A Reformatted Excerpt concerning Functional Finance and Purpose  in the Use of Money — copied from —

LERNER, Abba Ptachya (1903-1982)
by
Mathew Forstater
(in Dictionary of American Economists)

Functional Finance has been subject to a number of misconceptions, e.g., that it promotes big deficits.

Functional Finance simply refers to an approach to public finance that sees the federal budget and the management of the national debt as a means  to economic prosperity.  This notion needn't assume any particular a priori relation between government expenditures and revenues or a priori most desirable absolute or relative size of the national debt:

The central idea is that government fiscal policy, its 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 and what is 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 opposed to scholasticism.

The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance... Government should adjust its rates of expenditure and taxation such that total spending in the economy is neither more nor less than that which is sufficient to purchase the full employment level of output at current prices.

If this means there is a deficit, greater borrowing, “printing money”, etc., then these things in themselves are neither good nor bad, they are simply the means to the desired ends of full employment and price stability. (Lerner, 1943, p. 354, original emphases)

Thus, Functional Finance does not say anything about what the budget should be prior to economic analysis.  If it is concluded that under particular circumstances, a balanced budget describes the best means to economic prosperity, then even a balanced budget is not inconsistent with a functional approach to public finance.

‘Sound money’ is therefore only inconsistent with Functional Finance if the balanced budget is seen as an end in itself,  rather than as a means to an end.  If a balanced budget—or a surplus, to reduce the national debt—is insisted upon, even if it may be shown to have negative economic consequences (or be impossible), then this is not Functional Finance (it is, actually, ‘dysfunctional finance’).  Likewise, Functional Finance does not stipulate that bigger deficits are ‘better’ or that deficits are ‘good’, in and of themselves; what concerns us are the effects.

Such an approach has an immediate result that at first glance may appear shocking or surprising:

neither taxing nor government “borrowing” are funding operations. 

Decisions concerning taxation are to be made only with regard to the economic effects in terms of the promotion of full employment, price stability, or other economic goals, and not ever because ‘the government needs to make money payments’ (Lerner, 1943, p. 354).  Likewise, ‘the government should borrow only if... the effects’ of borrowing are desired, for example ‘if otherwise the rate of interest would be too low’ (Lerner, 1943, p. 355).

These points of view were repeated and elaborated by Lerner in his 1951 book, The Economics of Employment:

Taxes should never be imposed for the sake of the tax revenues. It is true that taxation makes money available to the government, but this is not an effect of any importance because money can be made available to the government so much more easily by having some created by the Treasury. (1951, p. 131, original emphasis).

Likewise, ‘borrowing’ is also not a funding operation for Lerner.

What are the purposes  of taxation and borrowing, if not to fund government spending? 

The purpose  of taxation for Lerner is its ‘effect on the public of influencing their economic behavior’  (Lerner, 1951, p. 131, original emphasis) including, as we will see below, creating a demand for government fiat currency.  

Like taxation, borrowing is not a funding operation; rather, it is a means of managing reserves and controlling the overnight interest rate when the government runs a budget deficit:

The spending of money...out of deficits keeps on increasing the stock of money [and bank reserves] and this keeps on pushing down the rate of interest.

Somehow the government must prevent the rate of interest from being pushed down by the additions to the stock of money coming from its own expenditures.... There is an obvious way of doing this. The government can borrow back the money it is spending (Lerner, 1951, p. 10-11, original emphases).

Two extraordinary results follow from Lerner’s analysis here.  First, the implication is that ‘borrowing’ logically follows, rather than precedes, government spending.  In fact, this analysis questions the accuracy and relevance of the term ‘borrowing’ itself for discussing government bond sales.  Second, note that the budget deficit is causing interest rates to fall, the exact opposite from what traditional theory has long predicted (i.e., ‘deficits cause high interest rates’).

The role of taxation and borrowing, reserve management and interest rate maintenance will become clearer upon examination of two, less well-known, Lerner contributions, ‘Money as a Creature of the State’ (1947) and his Encyclopaedia Britannica entry on ‘Money’ (1946), which place him squarely in the Keynes-Knapp Chartalist school, and which is key to fully understanding the possibility and effectiveness of Functional Finance.  The ability of the government to conduct fiscal and monetary policy according to the principles of Functional Finance is made possible by the fact that, as the title of Lerner’s paper states, ‘money is a creature of the state’:

The government—which is what the state means in practice—by virtue of its power to create or destroy money by fiat and its power to take money away from people by taxation, is in a position to keep the rate of spending of the economy at the level required to fill its two great responsibilities, the prevention of depression, and the maintenance of the value of money. (Lerner, 1947, p. 314)

In adopting this view Lerner followed Keynes, who in his Treatise on Money accepted the main thrust of Knapp’s ‘State Theory of Money’ (Keynes, 1930, p. 4, p. 6n1; Knapp, 1924).  The state has the power not only to tax, but to designate what will suffice to retire tax obligations, that is, what it will accept at its pay offices. By determining public receivability, the state can create a demand for otherwise worthless pieces of paper, leading to general acceptability. The state can issue this currency, and use it to purchase goods and services from the private sector:

The modern state can make anything it chooses generally acceptable as money and thus establish its value quite apart from any connection, even of the most formal kind, with gold or backing of any kind. It is true that a simple declaration that such and such is money will not do, even if backed by the most convincing constitutional evidence of the state's absolute sovereignty. But if the state is willing to accept the proposed money in the payment of taxes and other obligations to itself the trick is done. Everyone who has obligations to the state will be willing to accept the pieces of paper with which he can settle the obligations, and all other people will be willing to accept those pieces of paper because they know that taxpayers, etc., will accept them in turn. On the other hand if the state should decline to accept some kind of money in payment of obligations to itself, it is difficult to believe that it would retain much of its general acceptability...What this means is that whatever may have been the history of gold, at the present time, in a normally well-working economy, money is a creature of the state. Its general acceptability, which is its all-important attribute, stands or falls by its acceptability by the state. (Lerner, 1947, p. 313)

Thus, a variety of state powers, such as 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, constitute a menu of instruments with which full employment and stability of the value of the currency may be promoted.

The importance of the Lernerian contributions of Functional Finance and ‘money as a creature of the state’ are hard to overstate. Keynes called this ‘second of the two books which you have placed within one cover…very original and grand stuff’:

I shall have to try when I get back [to England, from his trip to the U.S.] to hold a seminar for the heads of the Treasury on Functional Finance.  It will be hard going—I think I shall ask them to let me hold a seminar for their sons instead, agreeing beforehand that, if I can convince the boys, they will take it from me that it is so! (Colander and Landreth, 1995, pp. 116-7)

Keynes does not trust that the heads of the Treasury can understand, because, as Lerner often noted, ‘Functional Finance is seen to run counter to economic principles’ (1951, p. 142).  Functional Finance, or Keynesian economics taken to its furthest logical conclusions (causing one author to ask, ‘Was Keynes a Keynesian or a Lernerian?’ [Colander, 1984]), was, in its application to unemployment, Lerner admitted, ‘topsy-turvy economics’ (1951, pp. 142-5). 

But this is no objection at all.  Topsy-turvy economics is just what is appropriate for an economy that is suffering from unemployment. An economy suffering from unemployment is an upside-down economy for which only a topsy-turvy economic theory is of any use. (1951, pp. 142-43)

By an ‘upside-down economy’, Lerner means an economy in which strongly held traditional economic principles, such as those regarding thrift and the economical use of scarce resources, do not hold.  Lerner noted that when there is unemployment, efficiency becomes inefficient: ‘an increase in efficiency in any particular productive process does not result in any increase in efficiency in the economy as a whole…The savings due to greater technical efficiency merely go to waste in more unemployment’ (1951, pp. 143-4).  Likewise, when there is unemployment a country has to suffer over its trade balance, because it must worry about rising unemployment stemming from an increase in the value of its imports over the value of exports. Since ‘[t]he input of the foreign trade industry consists of the effort involved in the manufacture of our exports’ and ‘[t]he output of our foreign trade industry consists of the imports which it yields to us for our use’, exports are a cost and imports are a benefit (1951, p. 321).  Thus, when a nation attempts to cure its unemployment problems by reducing its trade deficit, it is promoting costs and restricting benefits!

One final interesting result of Lerner’s Functional Finance is worthy of note here: 

‘Printing money’ in and of itself has no effect on the economy whatsoever and therefore should not be considered when conducting macroeconomic analysis and policymaking (contrary to those who claim that printing money is inflationary, for example). 

For Lerner, there are six (or three pairs of) fiscal instruments of government: taxing and spending, buying and selling, borrowing and lending. 

Only if the money printed is spent on goods and services or lent through issuing bonds or otherwise given away will there be some economic impact, but these impacts are already covered through the consideration of the six fiscal instruments:

‘The printing of money is not an instrument of policy.  It is only a servant of those policies, just like printing stationery used in the various government departments’ (1944, pp. 312-4):

To sacrifice the prevention of deflation because of shortage of money which could be printed is no more sensible than to refrain from carrying out any other important government action because the necessary paper forms or stationery would have to be printed. (1951, p. 133)

Lerner’s promotion of Functional Finance led to his engagement in debates concerning the ‘burden’ of the national debt and the harmful effects of large and persistent government budget deficits (e.g., 1961a).

One point worthy of note here, is that Functional Finance not only opposes the ‘deficit hawk’ view of government budget deficits as almost always and everywhere harmful (causing high interest rates, inflation, crowding out private spending, and/or a burden on future generations), but also the ‘deficit dove’ view that if the Federal government kept a capital budget or measured deficits and the national debt differently, they would not look as big. 

Lerner felt the doves ceded too much to the ‘sound money’ view, and that this would eventually come back to haunt them, a position that seems quite prescient in light of budgetary politics in the last two decades of the 20^th century (Lerner, 1951, pp. 15-6).

During the 1950s, and possibly as early as the late 1940s, Lerner began to become concerned with what he later called ‘sellers’ inflation’ (e.g., 1961b).  In his early versions of Functional Finance, inflation was seen as the result of excess aggregate demand, and therefore reducing spending and/or increasing taxation was seen as the cure. 

But as it became apparent to him that there were other sources of inflation, such as those due to supply-side or cost-push factors, this simple policy for demand-side inflation was no longer sufficient for managing the value of currency. 

In addition to other types of inflation, Lerner also began to note that inflation did not begin at true full employment, but well before that point.  Thus, he even began to use terms like ‘low full employment’ and ‘high full employment’, anticipating the idea of a NAIRU (non-accelerating inflation rate of unemployment) or ‘natural’ rate of unemployment (Lerner, 1951).

In the face of these developments, Lerner dedicated himself to the study of stagflation, and the evaluation and formulation of various income policies, market anti-inflation plans (or MAPs), and wage-price controls (Lerner and Colander, 1980).  These issues preoccupied Lerner for the rest of his career.  He suffered a stroke while in Jerusalem in 1980, and although his speech was impaired he was able to continue working until shortly before his death in Florida in 1982. 

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