Functional finance is an economic theory proposed by Abba P. Lerner, based on effective demand principle and chartalism. It states that government should finance itself to meet explicit goals, such as taming the business cycle, achieving full employment, ensuring growth, and low inflation.
The principal ideas behind functional finance can be summarized as:
- Governments have to intervene; the economy is not self-regulating.
- 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 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 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:
- 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.
- 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.
- 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, when they became basis for most textbook presentations of Keynesian economics 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 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 and supply-side inflation.
- Edward J. Nell, Mathew Forstater, Reinventing functional finance: transformational growth and full employment, ISBN 1-84542-220-1, Edward Elgar Publishing 2003
- Forstater, Mathew, Functional Finance and Full Employment: Lessons from Lerner for Today
- Lerner, Abba P., Economics of Employment, McGraw Hill (1951)
- Functional Finance: What, Why, and How? - a case for functional finance in most of the developed world (1999)
- Lerner, Abba: Functional Finance and the Federal Debt (1943)
- MacKenzie D. W. (2006) The Myth of Functional Finance: Mises vs. Lerner // Ludwig von Mises Institute website. May 23, 2006.