Daily Archives: January 8, 2012

MMP Blog #31: FUNCTIONAL FINANCE: Monetary and Fiscal Policy for Sovereign Currencies

By L. Randall Wray

This weekwe begin a new topic: functional finance. This will occupy us for the nextseveral blogs. Today we will lay out Abba Lerner’s approach to policy. In the1940s he came up with what he called the functional finance approach to policy.In one of those amazing historical coincidences, Lerner happened to teach atUMKC when he published one of his most famous papers, laying out the approach.Maybe there is something special in the air in Kansas City?

Lerner’s Functional Finance Approach. Lerner posed two principles:

First Principle: if domestic income is too low, governmentneeds to spend more. Unemployment is sufficient evidence of this condition, soif there is unemployment it means government spending is too low.

Second Principle: if the domestic interest rate is too high, itmeans government needs to provide more “money”, mostly in the form of bankreserves.

The idea ispretty simple. A government that issues its own currency has the fiscal andmonetary policy space to spend enough to get the economy to full employment andto set its interest rate target where it wants. (We will address exchange rateregimes later; a fixed exchange rate system requires a modification to thisclaim.) For a sovereign nation, “affordability” is not an issue—it spends bycrediting bank accounts with its own IOUs, something it can never run out of.If there is unemployed labor, government can always afford to hire it—and by definition,unemployed labor is willing to work for money.

Lernerrealized that this does not mean government should spend as if the “sky is thelimit”—runaway spending would be inflationary (and, as discussed many times inthe MMP, it does not presume that government spending won’t affect the exchangerate). When Lerner first formulated the functional finance approach (in theearly 1940s), inflation was not a major concern—the US had recently livedthrough deflation in the GreatDepression. However, over time, inflation became a serious concern, and Lernerproposed a form of wage and price controls to constrain inflation that hebelieved would result as the economy nears full employment. Whether or not thatwould be an effective and desired way of attenuating inflation pressures is notour concern here. The point is that Lerner was only arguing that governmentshould use its spending power with a view to moving the economy toward fullemployment—while recognizing that it might have to adopt measures to fight inflation.

Lernerrejected the notion of “sound finance”—that is the belief that government oughtto run its finances as if it were like a household or a firm. He could see noreason for the government to try to balance its budget annually, over thecourse of a business cycle, or ever. For Lerner, “sound” finance (budgetbalancing) was not “functional”—it did not help to achieve the public purpose(including, for example, full employment). If the budget were occasionallybalanced, so be it; but if it never balanced, that would be fine too. He alsorejected any attempt to keep a budget deficit below any specific ratio to GDP,as well as any arbitrary debt to GDP ratio. The “correct” deficit would be theone that achieves full employment.

Similarlythe “correct” debt ratio would be the one consistent with achieving the desiredinterest rate target. This follows from his second principle: if governmentissues too much debt, it has by the same token issued too few bank reserves andcash. The solution is for the treasury and central bank to stop selling bonds,and, indeed, for the central bank to engage in open market purchases (buyingtreasuries by crediting the selling banks with reserves). That will allow theovernight rate to fall as banks obtain more reserves and the public gets morecash.

Essentially,the second principle just says that government ought to let the banks,households, and firms achieve the portfolio balance between “money” (reservesand cash) and bonds desired. It follows that government bond sales are notreally a “borrowing” operation required to let the government deficit spend.Rather, bond sales are really part of monetary policy, designed to help thecentral bank to hit its interest rate target. All of that is consistent withthe modern money view advanced previously.

Functional Finance versus Superstition. The functional finance approach ofLerner was mostly forgotten by the 1970s. Indeed, it was replaced in academiawith something known as the “government budget constraint”. The idea is also simple:a government’s spending is constrained by its tax revenue, its ability toborrow (sell bonds) and “printing money”. In this view, government reallyspends its tax revenue and borrows money from markets in order to finance ashortfall of tax revenue. If all else fails, it can run the printing presses,but most economists abhor this activity because it is believed to be highlyinflationary. Indeed, economists continually refer to hyperinflationaryepisodes—such as Germany’s Weimar republic, Hungary’s experience, or in moderntimes, Zimbabwe—as a cautionary tale against “financing” spending throughprinting money.

Note thatthere are two related points that are being made. First, government is“constrained” much like a household. A household has income (wages, interest,profits) and when that is insufficient it can run a deficit through borrowingfrom a bank or other financial institution. While it is recognized thatgovernment can also print money, which is something households cannot do, theseis seen as extraordinary behaviour—sort of a last resort. There is norecognition that all spending bygovernment is actually done by crediting bank accounts—keystrokes that are moreakin to “printing money” than to “spending out of income”. That is to say, thesecond point is that the conventional view does not recognize that as theissuer of the sovereign currency, government cannot really rely on taxpayers or financial markets to supply itwith the “money” it needs. From inception, taxpayers and financial markets canonly supply to the government the “money” they received from government. That is to say, taxpayers pay taxes using government’sown IOUs; banks use government’s own IOUs to buy bonds from government.

Thisconfusion by economists then leads to the views propagated by the media and bypolicy-makers: a government that continually spends more than its tax revenueis “living beyond its means”, flirting with “insolvency” because eventuallymarkets will “shut off credit”. To be sure, most macroeconomists do not makethese mistakes—they recognize that a sovereign government cannot really becomeinsolvent in its own currency. They do recognize that government can make allpromises as they come due, because it can “run the printing presses”. Yet, theyshudder at the thought—since that would expose the nation to the dangers ofinflation or hyperinflation. The discussion by policy-makers—at least in theUS—is far more confused. For example, President Obama frequently assertedthroughout 2010 that the US government was “running out of money”—like ahousehold that had spent all the money it had saved in a cookie jar.

So how didwe get to this point? How could we have forgotten what Lerner clearlyunderstood and explained?

In a veryinteresting interview in a documentary produced by Mark Blaug on J.M. Keynes,Samuelson explained:
                “I think there is anelement of truth in the view that the superstition that the budget must bebalanced at all times [is necessary]. Once it is debunked [that] takes away oneof the bulwarks that every society must have against expenditure                 out of control. There must bediscipline in the allocation of resources or you will have anarchistic chaosand inefficiency. And one of the functions of old fashioned religion was toscare people by sometimes what might be regarded as myths into behaving in away that the long-run civilized life requires. We have taken away a belief inthe intrinsic necessity of balancing the budget if not in every year, [then] inevery short period of time. If Prime Minister Gladstone came back to life he    would say “uh, oh what you havedone” and James Buchanan argues in those terms. I have to say that I seemerit in that view.”

The beliefthat the government must balance its budget over some timeframe is likened to a“religion”, a “superstition” that is necessary to scare the population intobehaving in a desired manner. Otherwise, voters might demand that their electedofficials spend too much, causing inflation. Thus, the view that balancedbudgets are desirable has nothing to do with “affordability” and the analogiesbetween a household budget and a government budget are not correct. Rather, itis necessary to constrain government spending with the “myth” precisely becauseit does not really face a budget constraint.

The US (andmany other nations) really did face inflationary pressures from the late 1960suntil the 1990s (at least periodically). Those who believed the inflationresulted from too much government spending helped to fuel the creation of thebalanced budget “religion” to fight the inflation. The problem is that whatstarted as something recognized by economists and policymakers to be a “myth”came to be believed as the truth. An incorrect understanding was developed.

Originallythe myth was “functional” in the sense that it constrained a government thatotherwise would spend too much, creating inflation and endangering the dollarpeg to gold. But like many useful myths, this one eventually became a harmfulmyth—an example of what John Kenneth Galbraith called an “innocent fraud”, anunwarranted belief that prevents proper behaviour. Sovereign governments beganto believe that the really could not “afford” to undertake desired policy, onthe belief they might become insolvent. Ironically, in the midst of the worsteconomic crisis since the Great Depression of the 1930s, President Obamarepeatedly claimed that the US government had “run out of money”—that it couldnot afford to undertake policy that most believed to be desired. Asunemployment rose to nearly 10%, the government was paralysed—it could notadopt the policy that Lerner advocated: spend enough to return the economy towardfull employment.

Ironically,throughout the crisis, the Fed (as well as some other central banks, includingthe Bank of England and the Bank of Japan) essentially followed Lerner’s secondprinciple: it provided more than enough bank reserves to keep the overnightinterest rate on a target that was nearly zero. It did this by purchasingfinancial assets from banks (a policy known as “quantitative easing”), inrecord volumes ($1.75 trillion in the first phase, with a planned additional$600 billion in the second phase). Chairman Bernanke was actually grilled inCongress about where he obtained all the “money” to buy those bonds. He(correctly) stated that the Fed simply created it by crediting bankreserves—through keystrokes. The Fed can never run out “money”; it can affordto buy any financial assets banks are willing to sell. And yet we have thePresident (as well as many members of the economics profession as well as mostpoliticians in Congress) believing government is “running out of money”! Thereare plenty of “keystrokes” to buy financial assets, but no “keystrokes” to paywages.

Thatindicates just how dysfunctional the myth has become.

Next week, we’ll show that some Kansas City airmight have drifted northeast to the bastion of free market economics: theUniversity of Chicago

Geithner’s Ploy: Saving U.S. Banks at Taxpayer Expense, Once Again

By Michael Hudson

U.S. and foreign stockmarkets continue to zigzag wildly in response to expectations about whether theeuro can survive, in the face of populations suffering under neoliberalausterity policies being imposed on Ireland, Greece, Spain, Italy, etc. Here’sthe story that I’m being told by Europeans regarding the recent turmoil inGreece and other European debtor and budget-deficit economies. (The details arenot out, as the negotiations have been handled in utter secrecy. So whatfollows is a reconstruction.)

In autumn 2012, it became apparentthat Greece could not roll over its public debt. The EU concluded that debtshad to be written down by 50 percent. The alternative was outright default onall debt. So basically, the solution for Greece reflected what had happened toLatin American debt in the 1980s, when governments replaced existing debts andbank loans with Brady bonds, named for Reagan Treasury Secretary Nicolas F.Brady. These bonds had a lower principal, but at least their payment was deemedsecure. And indeed, their payments were made.

This write-down seemed radical, butEuropean banks already had hedged their bets and taken out default insurance.U.S. banks were the counterparties to much of this insurance.

In December (?) 2011, a quartercentury after Mr. Brady, Mr. Obama’s Secretary Geithner went to Europe met withEU leaders to demand that Greece make the write-downs voluntary on the part ofbanks and creditors. He explained that U.S. banks had bet that Greece would notdefault – and their net worth position was so shaky that if they had to pay ontheir bad gambles, they would go broke.
As German bankers have described thesituation to me, Mr. Geithner said he would kill the European banks andeconomies if they did not agree to take it on the chin and suffer the lossesthemselves – so that U.S. banks would not have to pay off on the collateralizeddefault swaps (CDOs) and other gambles for which they had collected billions ofdollars.

Europeans were enraged. But Mr.Geithner made a deal. OK, he finally agreed: The White House would indeedpermit Greece to default. But America needed time.

He agreed to open a credit line fromthe Federal Reserve Bank to the European Central Bank (ECB). The Fed wouldprovide the money to lend to banks during the interim when European governmentfinances faltered. The banks would be given time to unwind their defaultguarantees. In the end, the ECB would be the creditor. It – and presumably theFed – would bear the losses, “at taxpayer expense.” The U.S. banks (andprobably the European ones too) can avoid taking a loss that would wipe outtheir net worth.

What really are the details? What wedo know is that U.S. banks are pulling bank their credit lines to Europeanbanks and other borrowers as the old ones expire. The ECB is stepping in tofill the gap. This is called ‘providing liquidity,’ but it seems more to be acase of providing solvency for a basically insolvent situation. A debt thatcan’t be paid, won’t be, after all.

Geithner’s idea is that what workedbefore will work again. When the Federal Reserve or Treasury picks up a bankloss, they simply print government debt or open a Federal Reserve bank depositfor the banks. The public doesn’t view this as being as blatant as simplyhanding out money. The government says it is “saving the financial system,”without spelling out the cost at “taxpayer expense” (not that of the banks!).

It’s a giveaway.