Functional Finance Contends That

Functional Finance, a macroeconomic theory championed by Abba Lerner in the mid-20th century, fundamentally challenges conventional fiscal policy wisdom. It contends that governments should prioritize achieving specific economic objectives, like full employment and price stability, rather than adhering to balanced budgets or predetermined debt levels. The success of fiscal policy should be judged solely by its functional impact on the economy, hence the name.

At the heart of Functional Finance lies the principle that government spending and taxation are merely tools to manage the overall level of aggregate demand. Instead of viewing budget deficits as inherently problematic, Functional Finance sees them as a potential instrument to stimulate a sluggish economy. Conversely, budget surpluses can be used to curb inflationary pressures. The guiding principle isn’t budgetary balance, but rather the pursuit of economic health.

Lerner argued that governments possess the unique ability to create money, thereby removing any inherent financial constraints on their spending. If the economy suffers from unemployment due to insufficient demand, the government should increase spending, even if it leads to a deficit. This additional spending will boost demand, create jobs, and ultimately increase national income. The increased income, in turn, will generate more tax revenue, potentially reducing the deficit in the long run. The key is to ensure that the spending is targeted effectively to maximize its impact on employment and production.

Similarly, if inflation is a concern, the government should reduce spending or increase taxes to cool down the economy. The goal is to reduce aggregate demand to a level that matches the economy’s productive capacity. This might lead to a budget surplus, but again, the surplus is a byproduct of the policy aimed at price stability, not an objective in itself.

Functional Finance acknowledges the potential dangers of excessive debt accumulation but argues that the focus should be on the real burden of the debt, not its absolute size. If the debt is used to finance productive investments that boost future economic growth, the debt burden becomes less significant. Conversely, even a relatively small debt can be problematic if it is used to finance unproductive spending or if the economy is stagnant.

A crucial implication of Functional Finance is the rejection of the crowding-out effect, a common argument against deficit spending. Crowding-out suggests that government borrowing drives up interest rates, discouraging private investment. Functional Finance counters that the central bank can manage interest rates to maintain them at levels that support both public and private investment. The central bank’s monetary policy should be coordinated with the government’s fiscal policy to achieve overall economic stability.

While Functional Finance offers a powerful framework for understanding fiscal policy, it’s not without its critics. Some argue that it can lead to irresponsible government spending and runaway inflation if not implemented carefully. Others worry about the political challenges of maintaining fiscal discipline, particularly when faced with short-term political pressures. Despite these concerns, Functional Finance has significantly influenced macroeconomic thinking and continues to be relevant in debates about the role of government in managing the economy. It provides a powerful counterpoint to orthodox fiscal conservatism and highlights the importance of prioritizing economic outcomes over rigid budgetary rules.