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FUNCTIONAL FINANCE:
OLD AND NEW
From Abba Lerner to the New Consensus and the
Bernanke Doctrine

Pavlina R. Tcherneva, Ph.D.

Bard College and Levy Economics Institute
[email protected]

http://pavlina-tcherneva.net
@ptcherneva
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Overview
•  FUNCTIONAL FINANCE
•  Abba Lerner “Functional Finance and the Federal Debt” (1943)

•  ‘NEW’ FUNCTIONAL FINANCE?

•  CONTEXT: Fiscal Policy ‘reborn’?

•  THEORY
•  The unique nature of government liabilities
•  Ricardian Regimes, Monetary-Fiscal coordination and QE for the people
•  Effectiveness; transmission mechanisms

•  POLICY: The curious case of Ben Bernanke

•  POST-CRISIS THINKING
•  New Consensus ‘soul’ searching?
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Lerner’s principles of functional finance

•  Judged policy by its economic effects, not by an ex-post
accounting identity

•  Government policy is to be used at all times to address specific

economic problems, most importantly individual economic
insecurity

•  The government budget position or debt/deficit-to-GDP ratios are

endogenous variables and inappropriate policy objectives

•  Full employment and price stability

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Lerner’s principles of functional finance

•  3 pairs of government policy levers
•  Spending and taxation
•  Borrowing and repayment of loans
•  Issue of new money and withdrawal of money from circulation

•  All to be undertaken “with an eye only to the results of these actions

on the economy and not to any established traditional doctrine about
what is sound and what is unsound.” (Lerner 1943, p. 354)

•  Functional Finance is the principle of judging fiscal measures by the

effects on human activity
1. Government is responsible for adjusting its rates of expenditure and taxation
such that total spending in the economy is neither more nor less than that which
is sufficient to purchase the full employment level of output at current prices.
2. The preferred method à issuing new money
•  Any resulting deficits, greater borrowing, or "printing money," are in and of themselves
neither good nor bad. They are simply the means to the desired ends of full
employment and price stability (1943, 354).
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State money and functional finance

•  “Money as a Creature of the State” Lerner 1947

•  TWINTOPT
•  Money: a social power credit debt relationship and a tool
of distribution (Tcherneva 2016)

•  Simple public monopoly (Mosler 1993)

•  Sovereign vs. non-sovereign regimes and fiscal space
•  Currency boards, fixed pegs, monetary unions, dollarized countries

•  Functional finance’s impact on the economy depends on

the currency regime in question
•  What are the distributive effects
•  Not all countries can pursue functional finance for economic
security and full employment
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Implications for government spending I

•  Taxation is not a funding operation
•  its effect on the public is to influence economic behavior (Lerner,
1951, p. 131)

•  Borrowing is not a funding operation

•  Should be undertaken only if money in the hands of the public is
considered to be too large

•  The primary purpose of bond sales is to manage reserves and

thus the overnight rate of interest. (Lerner 1943, p. 355)
•  Modern Money—IRMA

•  Government spending precedes taxation and borrowing

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Implications for government spending II

•  By its very nature, our monetary system is a redistributive
system

•  How resources are employed, produced, and distributed

•  Functional finance is not a specific policy; it is a framework
within which various policies may be conducted

•  Functional finance can be practiced for achieving many

objectives: military aggression, financial sector resolution,
securing true full employment
•  Keynes-Lerner-Minsky: Full employment and Price Stability

•  Sound finance is a perverse distributive system

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Post Keynesian functional finance

•  Objective
•  full employment

•  Two Methods
1) Aggregate demand management (pro-investment, pro-growth)
•  Full employment = NAIRU (Hydraulic Keynesians)

2) Direct job creation/ELR

•  Full employment = jobs for all who want jobs
•  Price stability = f (stabilizing the most essential price in the economy, w)
•  Countercyclical (buffer stock) mechanism. (Minsky’s ELR, 1986)

•  Lerner’s legacy
•  High vs. low full employment
•  Direct job creation in the form of public works may be necessary in order to attain
and maintain full employment and price stability (Lerner, Economics of Control,
1944, p. 315n)
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Functional finance vs. sound finance

•  “Sound” finance
•  e.g., Reinhart-Rogoff’s ‘data’ approach to the crisis; Debt/GDP 90%
•  A budgetary outcome as an end in itself

Recall the Treasury view in the 30s (FP no effect/crowding out)

à Keynes’s critique
àNew Classical counter critique, Ricardian equivalence

•  The mainstream
•  Full employment abandoned
•  Fiscal policy abandoned

•  The shifting mainstream position on government finance & fiscal policy

•  “Non-Ricardian regimes”
•  Woodford’s bond drop vs. Bernanke and Adair Turner’s helicopter drop vs. people’s QE
•  Bernanke’s Doctrine: how to fight deflation
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‘New’ functional finance?

•  The ‘new view’ of fiscal policy effectiveness-New Consensus?
•  ZIRP/Japan
•  What role for fiscal policy and optimal policy mix

•  Woodford’s Fiscal Theory of the Price Level (1996, 1998,

2000), Leeper (1991), Cochrane (1998, 2014), Sims (1999)
•  Bernanke’s Non-traditional monetary policy (1999)
•  Non-Ricardian regimes
•  The unique nature of government liabilities

Sovereign money in the mainstream?

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Convergence in Macroeconomics:
Elements of the New Consensus (Woodford 2008)
•  Microfoundations of Macro
•  NK/RBC methodology (growth & business cycle models same principles)
•  Coherent intertemporal GE foundations/NK structural models ok
•  Need not be perfectly competitive/continuous market clearing (rigidities)
•  Quantitative theory + some a-theoretical models
•  The only debate is between Calibrationists and Bayesian Estimation of
DSGE, i.e., about technique
•  Rational Expectations
•  + sticky wages è Phillips Curve
•  Real disturbances
•  tech chocks, preferences, or fiscal shocks (real value of debt changes)
•  Monetary Policy is an effective means of inflation control
•  government must provide the nominal anchor, Ms, i-rt, Stock of Bonds
•  Money is not important
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Fiscal theory of the price level:

non-Ricardian regimes
•  Fiscal policy ineffectiveness and Ricardian Equivalence

•  Bt/Pt = Present value of primary fiscal surpluses as of time t, t = 0, 1, …

•  ‘Active fiscal-passive monetary’ regimes (Leeper 1991,

Woodford 1995, 1998)
•  Non-Ricardian regimes, no commitment to primary surpluses
•  fiscal policies have sizeable demand-side effects
•  prices must necessarily adjust
•  manifested via a wealth effect mechanism

•  How long can a Non-Ricardian regime last?

•  Doesn’t the private sector impose a budget constraint on government
spending anyhow?
•  Woodford: No. Government liabilities are in a unique position, distinct
from that of private sector liabilities
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Budget constraints imposed on

government by private agents?
•  “A subtler question is whether it makes sense to suppose that
actual market institutions do not actually impose a constraint
… upon governments (whether logically necessary or not),
given that we believe that they impose such borrowing limits
upon households and firms. The best answer to this question, I
believe, is to note that a government that issues debt
denominated in its own currency is in a different situation than
from that of private borrowers, in that its debt is a promise only
to deliver more of its own liabilities. (A Treasury bond is simply
a promise to pay dollars at various future dates, but these
dollars are simply additional government liabilities, that happen
to be non-interest-earning.) There is thus no possible doubt
about the government’s technical ability to deliver what it has
promised…”. (Woodford 2000, p. 32,original emphasis)
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Budget constraint imposed on

government by private agents?
•  What does it mean for the public to hold government debt?

•  …[it] is a consequence of optimal wealth accumulation by

households, not of any constraint upon government
borrowing programs other than the requirement that in
equilibrium someone has to choose to hold the debt that the
government issues.” (Woodford 2000, p. 30) (original
emphasis)

•  The proper interpretation: the private sector does not fund

the government. (Woodford, but not the rest of the
mainstream)

•  If the private sector refuses to buy bonds, the Federal

Reserve will step in as the residual buyer
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Government spending,
wealth effect, transmission mechanism

•  Woodford’s ‘bond drop’ theory of the fiscal impact on

output and inflation, via a wealth effect when bonds
end up in the hands of private agents.

•  Original formulation ‘cashless’ economy.

•  How is the bond drop financed?
•  How do agents buy these bonds?
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Problems with the “bond drop” view

•  Confused causality
1.  government spending creates reserves
2.  Bond sales/purchases à maintain interest rates
3.  If nfa in the hands of the private agents increase, it is because reserves
have increased first and bonds were purchased later
4.  Call it a ‘reserve drop’ theory of fiscal spending.
5.  The wealth effect cannot occur if the private sector buys bonds, because it
will lose one government asset (reserves) as it gets another (bonds).

•  Bernanke disagrees with Woodford (Adair Turner does too) :

•  ‘bond drops’ are Ricardian; ‘money drops’ are not
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Bernanke’s “money drop” policy

•  Bernanke’s ‘money drop’:
•  “Under a fiat (that is, paper) money system, a government (in
practice, the central bank in cooperation with other agencies)
should always be able to generate increased nominal spending
and inflation, even when the short-term nominal interest rate is
at zero... The U.S. government has a technology, called a
printing press (or, today, its electronic equivalent) that allows it
to produce as many U.S. dollars as it wishes at essentially no
cost.” (Bernanke 2002)
•  Japan’s “self-induced paralysis” (1999)
•  objective à QE
•  CB cannot ‘rain money unilaterally’ on the population.
•  Money drop via fiscal policy: Fiscal Components of Monetary Policy
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Bernanke’s Doctrine:
fiscal components of monetary policy
•  Fiscal components: ‘gifts’ policy — oriented with an eye to
a specific economic objectives:

•  Lower short or long term interest rates

•  Depreciate currency
•  Set a price floor on financial assets
•  Increase aggregate demand
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Bernanke’s functional finance

•  Non-traditional monetary policy

1.  Commitment to zero rates with inflation target

Anchor expectations

2.  Depreciation of the currency

open market purchase of foreign currency: fiscal component

3.  Non-standard Open Market Operations

short or long-term gov’t bonds, corporate bonds, MBS, CDOs, CP, etc.
Permanent OMOs: fiscal component
•  Working assumption: the purchase of non-performing assets is a free gift to
the private sector, which will boost aggregate demand

4.  Money-financed fiscal transfers

E.g., Clinton, Bush Jr., Obama tax cuts: fiscal component
‘Gifts’ do not increase government’s outstanding debt
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Central bank independence?

•  Temporary abdication of independence to reach goals and
coordinate with fiscal authority

•  Monetary policy is effective at the zero-bound only because of

its fiscal components

•  “Monetary policy actions, to be effective, must induce a fiscal policy

response” (Sims 2013)

•  Optimal policy mix is in question because:

•  If FP causes inflation, and inflation-targeting monetary policy can
neutralize the needed effect

•  But if the level of outstanding inflation-indexed government debt is too

high, monetary policy can be hyperinflationary (Loyo 1999, Sims 2013)
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Bernanke’s money drop

“In practice, the effectiveness of anti-deflation policy could
be significantly enhanced by cooperation between the
monetary and fiscal authorities. A broad-based tax cut, for
example, accommodated by a program of open-market
purchases to alleviate any tendency for interest rates to
increase, would almost certainly be an effective stimulant to
consumption and hence to prices. . . . A money-financed
tax cut is essentially equivalent to Milton Friedman’s
famous ‘helicopter drop’ of money.” (Bernanke 2002)
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Bernanke’s paradox:
financing the fiscal components
•  There is no limit to which we can finance fiscal components
•  SCOTT PELLEY (60 minutes): “Is that tax money that the Fed is
spending?”

•  CHAIRMAN BERNANKE: “It’s not tax money. The banks have

accounts with the Fed, much the same way that you have an account
in a commercial bank. So, to lend to a bank, we simply use the
computer to mark up the size of the account that they have with the
Fed.”

•  http://www.youtube.com/watch?v=11J_914RZ-o

•  But…
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Bernanke’s paradox:
financing the federal debt
•  “Prompt attention to questions of fiscal sustainability is
particularly critical because of the coming budgetary and
economic challenges associated with the retirement of the
baby-boom generation and continued increases in medical
costs. … With the ratio of debt to GDP already elevated, we
will not be able to continue borrowing indefinitely to meet
these demands” (June 3, 2009 Statement before House
Budget Committee)

•  “The prospect of growing fiscal imbalances and their

economic consequences also raises essential questions
of intergenerational fairness.” (Jan 18, 2007, see also
October 4, 2010)
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Bernanke’s (& orthodoxy’s) paradox

•  Unlimited ability to finance fiscal components of monetary policy…
•  …but limited ability in financing Medicare, Social Security?

•  Purchases of toxic financial assets—crowding in effect (‘gifts’)

•  Spending for general operations—crowding out effect

“In fact, there is no obvious reason why the desired saving rate in the
United States should have fallen precipitously over the 1996-2004
period. Indeed, the federal budget deficit, an oft-cited source of the
decline in U.S. saving, was actually in surplus during the 1998-2001
period even as the current account deficit was widening.”
(Bernanke, 9/11/07 Bundesbank Lecture)
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Helicopter Money (HM) -- Simon Wren-Lewis

•  A form of fiscal stimulus

•  HM ≠ tax cuts (HM: printing money, tax cuts: issuing more debt. HM new
money, tax cuts crowding out).

•  QE printing money to buy toxic assets. Better if we gave it to the people

to spend (People’s QE).

•  Do tax cuts increase private spending? Maybe. Ricadrian equivalence

means that since gov’t has to pay interest on the new bonds, there will be
crowding out. 5% on $100 debt per year, no new consumption, maybe all
$100 must be invested to generate the $5 interest. If it was funded by
printing $, no crowding out.

•  If inflation target, Fed’s money printing has to be unwound, Fed will sell
bonds (since they cannot raise taxes). Now debt is held by he public, and
gov’t needs to ‘raise’ money to pay interest on that debt è Ricardian
Equivalence holds.
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Theoretical problems
1. No macro sector balances
- Federal government surpluses = non-federal government deficits.

2. Government spending always results in a crowding in effect.

- Monetary policy is an asset swap
- Taxes crowd out private sector holdings of nfa by draining
reserves from the system
- Spending may not be crowded out if the private sector is
willing to take on more private credit

3. Fiscal components are ever present, not just in crises

- Confusion about what constitutes fiscal and monetary policy

4. New view reestablishes govt spending as inherently inflationary

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Genuine resurrection of fiscal policy?

•  Unique nature of government money is not fully
understood

•  Bonds and taxes are still viewed as funding operations,

sovereign finance is recognized only in extreme
circumstances when ‘money drops’ and ‘gifts’ are
recommended.

•  Some understanding of the role of bonds as IRMA tool

•  No real understanding of the role of taxation (except

Christopher Sims, 1999, 2005?)
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Sims on the nature of money

•  Christopher Sims (2005)
“tax-backed money”
“Some institutional frameworks aimed at ensuring
“independence” of the central bank undermine the credibility of
any claim to provide a ‘tax-backed floor’ to the value of
money” (Sims 2005, p. 287)

“By cutting all explicit connections with fiscal authorities and

ruling out the holdings of government debt as assets” The
ECB, unlike the Fed, lacks an “institutional structure to use in
case it were to need balance sheet replenishment” (Sims
2005, 295)
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Functional finance going forward?

•  Solvency recognized; not full implications of ‘tax-backed-
money’ and ‘money as a creature of the state’

•  Functional finance for stabilizing asset prices is understood and

practiced

•  Functional finance for setting interest rates (OMOs)

•  Taxing and spending for the purposes of full employment and

price stability is not. Flawed transmission mechanism.

•  The new view: some controversy, but solidifies the inflationary

aspects of government spending; monetary policy reigns
supreme: NGDP targeting
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Functional Finance in the Mainstream

•  NGDP targeting
•  % ∆ NGPD = % ∆ Real GDP + % ∆ Price level

•  If RGDP falls and inflation stays the same à late response with
inflation target
•  If RGDP rises and inflation falls à rate cut can add more stimulus and
create bubble

•  Tools of NGDP targeting (exactly the same as for inflation

targeting)
•  Communicate strategy
•  Fed funds rate, OMOs
•  @ zero-bound: asset purchases
•  Expectations
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The future of fiscal policy

•  Hogwarts School of Policy
•  Central Bank witchcraft and confidence fairies
•  Expectations

•  Sound finance/austerity
•  Near universal agreement that public debts & deficit are a problem
•  Obstacle to recovery, full employment, sustainable growth

•  The mainstream’s Bernanke paradox

•  Soul searching
•  Was the New Consensus Inadequate?
•  Was the theory inadequate
•  Were the method (models) inadequate
•  Was the (monetary) policy response inadequate

•  “Dysfunctional finance” vs. Functional finance a la Keynes,

Lerner and Minsky