Functional Finance, not fiscal rules is the responsible way to manage an economy

During Ed Balls’ speech a couple of weeks ago, he set out his thinking about how a Labour Government would need to operate within tight constraints if it won the election in 2015. Making clear he thought difficult choices would have to be made, he said Labour would have to show an ‘iron discipline’ on spending. He also spoke of ‘fiscal rules’, saying:

“Instead, Labour will set out, in our general election manifesto, tough fiscal rules that the next Labour government will have to stick to – to get our country’s current budget back to balance and national debt on a downward path.”

A lot of commentators praised the speech, including Polly Toynbee in The Guardian who wrote:

“Ed Balls’s brain was never in doubt, and his impressive speech set out a credible economic plan, tough as titanium – too tough for some Labour tweeters. Whatever flak he takes will not be for softness: one look in his steely eye and you know he’ll mince any colleague uttering an uncosted spending promise.”

So from this it would seem the way to go on the public finances is ‘responsible’ government, sound finances and fiscal rules. It seems there is agreement from left to right. Not on the specifics maybe, but certainly on the need to cut the deficit and get the public finances on a ‘sustainable’ footing. But is this approach actually ‘responsible’ at all? I say no. There is a much better approach available.

It’s called ‘Functional Finance’. It’s been around for a long time and was championed by the economist Abba Lerner in an article in ‘Social Research’ in 1943I’m going to quote quite extensively from this paper now to give you a flavour of what he was trying to say. It very straightforwardly cuts through the bullshit inherent in arguments about sound finance that were around even then (some things never change). Lerner writes:

The central idea [of functional finance] 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 or unsound.

The first responsibility of the government (since nobody else can undertake the 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. If 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 taxpayers have more money left to spend [and vice versa to reduce total 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) 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 particularly 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.”

My last post was on tax and how it’s not correct to think of governments needing taxation to finance its spending. Here’s Lerner on the same topic:

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.”

So that’s Functional Finance then. Simple, logical and theoretically sound. It places a focus on real outcomes rather than arbitrary numbers the government has little control over. If our leaders could share Lerner’s clarity of thought, our economic malaise could be brought to a close swiftly.

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9 thoughts on “Functional Finance, not fiscal rules is the responsible way to manage an economy

  1. Sound, except that as the sovereign creator of the currency, the government always has an infinite amount of it available to itself. It’s therefore incorrect to say that tax surpluses add to this infinite amount. Infinity plus anything is still just infinity. Surpluses in fact simply destroy an amount of money equal to the surplus; money which can later be recreated at the government’s whim.

    1. Depends what level of abstraction you’re playing at. At the consolidated government it does indeed disappear in a puff of accounting logic. At lower levels of abstraction – where Treasury, Central Bank and all the departments run separate accounts it can appear to exist.

      The confusion always starts when the Chinese walls appear.

  2. “Sound, except that as the sovereign creator of the currency, the government always has an infinite amount of it available to itself. It’s therefore incorrect to say that tax surpluses add to this infinite amount. Infinity plus anything is still just infinity. Surpluses in fact simply destroy an amount of money equal to the surplus; money which can later be recreated at the government’s whim.”

    When Lerner wrote, there were still gold standard limitations on money creation. Infinite availability only became the general case in the 1970s.

  3. Or maybe Ed Balls has found that he can’t buck the common sense appeal of the charge that’ you can’t borrow your way out of debt’. So he has to appeal to the electorate’s unshakeable belief that pain is needed to undo labour’s mess. He knows this is rubbish of course, and is being used to launch class warfare, but then maybe that’s how democracy works. If so, it’s all very sad indeed.

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