Critique of “Functional Finance and the Federal Debt” (Abba Lerner 1943)

Critique of “Functional Finance and the Federal Debt” (Abba Lerner 1943).

This blog post critiques the paper “Functional Finance and the Federal Debt” by Abba Lerner.

Key passages from the paper are reproduced, with corresponding points of rebuttal. The author of this post believes this critique to be a true and fair representation of the facts. The author welcomes comments, and will adjust the post if a better understanding is reached through discourse.

“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 or 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 as opposed to scholasticism. The principle of judging financial measures by the way they work or function in the economy we may call Functional Finance”.

This implies a process – we take action, the effects occur, we see whether the effects were good, we determine whether to continue the action based on the effects. The process is repeated.

This approach has the following potential problems:
1. It assumes that the effects will occur in a sufficiently short period of time to allow timely adjustment to the action. If the effects will not be apparent for a long time, or if the effects vary over time (e.g. initial good effects followed later by bad effects), then the process described is inappropriate.
2. Any chosen starting point in the evolution of an economy is influenced by myriad factors, and these factors vary over time. It may not be possible to determine whether any good effects or bad effects were due to the action or due to other factors.
3. Even in cases where we can tell whether a particular action had a good or bad effect, and we can use this information to determine a further course of action, the question remains: Is it best to do more of the same? Or is it time to stop and do something different? If the new state of affairs is better than the previous state of affairs, this does not mean that the action should be repeated.

“The first financial responsibility of the government (since nobody else can undertake that responsibility) is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate at which 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.”

This statement is ill-defined. The “total amount of all the goods that it is possible to produce” in any particular time period is impossible to determine. Therefore the “first financial responsibility of the government” as defined is a responsibility neither it nor any other entity can satisfy.

“The government can increase total spending by spending more itself or by reducing taxes so that taxpayers have more money left to spend. It can reduce total spending by spending less itself or by raising taxes so that taxpayers have less money left to spend.”

This statement ignores the creation of new deposits through private loans. These deposits can grow or shrink irrespective of any increase or decrease in government spending or taxation.

The statement also assumes that the level of spending is correlated one-to-one with the amount of money, which can be demonstrated empirically to be incorrect.

“In applying this first law of Functional Finance…”

As the first law is demonstrably not a law, any statements made in the rest of the paper that rest on this law are at best unproven.

“The second law of Functional Finance is that 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.”

An effect of government borrowing is not necessarily that the public has less money and more government bonds.

If the purchaser uses bank deposits to purchase a bond, and the government pays another depositor with the proceeds, the effect on bank deposits is zero.

If the purchaser borrows to purchase a bond, and the government pays a depositor, the effect on bank deposits is an increase.

If the purchaser uses bank deposits to purchase a bond, and the government pays a creditor who pays down debt, the effect on bank deposits is a decrease.

If the purchaser borrows to purchase a bond, and the government pays a creditor who pays down debt, the effect on bank deposits is zero.

As the second law is demonstrably not a law, any statements made in the rest of the paper that rest on this law are at best unproven.

A key passage further into the paper that relies on the second law is as follows (referring to the lack of any guarantee that the national budget could be balanced over the long term):

“At this point two things should have been made clear: first, that 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 demand for current output”

As we have seen, it is not possible for any government to follow the second law of Functional Finance, and therefore it is not possible to use Functional Finance to maintain a proper level of demand for current output. Further problems arise when we consider the meaning of “demand” in this context, as the paper is referring to demand in monetary terms, not actual demand from people who wish to make use of the goods and services produced. By “maintain a proper level of demand” the author means “induce enough spending so that all goods and services produced are bought”. However if a good or service is not really desired by anyone, but it is bought anyway, this will encourage its production again in the next period – i.e. Functional Finance will encourage the ongoing production of something that is not desired, in other words malinvestment. This presents a danger to society – i.e. that thing that the author is claiming to prevent.

“; and second (though this is much less important), that there is an automatic tendency for the budget to be balanced in the long run as the result of the application of Functional Finance, even if there is no place for the principle of balancing the budget.”

As we have seen above, the first law of Functional Finance as stated cannot be a law, and the second law is impossible to follow, therefore Functional Finance cannot be applied, and therefore there can be no result from it. There can of course be results of attempts to follow particular interpretations of Functional Finance, but these results will bear little or no relation to the results predicted by the paper, because the interpretations will necessarily be distorted manifestations of an ill-defined and impossible set of axioms.

The paragraph states that there is an automatic tendency for the budget to be balanced in the long run. Note that it does not state that once the budget is balanced there is no need for further money printing. This is discussed later in this critique.

“As long as the public is willing to keep on lending to government there is no difficulty, no matter how many zeros are added to the national debt. If the public becomes reluctant to keep on lending, it must either hoard the money or spend it”

This ignores the fact that money can be created and destroyed entirely within the private sector, even with no net change in the government debt. When viewed as a whole, the public do not simply have a choice to hoard or spend. They have the choice to create, destroy, hoard or spend. If we consider real assets rather than money, the choices are: create, consume, hoard or exchange.

“If the public hoards, the government can print the money to meet its interest and obligations, and the only effect is that the public holds government currency instead of government bonds and the government is saved the trouble of making interest payments”

The paragraph states that this is the only effect, but the paper makes no attempt at proving it. It does not investigate what effect the direct printing of money by the government would have on the public’s willingness to lend in the future. It does not investigate the effect of the government being able to acquire resources more cheaply than the private sector due to the zero interest rate on directly printed money. There is the possibility that the printing of money creates a positive feedback loop in which private lenders become less willing to lend, leading to more money printing, and so on until all spending is financed by printing. The paper does not attempt to explore this possibility.

Towards the end of the paper, the author attempts to show why the application of Functional Finance will have a tendency to balance the budget in the long run.

“Finally, there is no reason for assuming that, as a result of the continued application of Functional Finance to maintain full employment, the government must always be borrowing more money and increasing the national debt. There are a number of reasons for this.”

“First, full employment can be maintained by printing the money needed for it, and this does not increase the debt at all. It is probably advisable, however, to allow debt and money to increase together in a certain balance, as long as one or the other has to increase.”

This states that the budget can be balanced by not borrowing but printing money. This is true, but demonstrates that what the paper is referring to as an automatic tendency to balance the budget, does not include a tendency to reduce or eliminate the need for money printing.

It also introduces a new aspect of Functional Finance not previously mentioned, that of the need to keep debt and money increases in a certain balance. It is not stated as a law, but something that would probably be a good thing to do. There is no reasoning provided for why this would be a good thing to do, or to what extent they would need to be kept in balance. If they do need to be kept in balance, it is not possible to increase money printing without increasing debt, and so the budget will not be balanced. If they don’t, there is no need for it to be “probably advisable”. The procedure described is not well enough defined to be a valid prescription for running an economy.

“Second, since one of the greatest deterrents to private investment is the fear that the depression will come before the investment has paid for itself, the guarantee of permanent full employment will make private investment much more attractive, once investors have gotten over their suspicion of the new procedure. The greater private investment will diminish the need for deficit spending.”

One deterrent to private investment is the fear of recession or depression. There are other deterrents. There are many factors, both positive and negative, that bear on decisions to invest.

An assumption made in this paragraph is that guaranteed full employment means there will be no depression. If we define depression to mean a prolonged decline in production, then the assumption is not well founded. Production may decline if the fully employed workforce is not employed productively, and if their productivity does not grow over time.

Accordingly, full employment will not necessarily lead to private investment being made more attractive.

There are other reasons for private investment to be less attractive under the conditions described. If everyone is already employed, it will be harder to attract people to new jobs, especially if those jobs entail hard work, and the jobs provided by money printing are less onerous. Private investors may remain suspicious of the money printing if the guidelines for it are not clearly laid out, which is the case here.

“Third, as the national debt increases, and with it the sum of private wealth, there will be an increasingly yield from taxes on higher incomes and inheritances, even if the tax rates are unchanged. These higher tax payments do not represent reductions of spending by the taxpayers. Therefore the government does not have to use these proceeds to maintain the requisite rate of spending, and can devote them to paying the interest on the national debt.”

The sum of private wealth will not necessarily increase as the national debt increases. This will only occur if the increase in the nominal amount of debt outstrips inflation. Whether this occurs is dependent on the amount of money printed.

“Fourth, as the national debt increases it acts as a self-equilibrating force, gradually diminishing the further need for its growth and finally reaching an equilibrium level where its tendency to grow comes completely to an end. The greater the national debt the greater is the quantity of private wealth. The reason for this is simply that for every dollar of debt owed by the government there is a private creditor who owns the government obligations (possibly through a corporation in which he has shares), and who regards these obligations as part of his private fortune.”

It is not true that the greater the national debt, the greater the quantity of private wealth. If wealth is measured in real dollars (i.e. is adjusted for inflation), not nominal dollars, and money printing occurs alongside the increase in debt, wealth could very well diminish. If wealth is measured in possession of real goods, such as land, factories, inventories and property, any borrowing from the government only increases wealth if the government uses the funds to increase the quantity of such goods and repatriate them to private creditors. It is possible that the funds would be used in that way, but there is no guarantee, and nothing in the paper suggests measures to ensure that that would happen.

Therefore no self-equilibrating force is demonstrated by the paper.

In summary, the paper presents a series of statements that are not demonstrated to be true. It is therefore unsuitable as any kind of prescription for economic management.

The author of this critique believes it to be a true and fair representation of the facts. Comments are welcome, and the post will be adjusted if a better understanding is reached through discourse. Comments will be responded to respectfully in pursuit of true understanding for both the author and readers.

In order to minimize the potentially deleterious effects of ego on rational debate, please keep all comments anonymous and identify yourself only as “Commenter 1”, “Commenter 2” etc. The reason for anonymity is to find a faster and more reliable path to understanding, unencumbered by the obstacles of personality.

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One Comment on “Critique of “Functional Finance and the Federal Debt” (Abba Lerner 1943)”

  1. Commenter 1 says:

    Lerner wrote this in 1943. Subsequently, he updated his ideas in the book, MAP — A Market Anti-Inflation Plan (1980), with David Colander.

    Recently. Lerner’s functional finance has been reconsidered. See Edward J. Nell and Mathew Forstater, editor, Re-inventing Functional Finance, (Elgar 2003).

    Mathew Forstater, “Functional Finance and Full Employment: Lessons from Lerner for Today” (1999)


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