Functional Finance Fantasy

by Mario Rizzo

When people discuss the fiscal stimulus package of the Obama Administration they frequently use the word “Keynesian” to label those theories that support this policy. But the reality is that these theories owe more to the economist Abba P. Lerner than to John Maynard Keynes. Lerner, building on Keynes, called it “functional finance.” Lerner, unlike Keynes, was a socialist. 

According to the theory of functional finance, periods of expansionary fiscal policy to fight recession must be later followed by contractionary (tightening) fiscal policy to prevent inflation, high interest rates and other forms of distortions. So the period of huge spending and deficits we now have must be gradually unwound as the economy recovers. And ultimately the budgetary deficit must become a surplus. (To be clear, this might not require a surplus in the total spending account but only in those items of spending that are not forms of “social investment.”  This is a slippery concept, however.)  

My post today centers not around whether this is a good idea. Instead, I am concerned about whether it is a realistic idea. 

Recently Ben Bernanke, the Fed chairman, urged Congress to begin planning to reduce the fiscal deficit.  

“But it is very, very important for Congress and the administration to come to some kind of program, some kind of plan that will credibly show how the United States government is going to bring itself back to a sustainable position.” …

If the U.S. were to emerge from its recession and deficits weren’t brought down, Sen. David Vitter (R., La.) asked, “how quickly would that become a major problem in terms of the economy?”

“It could become a problem tomorrow if bond markets are not persuaded that Congress is serious about bringing down the deficit over time,” Mr. Bernanke answered.

Of course, this is easier said than done (as Bernanke knows) for at least three very simple reasons.  First, the political interests that benefit from stimulus spending will not want to give it up. Not all will be successful in keeping their share, but interest groups will have had the time to coalesce around their benefits and lobby for continuation. Second, the Administration is pushing for a healthcare bill that is not adequately financed and will likely add to the deficit. Third, the existing entitlements (Medicare and Medicaid) will be difficult to cut as their costs go out of control when more and more boomers retire.

So what happens to theory of functional finance?  

Spending is greatly expanding now but it will not be temporary simply to combat the recession. The reductions later, if any, will be half-measures taken half-heartedly. So over the long run the size and scope of government will expand permanently. Many advocates of fiscal stimulus do not mind this; they want a larger state. But one price we shall pay is that high deficits as well as higher taxes and interest rates in the future will reduce economic growth relative to what it otherwise would have been both now (as the economy anticipates it) and in the future.

Political reality interrupts the fantasy of functional finance.

24 thoughts on “Functional Finance Fantasy

  1. “…I am concerned about whether it is a realistic idea…”.

    Whether you call is Keynesian, or Functional Finance, it has been “done” by governments with observable success (though not perfection) since Keynes’s time.

    Are you saying “reality” may not be “realistic”?

    BTW: if Functional Finance HAD been employed at the time of the last “peek” – if Bush had continued the surplus and a accumulated a large “national asset” instead of a large “national debt”, the current “trough” would be easier to weather, and “the stimulus” a lot less precarious.

  2. The problem comes when the economy no longer grows fast enough to generate the tax revenue needed to pay for the growing cost of government — including the debt service. Some may remember the “unpleasant monetarist arithmetic” literature on point.

    I don’t read history the way Dave Pullin does, but the way Adam Smith did. Governments can barely finance themselves in normal times. In an emrgency, they resort to debt finance. The debts accumulate and end with “pretended payment” (currency debasement) or outright default. Smith observed that pretended payment is default by another name.

    As Ken Rogoff recently observed, the U.S. has defaulted once in the past — in the 1930s. It may do so again, or make a pretended payment instead. Either, it is a default on the promise to pay.

  3. Dave Pullin ignores some unpleasant (at least to advocates of liberty) unintended consequences of Functional Finance and the growth of government it brings, namely the
    inevitable degredation of rights and liberties of the Forgotten Man. As the State grows larger, it will tend to trample on rights, displace private enterprise and voluntary organizations, and replace them with the jackboot of Our Enemy, the State. A lot of intellectuals like this, as it endows them with power and authority, and puts them in charge of the masses.

  4. ‘Are you saying “reality” may not be “realistic”?’

    Dave, it’s fun to play “gotcha!” but does it really serve any purpose? Mario is asking whether or not it is realistic to think that this government at this time will actually cut its deficit, and not whether any government at any time has actually ever cut its deficit. He may be right or wrong to doubt this is realistic, but it is just silly to characterize his doubts as doubting that “reality” is realistic!

  5. The long-term vs cyclical issues need to be distinguished here. Functional finance is a supposedly semi-automatic process that balances the budget over business cycles. Mario’s argument suggests that cyclical increases in spending will likely become long-term fixtures, but programs like Medicare and Medicaid are long-term anyway and imply a structural (long-term) budget deficit regardless of the impact of recession.

    Unemployment benefits are a cyclical spending item and they usually go down as economic growth resumes. However, the pork projects in the stimulus package, for instance, may have staying power.

  6. Chidem,

    There are many nuances of “functional finance.” David Colander has a paper:

    Click to access Functional%20Finance,%20New%20Classical%20Economics%20and%20Great%20Great%20Grandsons.pdf

    It is true that Social Security, Medicare, and Medicaid are part of a “structural deficit.” That is why I mentioned at least the last two separately. However, it would seem that these deficits would still need to be offset in times of non-recession if the idea of balancing the budget over the business cycle means anything.

  7. I wonder if this is one of the forces that has shaped the success of states over the centuries. Many formerly important nations became much less important when their finances became bad.

    What may happen is that people in the developed world see states as prudent because they suffer from selection bias. Since a prudent state is more likely to become a developed one.

  8. Empires end in fiscal crisis rather than defeats on the abttlefield. The French revolution was a product of a fiscal crisis brought on by wars and court extragance.

  9. Mario, your argument is intriguing but the interaction between the cyclical and secular processes is not obvious. Basic functional finance theory suggests that over the cycle surpluses and deficits will more or less balance out– leaving aside the capital budget and any structural deficit, which is what the US faces today. You’re saying that cyclical deficits will add to the secular deficit. Some components may do that, but they need to be specified. For instance, increased spending on unemployment benefits probably is just cyclical.

  10. Roger Garrison claims that Keynes actually was a socialist.

    Jerry, your statement about empires is quite a claim, what kind of evidence backs it up? France became a greater empire after the revolution, while the Romanov, Habsburg, Hohenzollern & Ottoman empires all perished due to defeats in the first world war.

  11. “Romanov, Habsburg, Hohenzollern & Ottoman empires all perished due to defeats in the first world war.”

    Well, I don’t know about Jerry’s general thesis — I just haven’t studied the matter enough to comment — but there is a good case to be made that the Romanov, Habsburg & Ottoman empires were on their way out already, and lost because of their economic weakness.

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  14. The basic argument in the above article (namely that FF leads to a permanently bloated public sector) is total nonsense. As Abba Lerner, the founding father of FF said, FF is applicable to almost any sort of economy: capitalist, communist, fascist, you name it.

    FF simply says that in a recession NET, I REPEAT, NET public spending should be raised. Whether it is raised by boosting public spending or reducing taxes is pretty well immaterial. Either option has the effect of expanding NET public spending.


    Niggling irrelevant point for pendants: of course the effect of raising public spending by $X is not EXACTLY the same as cutting taxes by $X. But that’s a technical detail.

  15. Lerner’s functional finance is not simply classical Keynesianism or neoclassical synthesis Keynesianism, where the budget is balanced over the business cycle. Functional finance is far more radical than classical Keynesian economics:

    The modern form of functional finance is modern monetary theory/neochartalism:

    You say:

    Instead, I am concerned about whether it is a realistic idea.

    Experience from around the world shows that governments are perfectly capable of running surpluses when necessary, so “yes” it is a realistic idea.

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