury securities.
In the presence of an output gap, when the economy is underperforming and there is less than full employment, fiscal deficits (NFA injections into non-government) do not provoke inflation as a general continuous price rise, including the cost of labor. However, inflation or stagflation may occur due to supply shortages.

References

Stephanie Bell (now Kelton), Functional Finance: What, Why, and How?
Mathew Forstater, Functional Finance and Full Employment: Lessons from Lerner for Today
Abba Lerner, Functional Finance and the Federal Debt