Phantoms in the Dark Part 5

Functional finance---at last.  If you are of a traditionalist frame of mind about government debt or taxes, and you have not yet encountered functional finance or modern monetary theory I feel obligated to provide some warning: this could shock your pants off, which might startle anyone who happens to be nearby.  If you’re reading this in a public place you might want to pause to fasten on a sturdy and reliable pair of suspenders.  You know, to be on the safe side.

Yesterday I quoted James Buchanan from this book saying:

“The efficient means of purchasing the services of unemployed resources is through inflation of the currency.”

In other words, if there are idle resources that the government wants to use, the best way to purchase them is to simply create the money from thin air.  Abba Lerner agreed with that---and if I thought it was politically possible I would probably agree with it too. 

In the 1943 Abba Lerner published a paper called “Functional Finance and the Federal Debt” in which he asked us all to do something radical: he asked us to discard our moralistic presumptions regarding the financing of government activity and judge each different method of financing by its actual direct effects.  Debt, taxation and the government’s unique power to simply create money from nothing are, in this vision, all equally valid tools. In Lerner’s words,

“The central idea is that government fiscal policy, it’s spending and taxing, it’s 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.”

In fact, since the government has the ability to create money, and since creating money from nothing does not draw it from anyone’s private coffers, that should be the default method of financing the government.   Yes, that’s what he said.  The government should start from the assumption that it will simply create money to pay for anything it buys, and should use taxation or debt only when they serve some other function that is necessary to keep the economy operating well.  Lerner said:

“taxing is never to be undertaken merely because the government needs to make money payments…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.”

And similarly,

“the government should borrow money only if it is desirable that the public should have less money and more government bonds, for these are the effects of government borrowing.”

The main goal he prescribes for the finance methods used, the motive for choosing among finance methods is simply to adjust total spending to maintain full employment without inflation, that is, to make sure that the amount demanded in the economy is exactly equal to potential GDP. 

That, actually, is how he says we should choose between the two primary finance methods of printing money or taxing.  If demand is too low to maintain full employment the government should print money and spend it to absorb the unused economic capacity.  If the demand is too high the government should either reduce government spending or tax money away from the public.   There are many ways to tax (sales, income, value added, excise and so on) and each will have a different impact, but Lerner does not dwell in the paper on what kind of taxes to apply, or on targeting the resulting demand reduction.  He only emphasizes that in no case is the purpose to raise money for the government, since the government already has an infinite capacity to create whatever money it needs.  The purpose, he says, should be always and only to decrease overall demand sufficiently to avoid inflationary pressure. 

Similarly, the government should issue bonds only if it intends to raise the interest rate, and buy bonds back only if it intends to lower the interest rate, to either encourage or discourage longer-term investments by business or by consumers (in houses and cars, for example).

So in this vision, if Lerner is right, the government can exercise a lot of control over the larger economic variables without any need to interfere with details or direction of private economic activity.   But to achieve that we would all have to give up our fears about public debt and the creation of money from nothing. 

Lerner says, about the accumulation of national debt:

“this possibility presented no danger to society, no matter what unimagined heights the national debt might reach, so long as Functional Finance maintained the proper level of total demand for current output”

I have to say that I’m not comfortable with the idea of “unimagined heights” of debt (more on this below). On the other hand, I’m not sure why debt would ever be very large in a functional finance system. In fact I’m not completely sure why we would ever have any government debt at all.  It’s not easy to come up with good reasons for the government to issue bonds, in this system.  Why on earth would the government ever want to discourage longer-term investments by raising interest rates?  I can see why it might want to lower interest rates to encourage longer-term investments if the population became so short sighted and so voracious in its demand for pure consumption goods that the future of the country was in danger, but that could be done by raising taxes to reduce consumption demand, and balancing the economy again by printing and spending money on longer term projects---and the resulting decreased rate of interest would encourage private investment too.   

Functional Finance as Lerner described it sounds pretty radical.  But before we simply dismiss it as fantasy, I’d like to point out that the policy suggested by both Lerner and Buchanan in periods when there are idle resources is very similar to the net effect of what we are doing right now.  When the government issues bonds to the open market to cover the deficit, and then the Federal Reserve creates money to buy those bonds on the open market, the net effect is that the government owns its own bonds and has financed itself by printing money.  If the Fed holds those bonds until they mature, the Treasury will have to pay the bonds off, meaning it will have to pay the Fed the face value of the bonds.  But the Fed is non-profit.  At regular intervals it clears out any money it has accumulated by turning its profits over to the Treasury.   So when the Fed tries to combat unemployment by driving the interest rate down, which it does by buying bonds on the open market, that is almost exactly as though the fed simply went into the Treasury’s account and changed its balance to a larger number.   In the end I think the net effect of what we have done is exactly what Buchanan suggested, to finance ordinary government activity in slack times by printing money.  And our only failure in following Lerner’s explicit advice is that we are not doing it on a scale nearly large enough to achieve full employment.  

Of course, if we could be rational and open about the process, if we really could discard our moralistic presumptions regarding the financing of government activity and judge each different method of financing by its actual direct effects, we would stop disguising this money creation as a debt owned by the Fed, and just do the transaction in a straightforward way.  We would just let the Fed create money directly in the Treasury’s account whenever that was necessary to pay the government’s bills, particularly during recessions.  But if the public and the political world have trouble accepting large amounts of public debt, they feel even greater panic about the notion of the government “printing” large amounts of money.   So even though the net effect is the same, we have to keep pretending that the government is borrowing to finance the deficit, and the Fed is independently buying that debt to lower interest rates.

And as a result, the total national debt keeps rising (even though the Fed owns a sizable chunk of it, and other parts of the government like the Social Security Trust Fund own other sizable chunks of it), and public fear about its size keeps rising.  The phantom in the dark keeps growing.  As I said above, Lerner says the size of the total debt doesn’t matter, but I also said that I am not really comfortable with that.  I’ll try to explore my discomfort about it next.  But it may take a few days before I have time to get back to this.