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.

Countering myths about the reasons for austerity

The idea for this post came to me while watching Question Time last night and seeing the bizarre sight of Lib Dem Ed Davey and ‘celebrity’ MP Nadine Dorries teaming up to roll out the usual reasons why austerity was and is the only course of action available.

A lot of people on the left seem to concede that the economic crisis did mean that urgent action was required to reduce the deficit, and their policy proposals operate within those parameters. Alternative policies generally include raising taxes on the rich and cracking down on tax avoidance. Some even agree that we should get rid of universal benefits to save money. Every proposal seems to be of the form that “we will cut this or raise taxes on that to pay for this.”

This is a very unsuccessful strategy in my view because it implicitly accepts a lot of the myths that have grown up around how the economy works. These myths are repeated ad nauseum by politicians to the point now that they have almost become received wisdom. Unless the counter argument to austerity is altered to reflect the reality of the way the economy actually works, the deficit hawks will win every time.

I’m going to split this post into two parts. Here’s the first three (of six) common talking points you will have heard from those in favour of austerity and how you can counter them.

1) The UK could end up like Greece

On the face of it, this is a scary thought. Greece had a large deficit and the interest rates on its debts soared to the point where it became – to all intents and purposes – bankrupt. In reality though there is zero prospect of the UK ever becoming like Greece. If someone says there is, the appropriate response is to laugh in their face.

Greece joined a currency union with significantly wealthier nations which led to them using an overvalued (for them) currency over which they had no control leading to them having a massive competitive disadvantage. This led to ever increasing deficits and meant when the financial crisis struck, they were unable to pull any of the policy levers available to countries with their own currency like the UK. They couldn’t devalue, couldn’t change interest rates and most importantly couldn’t issue money. The lack of these tools means the ability of Greece to borrow on international markets very much depends upon the markets assessment of their ability to repay, and so bankruptcy becomes a very real risk.

The mere fact that the UK does issue its own currency, doesn’t borrow in others and its exchange rate floats means it could never end up like Greece.

2) The Coalition inherited the worst deficit in the Western world

Answer: No it didn’t. It inherited the largest deficit*. This is not the same thing at all. A deficit, whether large or small is neither a good or a bad thing. It could be either, but at the end of the day, all the deficit is, is an outcome, and all it tells you is that the non-government sector (the private sector here, plus the trade deficit) is running a surplus. The government’s deficit is the mirror image of the non-government surplus. A graphical representation of this can be found here. To a large extent the government has no control over its budget outcome. It depends upon the saving preferences of the private sector.

The appropriate response for the government to take when faced with excess private sector savings would be to either accommodate them by maintaining an expansionary fiscal stance, or to seek to confiscate some of the surplus through taxation (more difficult). Seeking to reduce the Government’s deficit while the private sector are still paying down debt, simply undermines those efforts and prolongs the slump unnecessarily. This is what we see now.

3) If we hadn’t implemented austerity, the markets would have panicked, interest rates would have gone up.

The underlying assumption here is that markets alone set bond rates based upon their view of the ‘credibility’ of the government’s fiscal stance. To a degree this is true for countries in the Eurozone for the reasons cited at point 1, but for a country like the UK, it’s just nonsense. For a start, countries that issue their own currencies like the UK present no involuntary default risk. Zero.

Secondly, even mainstream economic theory doesn’t say that markets set interest rates in the way politicians want us to believe. Jonathan Portes wrote a very good blog post on this topic in September here. Basically, long term interest rates are thought to be based on expectations about future short term rates. Short term rates are set by the Bank of England, and the Bank can make it clear what their thinking on future rates will be. The markets expect future rates to be low, so long term rates now are low. Nothing to do with the markets having ‘confidence’ in the government’s economic policies. Because markets don’t behave the way politicians suggest, there is no reason to believe alternative fiscal policies would place upward pressure on interest rates.

Part 2 will discuss these further common points we often hear related to austerity:

  • Gordon Brown spent all the money and now there’s none left. Just ask Liam Byrne
  • Cutting x will save £y
  • What would you cut?

*EDIT: A reader has pointed out that the US actually had the largest deficit in 2010, and the UK only the 2nd largest (h/t Richard Evans via Twitter), but my point still stands. Many politicians continue to claim the UK’s deficit was the worst, including Ed Davey on Question Time this week . So another counter argument is that the US had a higher deficit in 2010, but took a different path. It’s deficit has now shrunk from around 11.4% of GDP in 2010, to about 7% last year. The US economy grew by 3.1% in Q3 of 2012. Although the US lost its AAA credit rating, the interest rate of US government debt has remained very low.