A Guide to Functional Finance: Explaining the Fundamentals of Modern Monetary Theory (MMT)

Functional Finance: Building a Balanced Economy, Not a Balanced Budget

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What you will learn:

An explanation of what the phrase Functional Finance means; why balancing the government budget should not be treated as an end in itself; how spending and taxation are used to achieve real economic goals like full employment and price stability; why inflation and real resources — not revenue — are the true limits on government spending; and how this approach overturns conventional views about so-called fiscal responsibility.

Technical Terms/Jargon Used in This Article

You will find definitions of all of the technical terms/jargon used in this article in my series of MMT Economic Jargon Buster articles. Paid subscribers can also download my MMT Dictionary.

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And the functional finance award goes to Abba P. Lerner

In this article I explore the idea of functional finance: a core tenet of Modern Monetary Theory (MMT). I look at its origins and underpinning principles. I also briefly examine how MMT has embraced and expanded upon the functional finance framework. Note that, at the end of this newsletter, I have included definitions of some of the concepts mentioned—so as not to bar anyone from understanding what can be a complex subject, especially for readers who are new to the area.

Abba Lerner coined the term functional finance in his 1943 article ‘Functional Finance and the Federal Debt’. He argued that governments should focus on real-world outcomes such as full employment and the absence of inflation, rather than, abstract goals such as balanced budgets or deficit targets.

Economist Pavlina Tcherneva summarised Lerner’s approach in the following way: ‘We must judge fiscal measures by the effect on human activity, not by the effect on the budget.’

For Lerner, the main tool to achieve full employment and stable prices was spending and taxation. He first developed his ideas in an era dominated by monetary policy (manipulating interest rates) and balanced budgets, so Lerner was out of step with the prevalent ideas of his day. (Note that, although I’m referring to Lerner's 1947 paper, his core ideas were developed around the time of the Great Depression.)

However, Lerner was not alone; this was also the era (i.e., the early 1930s) when Keynes began pitching his idea that what was needed to solve the post-Great-Depression unemployment problem was not high interest rates, low wages and balanced budgets. But rather, a boost in ‘aggregate demand’. I.e. overall demand in the economy should be boosted by additional government spending. That additional government spending would raise the demand for goods and services, which in turn would force businesses to take on more employees (Keynes’ book ‘The General Theory of Employment, Interest, and Money’ was published in 1936).

Although Lerner supported Keynes’ ideas (he attended his lectures when he was a student), he wasn’t so keen on the idea that it didn’t matter where the spending was directed. He believed that spending should be carefully directed toward those sectors in the economy that needed it most, sectors in which it would have the greatest impact. Today that could mean offering tax incentives in sectors that have the potential to create jobs and contribute to sustainable growth, for example, by investing in renewable energy projects.

Abba P. Lerner - Photo: Public Domain

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Control of inflation: taxation and government borrowing

Lerner also viewed taxation as a powerful policy tool. Governments could cut taxes to increase private sector spending, stimulating demand. Or they could increase taxes to reduce spending, as a way to control inflation. He understood that tax increases can be used to free up capacity in the economy allowing for additional government spending (otherwise that spending could compete with private sector spending, causing inflation). Economist Bill Mitchell explains,

“…if the economy was at full capacity and the government tried to undertake a major nation building exercise then it might hit inflationary problems – it would have to compete at market prices for resources and bid them away from their existing uses. In those circumstances, the government may – if it thought it was politically reasonable to build the infrastructure – quell demand for those resources elsewhere – that is, create some unemployment. How? By increasing taxes.” Bill Mitchell

Government borrowing as a policy tool

Lerner also viewed government borrowing as a tool to manage inflation. He understood that ‘borrowing’ (i.e. selling government bonds) was not a way to raise money for government spending – as was the common belief at the time – but a way to control interest rates. Controlling interest rates was, in turn, a way to control inflation.

His understanding was that increasing interest rates reduces business investment. That reduction in investment means lower growth. Lower growth means businesses will shed workers. And that reduction in demand means there would no longer be ‘too much money chasing too few goods’. In other words, prices would not be pushed up as workers compete for limited goods and services.

In the Biographical Memoir of Lerner by David Landes, we find the following,

“the government should borrow or repay only insofar as it wants to change the proportions in which the public holds securities or money. Changing this proportion will raise or lower interest rates and hence discourage or promote investment and credit purchasing.” Biography of Lerner

The misguided notion that selling government bonds is about raising funds for government spending is still widespread. However, a simple look at the mechanics of bond sales (as MMT reveals) dismantles that myth. No government money is raised in the act of ‘government borrowing’. In fact, you could say the opposite happens: the government adds money to the private sector by paying interest on the bonds it sells (when I say sells I mean swapping government bonds for bank reserves). Currency-issuing governments do not need to borrow their own currency to raise funds. And even the interest paid on government bonds does not need to be raised via taxes or borrowing; like all government spending it comes into existence at the point when the interest payments are made.

However, the ‘government borrowing’ myth is hard to shift, because it’s rooted in the idea that money is scarce — and that government must either collect it from taxpayers or borrow it from somewhere else. As MMT economist Bill Mitchell explains, it is only in the world of obfuscation and myth that currency issuing governments have to borrow their own currency: in the real world ‘borrowing’ is about controlling the interest rate.

“…issuing debt is just about removing excess reserves - which are in the system due to government deficit spending. The government deficit spends and then just borrows some of that spending back…If it didn’t do that and if the central bank didn’t pay a return on overnight reserves then the interest rate would fall to zero (or some support rate that the central bank did pay).” Bill Mitchell

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MMT, monetary policy and inflation

It should be noted that MMT advocates do not fully buy into the idea that interest rates are an effective tool for controlling inflation. Warren Mosler is well known for saying that raising interest rates may actually do the exact opposite, i.e. increasing the price of money is as likely to increase inflation as to reduce it. Research exists supporting both of these outcomes. High interest rates result in an increase in savings and a portion of those savings are likely to be spent into the economy.

In summary – Lerner put forward three rules for his functional finance

Lerner’s approach to fiscal policy was centred on achieving tangible outcomes rather than adhering to abstract fiscal targets. Functional finance is based on the idea that government intervention—through spending and taxation—should be guided by the needs of the economy, such as achieving full employment and stable prices: as Stephanie Kelton later wrote: it’s about achieving a balanced economy rather than a balanced budget.

Lerner’s thinking was ahead of its time, challenging the dominant economic mindset of balanced budgets and reliance on interest rate manipulation. Here are the three fundamental rules that Lerner proposed to guide government policy under this functional finance framework:

1. The government should spend to ensure sufficient levels of demand to achieve full employment and respond to inflation by spending less or using taxes to reduce private sector demand.

2. The government should ‘borrow’ (i.e. sell government debt/bonds), when it wishes to raise the interest rate, or buy back government debt/bonds when it wishes to lower the interest rate. This is based on the belief that interest rates effect the level of investment in the economy. It is clear that Lerner knew that selling government debt was not ‘borrowing in order to raise finance’ but instead was a monetary tool to manipulate interest rates.

3. Balancing the budget should not be the basis on which government policy decisions are made. Instead policy decisions should always be about achieving real-world goals.

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MMT adopted and further developed Lerner’s functional finance framework

MMT combines Lerner’s functional finance framework with an understanding of sectoral balances and the ‘stock-flow consistent framework’ made popular by Wynne Godley. Together, these tools provide a robust framework for analysing money flows across different sectors of the economy.

In stock-flow consistent modelling, 'stocks' refer to the amount of assets or liabilities held at a point in time, while 'flows' represent the changes in these quantities over a specific period. Stock-flow consistent modelling therefore, is about keeping track of money and asset flows between different parts of the economy over time.

If stock-flow consistent modelling is about the details, sectoral balances is about the big picture, i.e., the flows between the three main sectors of the economy. The three sectors are the government sector, the private sector and the foreign sector. A sectoral balances approach tells us the flows between each of the sectors must always add up to zero. For example, if the government is in deficit that means at least one other sector must have a surplus.

By incorporating the idea that government spending can be used to manage aggregate demand; by revealing that neither taxes nor ‘borrowing’ fund services; and by providing a set of tools to analyse how money flows through modern economies, MMT extends Lerner’s vision into a modern context. This combination offers a clearer understanding of the interactions between the government, private sector, and foreign sector in the economy.

That’s all for now.

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Addendum

Definitions: government debt, government bonds, reserves, stock-flow consistent (SFC) modelling and reserves and a note about buying and selling government bonds

Government Debt: Government debt is the total amount of money the government has spent into the economy that hasn’t been taxed back yet. It’s the accumulation of all the annual deficits or the difference between what the government spends and what it collects in taxes. Basically, it’s the sum of all the money the government owes to the non-government sector (like banks, individuals, and foreign governments).

Government Bonds: When the government issues bonds it's not actually borrowing money in the traditional sense, instead, it’s swapping interest-bearing bonds with reserves from the banking system. Think of it as the government saying, “We’ll give you a promise to pay back this money with interest later, in exchange for some of your funds now.” This helps the government manage interest rates and the amount of money circulating in the economy. Bonds are a tool to control the economy, not a way to fund government spending.

Reserves: Reserves are the money that commercial banks hold in their accounts at the central bank. It’s the basic money that banks use to settle payments between each other and meet regulatory requirements.

Definition of the words 'stocks' and 'flows' in the context of economics

'Stocks' refer to the amount of assets or liabilities held at a particular point in time, while 'flows' represent the changes in these quantities over a specific period. An example of stocks would be the amount of money in your bank account at the end of a particular year. The 'flows' would be the deposits and withdrawals you made during that year.

Stock-Flow Consistent (SFC) Modelling:
Keeping track of how money and assets move between different parts of the economy and making sure that every time money goes out of one place, it shows up somewhere else. It’s like keeping a detailed budget where nothing is allowed to just disappear or appear out of nowhere. This helps build a clear and realistic picture of how spending, saving, borrowing, and lending all fit together over time. SFC modelling is a way of looking at the economy that makes sure everything adds up properly.

Sectoral balances: Sectoral balances is the name for an approach that tracks the flows of money and assets between different sectors of the economy—government, private (households, businesses) and the foreign sector. In a sectoral balances approach the economy is viewed as a closed system in which one sector’s surplus (savings) is necessarily offset by another sector’s deficit (debt).

A note about selling and buying government bonds: when selling government bonds, the instruction to sell comes from the Treasury (making it a fiscal operation) and the Central Bank merely carries out the instructions (i.e. it manages the transaction with the commercial banks). However, when buying back bonds, it is the Central Bank that instigates the transactions (thus, this is a ‘monetary operation’). Having said that, it is always the central bank that carries out the transactions.