Monetary and Fiscal Policy for Sovereign Currencies

By L. Randall Wray

This week we begin a new topic: functional finance. This will occupy us for the next several blog posts. Today we will lay out Abba Lerner’s approach to policy. In the 1940s, he came up with what he called the functional finance approach to policy. In one of those amazing historical coincidences, Lerner happened to teach at UMKC when he published one of his most famous papers, laying out the approach. Maybe there is something special in the air in Kansas City?

Lerner’s Functional Finance Approach. Lerner posed two principles:

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First Principle: if domestic income is too low, government needs to spend more. Unemployment is sufficient evidence of this condition, so if there is unemployment it means government spending is too low.

Second Principle: if the domestic interest rate is too high, it means government needs to provide more “money”, mostly in the form of bank reserves.

The idea is pretty simple. A government that issues its own currency has the fiscal and monetary policy space to spend enough to get the economy to full employment and to set its interest rate target where it wants. (We will address exchange rate regimes later; a fixed exchange rate system requires a modification to this claim.) For a sovereign nation, “affordability” is not an issue—it spends by crediting bank accounts with its own IOUs, something it can never run out of. If there is unemployed labor, government can always afford to hire it—and by definition, unemployed labor is willing to work for money.

Lerner realized that this does not mean government should spend as if the “sky is the limit”—runaway spending would be inflationary (and, as discussed many times in the Modern Money Primer, it does not presume that government spending won’t affect the exchange rate). When Lerner first formulated the functional finance approach (in the early 1940s), inflation was not a major concern—the US had recently lived through deflation in the Great Depression. However, over time, inflation became a serious concern, and Lerner proposed a form of wage and price controls to constrain inflation that he believed would result as the economy nears full employment. Whether or not that would be an effective and desired way of attenuating inflation pressures is not our concern here. The point is that Lerner was only arguing that government should use its spending power with a view to moving the economy toward full employment—while recognizing that it might have to adopt measures to fight inflation.

Lerner rejected the notion of “sound finance”—that is the belief that government ought to run its finances as if it were like a household or a firm. He could see no reason for the government to try to balance its budget annually, over the course of a business cycle, or ever. For Lerner, “sound” finance (budget balancing) was not “functional”—it did not help to achieve the public purpose (including, for example, full employment). If the budget were occasionally balanced, so be it; but if it never balanced, that would be fine too. He also rejected any attempt to keep a budget deficit below any specific ratio to GDP, as well as any arbitrary debt to GDP ratio. The “correct” deficit would be the one that achieves full employment.

Similarly the “correct” debt ratio would be the one consistent with achieving the desired interest rate target. This follows from his second principle: if government issues too much debt, it has by the same token issued too few bank reserves and cash. The solution is for the treasury and central bank to stop selling bonds, and, indeed, for the central bank to engage in open market purchases (buying treasuries by crediting the selling banks with reserves). That will allow the overnight rate to fall as banks obtain more reserves and the public gets more cash.

Essentially, the second principle just says that government ought to let the banks, households, and firms achieve the portfolio balance between “money” (reserves and cash) and bonds desired. It follows that government bond sales are not really a “borrowing” operation required to let the government deficit spend. Rather, bond sales are really part of monetary policy, designed to help the central bank to hit its interest rate target. All of that is consistent with the modern money view advanced previously.

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Functional Finance versus Superstition. The functional finance approach of Lerner was mostly forgotten by the 1970s. Indeed, it was replaced in academia with something known as the “government budget constraint”. The idea is also simple: a government’s spending is constrained by its tax revenue, its ability to borrow (sell bonds) and “printing money”. In this view, government really spends its tax revenue and borrows money from markets in order to finance a shortfall of tax revenue. If all else fails, it can run the printing presses, but most economists abhor this activity because it is believed to be highly inflationary. Indeed, economists continually refer to hyperinflationary episodes—such as Germany’s Weimar republic, Hungary’s experience, or in modern times, Zimbabwe—as a cautionary tale against “financing” spending through printing money.

Note that there are two related points that are being made. First, government is “constrained” much like a household. A household has income (wages, interest, profits) and when that is insufficient it can run a deficit through borrowing from a bank or other financial institution. While it is recognized that government can also print money, which is something households cannot do, these is seen as extraordinary behaviour—sort of a last resort. There is no recognition that all spending by government is actually done by crediting bank accounts—keystrokes that are more akin to “printing money” than to “spending out of income”. That is to say, the second point is that the conventional view does not recognize that as the issuer of the sovereign currency, government cannot really rely on taxpayers or financial markets to supply it with the “money” it needs. From inception, taxpayers and financial markets can only supply to the government the “money” they received from government. That is to say, taxpayers pay taxes using government’s own IOUs; banks use government’s own IOUs to buy bonds from government.

This confusion by economists then leads to the views propagated by the media and by policy-makers: a government that continually spends more than its tax revenue is “living beyond its means”, flirting with “insolvency” because eventually markets will “shut off credit”. To be sure, most macroeconomists do not make these mistakes—they recognize that a sovereign government cannot really become insolvent in its own currency. They do recognize that government can make all promises as they come due, because it can “run the printing presses”. Yet, they shudder at the thought—since that would expose the nation to the dangers of inflation or hyperinflation. The discussion by policy-makers—at least in the US—is far more confused. For example, President Obama frequently asserted throughout 2010 that the US government was “running out of money”—like a household that had spent all the money it had saved in a cookie jar.

So how did we get to this point? How could we have forgotten what Lerner clearly understood and explained?

In a very interesting interview in a documentary produced by Mark Blaug on J.M. Keynes, Samuelson explained:

"I think there is an element of truth in the view that the superstition that the budget must be balanced at all times [is necessary]. Once it is debunked [that] takes away one of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and inefficiency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires. We have taken away a belief in the intrinsic necessity of balancing the budget if not in every year, [then] in every short period of time. If Prime Minister Gladstone came back to life he  would say "uh, oh what you have done" and James Buchanan argues in those terms. I have to say that I see merit in that view."

The belief that the government must balance its budget over some timeframe is likened to a “religion”, a “superstition” that is necessary to scare the population into behaving in a desired manner. Otherwise, voters might demand that their elected officials spend too much, causing inflation. Thus, the view that balanced budgets are desirable has nothing to do with “affordability” and the analogies between a household budget and a government budget are not correct. Rather, it is necessary to constrain government spending with the “myth” precisely because it does not really face a budget constraint.

The US (and many other nations) really did face inflationary pressures from the late 1960s until the 1990s (at least periodically). Those who believed the inflation resulted from too much government spending helped to fuel the creation of the balanced budget “religion” to fight the inflation. The problem is that what started as something recognized by economists and policymakers to be a “myth” came to be believed as the truth. An incorrect understanding was developed.

Originally the myth was “functional” in the sense that it constrained a government that otherwise would spend too much, creating inflation and endangering the dollar peg to gold. But like many useful myths, this one eventually became a harmful myth—an example of what John Kenneth Galbraith called an “innocent fraud”, an unwarranted belief that prevents proper behaviour. Sovereign governments began to believe that the really could not “afford” to undertake desired policy, on the belief they might become insolvent. Ironically, in the midst of the worst economic crisis since the Great Depression of the 1930s, President Obama repeatedly claimed that the US government had “run out of money”—that it could not afford to undertake policy that most believed to be desired. As unemployment rose to nearly 10%, the government was paralysed—it could not adopt the policy that Lerner advocated: spend enough to return the economy toward full employment.

Ironically, throughout the crisis, the Fed (as well as some other central banks, including the Bank of England and the Bank of Japan) essentially followed Lerner’s second principle: it provided more than enough bank reserves to keep the overnight interest rate on a target that was nearly zero. It did this by purchasing financial assets from banks (a policy known as “quantitative easing”), in record volumes ($1.75 trillion in the first phase, with a planned additional $600 billion in the second phase). Chairman Bernanke was actually grilled in Congress about where he obtained all the “money” to buy those bonds. He (correctly) stated that the Fed simply created it by crediting bank reserves—through keystrokes. The Fed can never run out “money”; it can afford to buy any financial assets banks are willing to sell. And yet we have the President (as well as many members of the economics profession as well as most politicians in Congress) believing government is “running out of money”! There are plenty of “keystrokes” to buy financial assets, but no “keystrokes” to pay wages.

That indicates just how dysfunctional the myth has become.

Next week, we’ll show that some Kansas City air might have drifted northeast to the bastion of free market economics: the University of Chicago

This post first appeared at New Economic Perspectives.

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