Functional finance and modern monetary theory
Today I am continuing my recent theme of considering the flaws in the standard progressive attack on neo-liberalism. I will write sometime about manufacturing but it is Sunday and it has been a beautiful day here and I don’t feel like setting off the flamethrowers out there that clearly think manufacturing is important. It might be, but the standard arguments are based on a vertically integrated conception of the sector that we haven’t had for years anyway. But later. Today, I consider the “public debt is good” approach that progressive use to counter the manic “public debt is always bad” arguments proferred by the mainstream of my profession.
The vehicle I use to explore this issue is yesterday’s economic commentary by the Sydney Morning Herald’s Ross Gittins – No infrastructure unless you borrow (published October 31, 2009).
Gittins begins:
Get this straight: if you think we should be spending a lot more on economic infrastructure, you can’t be chicken-hearted about government debt. Similarly, if you think debt-free is the only acceptable way for governments to be, resign yourself to living in an economy characterised by bottlenecks at ports, inadequate rail and road systems, rising congestion on urban roads, inadequate public transport and the threat of urban water shortages.
As a literary device he often opens articles or paragraphs with statements such as “get this straight” or “get this” and similar. It is a way of trying to capture authority and to portray to the reader that he knows something about the topic he is writing about. I just think … poor fool reader – hoodwinked again.
Anyway, his opening juxtaposition is a standard ploy by “self-styled” progressives who think they are being reasonable in the face of the conservative morality and denial that public investment is useful.
But of-course, the argument is, in itself conservative and fails to reflect an understand of the way the modern monetary system operates and the opportunities that fiat monetary system offers to governments.
Gittins continues:
It’s not good enough for big business to be demanding hugely increased spending on infrastructure while looking the other way as its Coalition mates do all in their power to put the frighteners on the punters over government deficits and debt. That was the simplistic, short-sighted and self-serving line of Peter Costello that did so much to help create our infrastructure backlog. The more success his successors have in using it against the easily frightened Rudd Government, the more inadequate its infrastructure efforts will be.
The simple point is that, to a large extent, spending on capital works has to be financed by borrowing. That’s the way the private sector always does it and governments have to do it, too.
Well I agree with the first point – the sheer hypocrisy of the conservative side of politics and the games big business play to extract as much corporate welfare for themselves and deny as much social welfare to the disadvantaged. It is not as if big business does much that is worth anything anyway (in my view). I value public goods well above the private goods that are available.
I also agree with the criticisms of the past conservative government (Costello was Treasurer – see later on him) and the weak-kneed current government. I haven’t written anything about the federal government’s handling of the current refugee crisis in the north west – but suffice to say is is a bit more tricky (read sneaky) than the brazen way Howard and his government handled the matter – but none the less shameful. Maybe a separate blog on this but it would just be a stream of personal consciousness rather than any professional level understanding (as is my usual blogs) and I tend to avoid this sort of writing – that is what Saturday morning cups of tea are about!
But the final paragraph is straight ignorance – and just takes us back down the deficit-dove road back to nowhere – that is, nowhere progressive.
First, spending on capital works could easily be realised without a cent of debt being issued. Not a cent is required to allow a sovereign government to spend whatever it likes subject to goods and services being available for sale. This is not the same thing as saying the government can always build infrastructure without concern for other dimensions in the aggregate economy.
For example, if the economy was at full capacity and the government tried to undertake a major nation building exercise then it might hit inflationary problems – it would have to compete at market prices for resources and bid them away from their existing uses.
In those circumstances, the government may – if it thought it was politically reasonable to build the infrastructure – quell demand for those resources elsewhere – that is, create some unemployment. How? By increasing taxes. It might also issue debt – more about which later. But neither of these actions (tax rate rises or debt-issuance) would be about raising funds for the spending. They would not even be remotely about that.
As we will see in a moment – these policy actions are about reducing the amount of spending capacity in the private sector.
Second, the analogy that if it is okay for the the corporate sector to borrow to invest and earn profits, then it must be okay for government to follow the same strategy, even if the profits are in the form of social returns, is flawed at the most elemental level. It is often used by progressives in a way that they think skewers the conservatives. Then the debate, they think, has to shift to the returns on the “investment” rather than the act of “financing” it via debt.
The problem is that the corporate sector has to finance its spending (whether it be consumption or investment) from a variety of sources, one of which is debt. It is the user of the currency and so it is always revenue-constrained.
Conversely, the sovereign government is the monopoly issuer of the currency and is never revenue-constrained. So it never has to “obey” the constraints that the private sector always has to obey.
The household/corporate/government analogy is a non-sequiter. It is a basic tactic used by mainstream economists to come up with all the nonsense that appears in the text books which ultimately is used to argue against deficits and to justify moralistic fiscal rules.
In the influential textbook by Mankiw “The Principles of Economics” (First edition) we read on page 767 in the chapter “Five Debates over Macroeconomic Policy” that:
The most direct effect of the government debt is to place a burden on future generations of taxpayers. When these debts and accumulated interst come due, future taxpayers will face a difficult choice. They can pay higher taxes, enjoy less government spending, or both, in order to make resources available to pay off the debt and accumulated interest. Or they can delay the day of reckoning and put the government into even deeper debt by borrowing once again to pay off the old debt and interest. In essence, when the government runs a budget deficit, it allows current taxpayers to pass the bill for some of their government spending on to future taxpayers. Inheriting such a large debt cannot help but lower the living standard of future generations.
In addition to this direct effect, budget deficits also have various macroeconomic effects. Because budget deficits represent negative public saving, they lower national saving (the sum of private and public saving). Reduced national saving causes real interest rates to rise and investment to fall. Reduced investment leads over time to a smaller stock of capital. A lower capital stock reduces labor productivity, real wages, and the economy’s production of goods and services. Thus, when the government increases its debt, future generations are born into an economty with lower incomes as well as higher taxes.
Now this nonsensical view of the way the monetary system operates is based on the same fundamental building blocks as Gittin’s view expressed above. The only difference between the two (and between deficit-doves and the more extreme mainstreamers) is that the former think there is some return on the public investment which transfers to future generations and justifies the higher tax burden they have to bear as a consequence of the public debt accumulation.
None of these arguments are remotely correct in a fiat monetary system.
Gittins continues:
… if you want adequate infrastructure you have to be prepared to live with a fair bit of debt. And if you want to build all the additional economic – and social – infrastructure needed to cope with a 60 per cent increase in the population over the next 40 years, you have to be prepared to live with a huge whack of debt. As every economist understands, there’s nothing wrong with borrowing a high proportion of the cost of infrastructure, provided that infrastructure efficiently fulfils a genuine need. That is, provided it earns an adequate “social” rate of return (not necessarily an actual, money-in-the-hand rate of return).
The point is that capital works – from a new police station to a new port – deliver a flow of services stretching over 20, 30 or 40 years. Borrowing to cover, say, half the cost of the work is a way of sharing its cost between the present and future generations who will benefit from its services.
There’s a price to be paid for this sharing – and for gaining the services of the facility before we’ve saved sufficient money to be able to buy it for cash – of course, and that’s the interest bill. Nothing wrong with that …
When the Opposition carries on about all this debt and interest burden we’re leaving for our children, it forgets to mention the benefits that go with the debt. It’s not clear our children would be better off if we left them a debt-free government, but also a world with inadequate infrastructure.
So you see that the difference between the two views turns on whether the public investment delivers future returns that offset (to some extent) the costs that are imposed on future generations.
However, there is no understanding that a sovereign government does not have to reach a point where it says – today, we have to pay the debt back … therefore we have to cut spending on other things or increase taxes. It might have to make those decisions but as we will see not because it issued the debt in the first place.
But Gittins digs himself further in a hole by trying to be cute:
… Maybe in an ideal world you and I would hold off buying things until we’d saved enough to pay cash, thereby avoiding all debt and interest payments.
Trouble is, many of us don’t have sufficient self-control to keep saving until we’ve got enough. We’d end up spending more than we should on cheap frivolities and not enough on durable items that could make a big difference to the amenity of our lives.
Thus borrowing turns out to be a form of ”commitment device” to overcome our self-control problem. It’s not just a way of getting to use something before you can afford it, it’s also a way of leaving yourself no choice but to save.
When you borrow to buy something, you don’t avoid having to save. You just do your saving in retrospect (as you make your monthly repayments), rather than in prospect. The interest you pay is the cost of doing your saving in reverse because you lack the self-control to save before you buy.
It’s possible that what’s true for individuals has some parallel at government level. Where governments eschew debt, they probably save less than they otherwise would, end up with less adequate infrastructure and spend more on less-beneficial bits and pieces on the way through.
It is not possible that there is any parallel between the individal person (clearly revenue-constrained) and the national government. This is the worst of the worst when it comes to trying to explain the options facing a sovereign government in a fiat monetary system.
The two choice (and constraint) sets are not alike in any way, except that neither can buy what is not available for sale. After that point, there is no similarity or analogy that can be exploited.
Of-course, the evolution in the 1960s of the literature on the so-called government budget constraint (GBC), was part of a deliberate strategy to argue that the microeconomic constraint facing the individual applied to a national government as well. So therefore while the individual had to pay the piper when he/she spent so to did the government. This provided the conservatives who hated public activity and were advocating small government, with the ammunition it needed.
It used this concept (GBC) relentlessly to justify the sort of statements that Mankiw (above) drums into his poor impressionable students, who should sue him for being deceived during their university education.
And Gittins uses his influential column to perpetuate the same myths even though he is trying to appear reasonable and distance himself from the manic deficit terrorists. The problem is that he is one of them.
This all reminded me of Abba Lerner and his notions of functional finance. Here is a useful Bio of Lerner.
Lerner’s objective was to advance economic policy debate beyond what he called “sound finance” (which is the precursor of modern mainstream (neo-liberal) thinking). So he juxtaposed the his “economics of control” policy thinking with the dominant laissez-faire approach that prevailed during the Great Depression.
Chapter 1 of Lerner’s 1951 book The Economics of Employment, was really a rewritten version of the 1941 article The Economic Steering Wheel where he elaborated his version of Keynesian thinking. He began the book as such (1951: 3-5):
Our economic system is frequently put to shame in being displayed before an imaginary visitor from a strange planet. It is time to reverse the procedure. Imagine yourself instead in a Buck Rogers interplanetary adventure, looking at a highway in a City of Tomorrow. The highway is wide and straight, and its edges are turned up so that it is almost impossible for a car to run off the road. What appears to be a runaway car is speeding along the road and veering off to one side. As it approaches the rising edge of the highway, its front wheels are turned so that it gets back onto the road and goes off at an angle, making for the other side, where the wheels are turned again. This happens many times, the car zigzagging but keeping on the highway until it is out of sight. You are wondering how long it will take for it to crash, when another car appears which behaves in the same fashion. When it comes near you it stops with a jerk. A door is opened, and an occupant asks whether you would like a lift. You look into the car and before you can control yourself you cry out, “Why! There’s no steering wheel!”
“Of course we have no steering wheel!” says one of the occupants rather crossly. “Just think how it would cramp the front seat. It is worse than an old-fashioned gear-shift lever and it is dangerous. Suppose we had a steering wheel and somebody held on to it when we reached a curb! He would prevent the automatic turning of the wheel, and the car would surely be overturned! And besides, we believe in democracy and cannot give anyone the extreme authority of life and death over all the occupants of the care. That would be dictatorship.”
“Down with dictatorship!” chorus the other occupants of the car.
“If you are worried about the way the car goes from side to side,” continues the first speaker, “forget it! We have wonderful brakes so that collisions are prevented nine times out of ten. On our better roads the curb is so effective that one can travel hundreds of miles without going off the road once. We have a very efficient system of carrying survivors of wrecks to nearby hospitals and for rapidly sweeping the remnants from the road to deposit them on nearby fields as a reminder to man of the inevitability.”
You look around to see the piles of wrecks and burned-out automobiles as the man in the car continues. “Impressive, isn’t it. But things are going to improve. See those men marking and photographing the tracks of the car that preceded us? They are going to take those pictures into their laboratories and pictures of our tracks, too, to analyze the cyclical characteristics of the curves, their degree of regularity, the average distance from turn to turn, the amplitude of the swings, and so on. When they have come to an agreement on their true nature we may know whether something can be done about it. At present they are disputing whether this cyclical movement is due to the type of road surface or to its shape or whether it is due to the length of the car or to the kind of rubber in the tires or to the weather. Some of them think that it will be impossible to avoid having cycles unless we go back to the horse and buggy, but we can’t do that because we believe in Progress. Well, want a ride?”
In other words, macroeconomics was all about “steering” the fluctuations in the economy. Fiscal policy was the steering wheel and should be applied for functional purposes. Laissez-faire (free market) was akin to letting the car zigzag all over the road and if you wanted the economy to develop in a stable way you had to control its movement.
This led to the concept of functional finance and the differentiation from what he called sound finance (that proposed by the free market lobby). Sound finance was all about fiscal rules – the type you read about every day even these days. So balance the budget over the course of the business cycle; only increase the money supply in line with the real rate of output growth; etc.
Lerner thought that these rules were based more in conservative morality than being well founded ways to achieve the goals of economic behaviour – full employment and price stability.
He said that once you understood the monetary system you would always employ functional finance – that is, fiscal and monetary policy decisions should be functional – advance public purpose and eschew the moralising concepts that public deficits were profligate and dangerous.
Lerner thought that the government should always use its capacity to achieve full employment and price stability. In modern monetary theory (MMT) we express this responsibility as “advancing public purpose”. In his 1943 article (page 39) we read:
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 …
This is why I always criticise the mainstream use of fiscal rules as being divorced from a functional context. It may be that a budget surplus is necessary at some point in time – for example, if net exports are very strong and fiscal policy has to contract spending to take the inflationary pressures out of the economy. This will be a rare situation but in those cases I would as a proponent of MMT advocate fiscal surpluses.
But just mindlessly rehearsing the sort of nonsense that you read in Mankiw which proposes fiscal rules that always apply is totally irresponsible.
Lerner outlined three fundamental rules of functional finance in his 1941 (and later 1951) works.
1. The government shall maintain a reasonable level of demand at all times. If there is too little spending and, thus, excessive unemployment, the government shall reduce taxes or increase its own spending. If there is too much spending, the government shall prevent inflation by reducing its own expenditures or by increasing taxes.
2. By borrowing money when it wishes to raise the rate of interest, and by lending money or repaying debt when it wishes to lower the rate of interest, the government shall maintain that rate of interest that induces the optimum amount of investment.
3. If either of the first two rules conflicts with the principles of ‘sound finance’, balancing the budget, or limiting the national debt, so much the worse for these principles. The government press shall print any money that may be needed to carry out rules 1 and 2.
In this Biography of Lerner you read the following (pages 218-19):
In 1943 Lerner published an article, “Functional Finance and the Federal Debt,” that announced a new approach to fiscal policy. (The subject was further developed in his Economics of Control and the Economics of Employment.) He noted that conventional fiscal wisdom was based on the principles and morals of good household management: don’t spend what you don’t have – a tacit reminder that the words “economy” and “economics” are etymologically derived from oikos, the Greek word for household.
Lerner, however, picking up on the summary Keynesian prescription of deficit spending, argued that governments should not be concerned with conventional morality but rather should consider only the results of their actions. The aim of government spending and taxing, he said, should be to hold the economy’s total spending at a level compatible with and conducive to full employment at current prices – in other words, no unemployment and no inflation. In doing this the government should not be concerned with deficits or debt. Second, the government should borrow or repay only insofar as it wants to change the proportions in which the public holds securities or money. Changing this proportion will raise or lower interest rates and hence discourage or promote investment and credit purchasing. If the only question, then, was how to finance a deficit, Lerner advocated printing money. Third, the government should put money into circulation or withdraw (and destroy) it as needed to effect the results called for by the first two principles.
So the only reason a government should issue debt is if it wanted to alter the “proportions in which the public holds securities or money”. It is clearly recognised that the government does not need to raise revenue. Debt and taxation are dimensions of the “steering wheel” and help keep the economy on the road.
In his 1943 article Lerner says (page 355) that the government would only issue debt “if otherwise the rate of interest would be too low”. So you start to understand that the “borrowing” is a monetary operation not a funding necessity. He went further on this theme in his 1951 book when he says (pages 10-11) that 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 (emphasis in original).
This is one of the fundamental insights of MMT – that the issuing of debt drains excess bank reserves that were generated by the net spending (deficits) in the first place. The government just borrows its one spending back. If it didn’t do that and if the central bank didn’t pay a return on overnight reserves then the interest rate would fall to zero (or some support rate that the central bank did pay).
So two things are learned here: (a) net public spending generates the financial assets which are then borrowed – so debt issuance cannot “finance” (by which we mean allow) government net spending; and (b) deficits do not put upward pressure on interest rates contrary to the crowding out story rehearsed above in Mankiw.
And for those progressives (the deficit-doves) – the “proponents of organized prosperity”, Lerner had this to say in his 1951 book (page 15).
A kind of timidity makes them shrink from saying anything that might shock the respectable upholders of traditional doctrine and tempts them to disguise the new doctrine so that it might be easily mistaken for the old. This does not help much, for they are soon found out, and it hinders them because, in endeavoring to make the new doctrine appear harmless in the eyes of the upholders of tradition, they often damage their case. Thus instead of saying that the size of the national debt is of no great concern … [and] … that the budget may have to be unbalanced and that this is insignificant when compared with the attainment of prosperity, it is proposed to disguise an unbalanced budget (and therefore the size of the national debt) by having an elaborate system of annual, cyclical, capital, and other special budgets.
On the next page (p.16) Lerner addressed the problem of progressives who present their arguments in a conservative way because the public might not understand the fundamentals of functional finance. He says:
The scholars who understand it hesitate to speak out boldly for fear that the people will not understand. The people, who understand it quite easily, also fear to speak out while they wait for the scholars to speak out first. The difference between our present situation and that of the story is that it is not an emperor but the people who are periodically made to go naked and hungry and insecure and discontented – a ready prey to less timid organizers of discontent for the destruction of civilization (emphasis in original).
So way back then Lerner was dealing with the same debates and charlatans as are everywhere today.
Once you understand these ideas then you are well on the way to comprehending the basis of policy design in MMT, which adds a very rigorous stock-flow consistent framework ground in the national accounting identities to the principles of functional finance.
It also helps you realise why the progressives who argue like Gittins are really conservatives.
You might like to read the following references:
Lerner, A. (1941) ‘The Economic Steering Wheel’, University of Kansas Review, June.
Lerner, A. (1943) ‘Functional Finance and the Federal Debt’, Social Research, 10, 38-51.
Lerner, A. (1944) The Economics of Control, New York, Macmillan.
Lerner, A. (1951) The Economics of Employment, New York, McGraw Hill.
Digression: what the hell?
The federal government announced today that it was appointing former (failed) conservative treasurer Peter Costello to the board of the Future Fund which was the fund that Costello, himself created by denying Australia of investment in public infrastructure and full employment. Towards the end of the conservative period in office, they started to purchase financial assets claiming it was salting away the budget surplus.
In fact, it was just spending but rather than create jobs or improve our schooling or health system, they speculated in financial assets. They bought the remaining “public shares” in the privatised Telstra which have since declined in value. They did that to avoid having to sell the shares privately after the second tranche of Telstra shares had brought such losses.
By the end of the conservative’s 11 years in office (10 of them in budget surplus) Australian households had record levels of debt, our public infrastructure including our higher education system was in tatters, and we still had 8.5 per cent of our willing labour resources underutilised (either unemployed or underemployed).
And now the Labor Government has the audacity to appoint the architect of this fiscal abomination to the very totem of his failure.
Read the former Labor Treasurer then Prime Minister (before the conservatives 11 years) comments HERE. He also didn’t get it but at least his outrage to this decision is genuine and supportable.
0 Comments:
コメントを投稿
<< Home