Important Figures in the Development of MMT: Abba P. Lerner ‘Functional Finance'
Exploring Abba P. Lerner's Functional Finance and its Influence on Modern Monetary Theory (MMT).
“Many of our publicly minded men who have come to see that deficit spending actually works still oppose the permanent maintenance of prosperity, because in their failure to see how it all works, they are easily frightened by fairy tales of terrible consequences” Abba P. Lerner, Functional Finance and the Federal Debt.
For Abba P. Lerner, the correct level of government spending and taxation is that which is needed to achieve full employment and price stability. The focus of government spending policy should always be on real outcomes in the real economy - not arbitrary goals – such as balancing the budget or achieving a particular deficit size. From Lerner’s point of view, the size of the deficits (or surplus) is an outcome of a full employment policy, not a goal in itself.
Economist Pavlina Tcherneva summarised his approach in the following way, ‘we must judge fiscal measures by the effect on human activity, not by the effect on the budget.’
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Lerner’s Functional Finance Framework
Lerner called his approach, ‘functional finance’ – a term introduced in his 1943 article, "Functional Finance and the Federal Debt.” The article describes functional finance as a framework for thinking about the role and workings of the government’s fiscal and monetary policy.
Lerner developed these ideas in the period after the Second World War, when economists were in agreement that economic and welfare rights should be the central aim of government policy. Keynes, who Lerner had seen giving a talk at London School of Economics (LSE) in 1933 (where Lerner was taking night classes), agreed with this goal, while disagreeing with the default approach to achieving it. The default approach at the time (and still is to the largest extent) was monetary policy and balanced budgets.
For Keynes and for Lerner, monetary policy should have a supporting role, rather than being the main policy tool used to control economic outcomes. Keynes advocated spending and taxation (i.e. fiscal policy) as the most effective tool to achieve the goal of full employment.
Lerner And Aggregate Demand
Lerner adopted Keynes belief that governments should use fiscal policy as a way to manage ‘aggregate demand’ in the economy - though he was critical of undirected aggregate demand, i.e. general spending won’t necessarily lead to full employment. The general idea is that increased aggregate demand will force employers to take on new workers thus reducing unemployment.
“Apart from the necessity of winning the war, there is no task facing society today so important as the elimination of economic insecurity.” Abba P. Lerner, Functional Finance and the Federal Debt.
What does ‘aggregate demand’ mean?
Aggregate demand refers to the total demand for goods and services within an economy at a given overall price level and within a specified time period. It includes the combined spending of households, businesses, the government, and exports minus imports.What’s the difference between undirected and directed aggregate demand?
Undirected boosting of aggregate demand would include tax cuts for all income levels. Or spending on general infrastructure projects, without considering whether they will tackle unemployment in particular areas or sectors. An example of directed aggregate demand would be a job guarantee programme that directly employs unemployed workers. Or offering tax incentives in sectors that have the potential to create jobs and contribute to sustainable growth—for example, investing in renewable energy projects.
Tools for Achieving Full Employment and Stable Prices
Pavlina Tcherneva notes that Lerner outlined three tools that governments can use to carry out their fiscal policies.
Spending and taxing.
Borrowing and repayment of loans.
Issuing and withdrawing money from circulation.
Spending and taxing
Lerner tells us that we will know the correct level of total spending in the economy when we have reached full employment – while still maintaining stable prices. If there is unemployment in the economy, that implies a lack of aggregate demand, which means there is too little spending to support full employment. When there is full employment but inflation, that implies there is too much aggregate demand, which means there is excessive spending in the economy. Government spending can be used to reach the former, i.e. full employment and stable prices, while taxes can be used to ‘fix’ the latter, i.e. too much spending.
Lerner understood that the role of taxation was to influence behaviour. Consistent with MMT, he did not view taxation as a way to raise revenue.
Borrowing and repayment of loans
Lerner also understood that borrowing was not about funding government. He understood, that selling government securities was a way to remove money from the economy and to manage the overnight bank rate. When government bonds are ‘sold’, bank reserves are swapped for government bonds - reducing liquidity and thus spending power. The selling of bonds is a way to manage the overnight bank rate: fewer reserves in the system mean overnight interest rates go up as banks compete to borrow those reserves.
Issuing and withdrawing money from circulation
Lerner advocated direct spending into the economy to boost purchasing power and enable business to expand – the so-called ‘fiscal stimulus’. As businesses expand they will need new workers.
However, when productive capacity is exceeded, the economy will ‘overheat’, creating inflation. Taxes should be used to withdraw money from the economy. Spending and taxing should be used to ‘balance the economy’ not as a way to ‘balance the budget’. Pavlina Tcherneva notes that Lerner’s approach was consistent with the general Keynesian notion that fiscal policy could be used to ‘steer the economy back onto the correct path’ when it strayed.
About Abba P. Lerner
Abba P. Lerner was born in Romania in 1903. He came to Britain in 1906, where he studied at the London School of Economics under Friedrich Hayek. In 1934, during a short stay in Cambridge, he met and was influenced by John Maynard Keynes. In 1937 he moved to the United States where he held teaching positions in several prestigious universities including Columbia University, University of Kansas City and Roosevelt University. At the age of 62 he was appointed as a professor at the University of California, Berkeley, where he served until 1971.
Lerner is recognised as one of the first economists to fully understand the potential impact of the ideas within Keynes's General Theory. He is considered also one of the leading pioneers of the Keynesian Revolution. He is best known for coining the phrase ’functional finance’. Much of what he wrote resonates with and has influenced, MMT advocates and MMT economists.
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Thanks,
Jim
If you’re finding value in these articles, become a paid subscriber. Your support allows me to continue to write, teach and to build a community of like-minded individuals—individuals, like you, who understand that MMT offers an opportunity to change the world for the better. Become a paid subscriber now.