MMP #35 Functional Finance: A Conclusion

By L. Randall Wray

Let’sfinish up the discussion of Lerner’s functional finance approach addressing twoissues: functional finance and developing nations and also the functionalfinance approach to trade deficits.

Functional Finance and Developing Nations. Most of the developing nations havea sovereign currency—which means they can “afford” to buy whatever is for salein the domestic currency, including unemployed labor. As Lerner would put it,unemployment is evidence that there is an unmet demand for domestic currencythat can be filled by additional government spending. At the same time, manydeveloping nations have fixed or managed exchange rates that reduce domesticpolicy space to some degree. They can increase policy space either throughpolicies that generate foreign currency reserves (including development thatincreases exports), or they can protect foreign currency reserves throughcapital controls.

Inaddition, they can favour policy that leads to employment and developmentwithout increasing imports (import substitution policies, for example). Theycan create jobs programs that are labor intensive (so that foreign made capitalequipment is not needed) or programs that provide the output that the newlyemployed workers need (so that they do not spend their new incomes on imports).

Governmentcan favour domestic producers over foreign producers. It can limit itspurchases of foreign goods and services to export earnings. It can try to avoidborrowing in foreign currency in order to limit its need to devote foreigncurrency earnings to interest payments.

Asdiscussed, ability to impose and collect taxes can be impaired in a developingnation. This will limit government’s ability to directly command domesticoutput. And even if it finds plenty of unemployed labor willing to work for itscurrency, those workers might find it difficult to purchase output with thatcurrency at stable prices. More diligent tax collection will help to increasedemand for the currency (since taxes are paid in the domestic currency). Inaddition, government needs to focus job creation in those areas that will leadto increased production of the kinds of goods and services the new workers willwant to purchase. That can relieve inflationary pressures resulting from risingemployment. 

For thelong run, avoiding foreign currency indebtedness and moving toward floatingexchange rates would be conducive to expansion of domestic policy space. Fullutilization of domestic resources (most importantly, labor) will allowdeveloping nations to maximize output while reducing inflation caused byinsufficient supply. Full employment of labor also provides many otherwell-known benefits that will not be detailed here.

A sovereigncurrency provides more policy space to government—it spends by crediting bankaccounts and thus is not subject to the budget constraint that applies to acurrency user. A floating exchange rate (or a managed rate with capitalcontrols) expands the policy space further—because the government does not needto accumulate sufficient reserves to maintain a peg. Well-planned use of thispolicy space will allow the government to move toward full employment withoutsetting off currency depreciation or domestic price inflation. To that end, theemployer of last resort or job guarantee model is particularly useful, a topicpursued in more detail elsewhere in the Primer.

Exports are a cost, Imports are a benefit. In real terms, exports are a costand imports are a benefit from the perspective of a nation as a whole. Theexplanation is simple. When resources including labor are used to produceoutput that is shipped to foreigners, the domestic population does not get toconsume that output, or use it for further production (in the case ofinvestment goods). The nation bears the cost of producing the output, but doesnot get the benefit. On the other hand, the importing nation gets the outputbut did not have to produce it. For this reason, in real terms net exports meannet costs; and net imports mean net benefits.

Now thereare several caveats. First, from the perspective of the producer of output, itdoes not matter who buys the produced goods or services—the firm is equallyhappy selling domestically or to foreign buyers. What the firm wants is to sellfor domestic currency in order to cover costs and reap profits. If the outputis sold domestically, the bank accounts of purchasers are debited, and theaccounts of the producing firm are credited. Everyone is happy. If the outputis sold to foreigners, the receipts will need to go through a currency exchangeso that the producer can receive domestic currency while the ultimatepurchasers are using their own currency. We will not concern ourselves with thedetails, but usually a domestic bank or the central bank will end up holdingreserves of the foreign currency (this will normally be a credit to a reserveaccount at the foreign central bank). The fact remains, however, that in termsof real resources, the “fruit of the labor” is enjoyed by foreigners when theoutput is exported, even though in financial terms the producing firm receivesa net credit to a bank account and the nation receives a net financial asset interms of foreign currency.

Second, netexports add to aggregate demand and increase measured GDP and national income.Jobs are created to produce goods and services for export. Hence, a nation thatwould otherwise operate below full employment can put resources to work in theexport sector. Wages and profits are generated, families receive incomes theywould not have received so that they are able to purchase consumption goods,and firms stay in business that otherwise might have gone bankrupt. This isprobably the main reason why governments encourage growth of exports. In themidst of the economic downturn, President Obama announced that his goal for theUS economy was to double its exports. This is a common strategy for nationsthat want to grow. However, note that for every export there must be an import;for every trade surplus there must be a trade deficit. Obviously it is notpossible for all countries to simultaneously grow in this manner—it isfundamentally a “beggar thy neighbour” strategy.

To theextent that resources are mobilized to produce for foreigners, the domesticpopulation does not receive any net real benefit. True, labor and otherresources that would have been left idle are now employed; workers who wouldnot have received a wage now get income; owners of firms who would not havesold output now receive profits. Yet, if the produced output is sent abroad,there is no extra output for domestic residents to purchase. What happens isthat existing output gets redistributed to these additional claimants—who nowhave wage and profit income. Thus, if we have only put unemployed resources towork in order to produce exports, there is no net benefit—the domesticpopulation is working “harder” but not consuming more in the aggregate becausethe “pie” available for the domestic population has not increased. Theredistribution process itself will probably require inflation as those who nowhave jobs compete for a piece of the pie, bidding up prices. To be sure, thiscould be a desirable social outcome—output gets redistributed from the “haves”to the “have-nots”, and putting unemployed people to work has numerous benefitsfor families and society as a whole (in terms of crime, family break-ups, andsocial cohesion).

But notethat this relied on the presumption that the nation had excess capacity tobegin with. If it had been operating at full capacity of labor, plant, andequipment, then it could only increase exports by reducing domesticconsumption, investment, or government use of resources. Labor and otherresources would be shifted from producing for domestic use toward satisfyingforeign demand for output. Clearly it would usually be preferable to achievefull employment by producing for domestic use rather than for export. Theadditional employment would provide both income as well as more output. Thedomestic “pie” would be larger, so that rather than redistributing from “haves”to “have-nots”, the newly employed would get pieces of the larger pie.

Anotherobvious caveat is that producing output for foreigners can be in a nation’seconomic and political interests. A nation might produce goods and servicesthat are sent abroad for humanitarian reasons—to aid in disaster relief, forexample. It might produce military supplies to aid allies. Foreign directinvestment could aid a developing country that might become a strategicpartner. And there is certainly no reason for a nation to balance its currentaccount on an annual basis—something that would be nearly impossible in ahighly globalized economy with international links in production processes.Hence we would not want to ignore various strategic reasons for exportingoutput and running trade surpluses.

We concludethat we should also take a “functional” approach to international trade: itmakes no more sense for a sovereign government that issues its own floatingcurrency to pursue a trade surplus than it does for that government to seek abudget surplus. Maximization of a current account surplus imposes net realcosts (given the caveats discussed above). Instead, it is best to pursue fullemployment at home, and let the current account and budget balances adjust.That is far better than the usual strategy—which is to pursue a trade surplusin order to get to full employment.

We now turnto a policy that will generate full employment at home. Next week: more on theemployer of last resort proposal.

3 Responses to MMP #35 Functional Finance: A Conclusion

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  2. “However, note that for every export there must be an import;for every trade surplus there must be a trade deficit.”

    With nations running on their own sovereign currencies shouldn’t the capital account for each country be independent from one another?
    I mean it’s perfectly fine for sovereign governments to run trade deficits against each other (in their own currencies). You are accumulating their currency, they are accumulating yours, which is probably an indication that the exchange of real goods is increasing in both directions (and the mutual indebtedness is required as a buffer).
    So the opposite, which is trade surpluses should be able to work also (for a brief period).
    It seems to me though, the obvious boundary for a trade surplus is: sooner or later the foreign sector is going to run out of your currency.