Functional finance

Functional finance

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Functional finance is an economic theory proposed by Abba P. Lerner
Abba P. Lerner
Abba Ptachya Lerner was an American economist.Lerner was born on October 28, 1903 in Bessarabia . He grew up in a Jewish family, which emigrated to Great Britain when Lerner was three years old. Lerner grew up in the London East End. From the age of sixteen he worked as a machinist, a teacher in...

, based on effective demand
Effective demand
In economics, effective demand in a market is the demand for a product or service which occurs when purchasers are constrained in a different market. It contrasts with notional demand, which is the demand that occurs when purchasers are not constrained in any other market...

 principle and chartalism
Chartalism
Chartalism is a descriptive economic theory that details the procedures and consequences of using government-issued tokens as the unit of money. The name derives from the Latin charta, in the sense of a token or ticket...

. It states that government should finance itself to meet explicit goals, such as taming the business cycle, achieving full employment
Full employment
In macroeconomics, full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so....

, ensuring growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

 and low inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

.

Principles


The principal ideas behind functional finance can be summarised as:
  • Governments have to intervene; the economy is not self-regulating
    Free market
    A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...

    .
  • The principal economic objective of the state should be to ensure a prosperous economy.
  • Money is a creature of the state; it has to be managed.
  • Fiscal policy
    Fiscal policy
    In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

     should be directed in the light of its impact on the economy, and the budget should be managed accordingly, that is, 'balance' is not important in itself.
  • The amount and pace of government spending
    Government spending
    Government spending includes all government consumption, investment but excludes transfer payments made by a state. Government acquisition of goods and services for current use to directly satisfy individual or collective needs of the members of the community is classed as government final...

     should be set in the light of the desired level of activity, and taxes should be levied for their economic impact, rather than to raise revenue.
  • Principles of 'sound finance' apply to individuals. They make sense for households and businesses, but do not apply to the governments of sovereign states, capable of issuing money.

Rules for fiscal policy


Lerner postulated that government's fiscal policy should be governed by three rules:
  1. There 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 principles of 'sound finance' or of balancing the budget, or of 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.

History of use


Lerner's ideas were most heavily in use during the Post-World War II economic expansion
Post-World War II economic expansion
The post–World War II economic expansion, also known as the postwar economic boom, the long boom, and the Golden Age of Capitalism, was a period of economic prosperity in the mid 20th century, which occurred mainly in western countries, followed the end of World War II in 1945, and lasted until the...

, when they became basis for most textbook presentations of Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

 and the basis for policy. Thus when Keynesian policy become under fire in the late 60's and early 70's it was Lerner's idea of functional finance most people were attacking. Functional finance lost favor as basis of policy because empirically it did not seem to lead to the desired state of economy. Specifically, 3% initial target for unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

 and low inflation seemed mutually exclusive. Lerner's functional finance rules do not say what the non-inflation accelerating unemployment rate is or what should be done if both low levels of inflation and unemployment cannot be achieved. Lerner recognized these problems and developed his theory of macroeconomics to allow for multiple equilibria
Economic equilibrium
In economics, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal...

 and supply-side inflation. By then Keynesian economics had fallen out of favor.

Global financial concerns in 2010 that surround national debt, national and global aggregate demands, and proposed inconsistent applications of austerity and reduced government spending, on the one hand, and quantitative easing
Quantitative easing
Quantitative easing is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a pre-determined quantity of money into the economy...

and increased government spending on the other hand, have made functional finance relevant again. If unemployment is minimized rapidly by application of functional finance (modified to require green production of the material wants that prevents unacceptable environmental stress and/or financial inflation,) and its principles would in fact achieve freedom from want, Lerner will be one of the fathers of reforms suggested in the 20th Century that finds favor in the 21st.

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