Wednesday, 8 September 2010

'Functional Finance' and budget surpluses

Functional Finance is another name for Modern Monetary Theory (MMT). The paper compares the approach with 'sound finance', which is the classical view of money.

It's worth a read in its own right, however the summary is extracted below.

All modern governments spend by emitting High Powered Money (HPM), normally by having the Treasury issue a check. Taxes are never necessary to “finance” spending, nor, indeed, is it possible for them to do so. The government must first provide the HPM before it can receive HPM in tax payment. Thus, taxes serve a different purpose. The primary function of taxes is to create a demand for HPM—for why would the private sector provide goods and services to government in return for HPM unless it needed HPM for taxes? Of course, we recognize that HPM can be used for many things other than tax payment, but these other uses must be derivative. Taxes also serve another useful purpose, as Lerner emphasized: they remove disposable income and destroy private sector net wealth.
Far from recommending perpetual deficits come what may, the functional finance approach recognizes that the private sector can become overheated, which is remedied through rising taxes to drain HPM and disposable income. Deficits can be too large, but also too small. We normally expect that a deficit will be required, however, for the simple reason that the private sector prefers to accumulate some net wealth in the form of HPM and Treasury bonds. For this reason, the government will usually be required to run a deficit, which means that its outstanding debt stock will grow over time. This is nothing to be feared. The government never faces a “financial constraint”, so long as its offers of HPM for goods and services are taken. Bond sales come after government spending, so, like taxes, cannot possibly be required to “finance” spending. Rather, bond sales are used to drain excess HPM to maintain a positive overnight interest rate. Whether that interest rate target is high or low, it must be set discretionarily by the central bank and then maintained by ensuring banks have the desired level of reserves. While taxes and bond sales both remove HPM from the economy, taxes drain income and wealth while bond sales merely offer an interest-earning alternative to non-interest-earning HPM.
The functional finance approach concludes that there is no magic deficit-to-GDP ratio or debt-to-GDP ratio that ought to be maintained or avoided. It also demonstrates that there is no sense in which budget surpluses in one year can be “locked away and saved” for spending in future years. And it leaves one perplexed when faced with the argument advanced by Nobel winners that running surpluses today—hence, destroying private sector income and wealth—is the best way to encourage investment in order to enhance living standards into the future.