Keynes Functional Finance - Financial Business

Keynesian Functional Finance, a school of thought closely associated with economist Abba Lerner, provides a unique perspective on government fiscal policy. It departs from traditional views that prioritize balanced budgets or specific debt-to-GDP ratios as inherent goals. Instead, Functional Finance posits that the primary objective of government fiscal policy should be to achieve macroeconomic stability and full employment, regardless of the impact on the budget.

The core principle of Functional Finance is that government spending and taxation should be used as tools to manage aggregate demand. If the economy is operating below full employment, meaning there are unemployed resources, the government should increase spending or cut taxes, even if it leads to a budget deficit. This injection of demand will stimulate economic activity, create jobs, and ultimately boost output. Conversely, if the economy is experiencing inflation, the government should decrease spending or raise taxes to cool down demand and prevent prices from rising excessively.

Lerner outlined three fundamental rules for Functional Finance:

The government should maintain a level of aggregate demand that ensures full employment, avoiding both inflationary pressures and recessionary conditions.
The government should borrow money when necessary to achieve the first objective.
If borrowing proves insufficient to maintain full employment, the government should print money.

The last rule, particularly, is often controversial. Opponents raise concerns about the potential for hyperinflation if the government simply prints money to finance its expenditures. Proponents of Functional Finance argue that this concern is overblown, as the government’s ability to tax provides an effective check on inflation. If excessive money creation leads to rising prices, the government can simply raise taxes to reduce disposable income and curb spending.

Furthermore, Functional Finance emphasizes the importance of distinguishing between nominal and real deficits. A nominal deficit simply reflects the difference between government spending and revenue in a given period. A real deficit, on the other hand, accounts for the impact of inflation on the value of outstanding government debt. Functional Finance argues that a nominal deficit is not inherently harmful as long as it is contributing to the achievement of macroeconomic stability and does not lead to unsustainable levels of real debt.

Functional Finance has significant implications for government policy. It challenges the conventional wisdom that balanced budgets are always desirable and that government debt is always bad. Instead, it advocates for a pragmatic approach, where fiscal policy is judged by its effectiveness in achieving specific macroeconomic goals. Critics argue that this approach can lead to irresponsible government spending and inflationary pressures. However, proponents maintain that it provides a valuable framework for managing the economy and ensuring that resources are fully utilized.