Sudhir Mulji: On functional finance

What we lack is not resources but jobs and money

In their book History of Economic Thought (Houghton Mifflin, 2002), Landreth and Colander provide a list of 100 important publications in economics starting with Guan Zhong's book, which appeared in 700 BC, and ending with Paul Davidson's Money and the Real World and Kirtzner's Competition and Entrepreneurship, published in 1972 and 1973, respectively.

In so comprehensive a list, the most surprising omission is Abba Lerner's Economics of Employment, published by McGraw Hill in 1951.

Perhaps Landreth and Colander took the view that only one book per author could be on their list, and so for Lerner chose his classic Economics of Control, which has been a textbook for many students of economics. However, it would seem that his Economics of Employment, though much less known, developed Lerner's more radical theme of functional finance far more comprehensively.

On the subject of economic policy, Lerner was wholly conventional. He argued that government policies should be aimed to achieve full employment with price stability, a goal that no one would disagree with.

But in the choice of economic tools for achieving his object, Lerner was utterly flexible. In particular, he deplored the conventions that had ruled economic thought on what constitutes sound finance.

And since his writings were characterised by extreme logic and simplicity, he has proved to be a formidable exponent of economics. For Lerner, what "made sense in theory made sense in practice".

Certainly his exposition of macroeconomic policy, under the general concept of "functional finance," is simply breath-taking in its clarity, even when the conclusions are strikingly unexpected.

Consider, for example, his analysis of taxation. He says: "According to 'sound finance' taxation is the normal and proper way for the government to get the money it needs, borrowing is only for emergencies, and printing money is unthinkable."

If you consulted many of your columnists they would entirely agree with the validity of that proposition; however, as Lerner points out, the reasoning behind this argument is based on the analogy of an individual "in which tax collecting by the government is taken to correspond to an individual earning his income."

"An alternative analogy could consider tax collection as corresponding to stealing or robbery and the creation of money as a legitimate occupation of the government. This would lead to the conclusion that the normal way for (the) government to get all the money it spends is to print it. This would be no less logical than the sound finance approach, but neither would it be any more logical" (Lerner, Economics of Employment, page 270).

It was not that Lerner disapproved of taxation; indeed he has been deemed by many to have been a Marxist; but the above example is just an illustration of the allowance he makes for analytic propositions.

Under "functional finance," economic policies should be judged by their consequences, not by established conventions; So long as a policy assisted the goals of full employment without endangering price stability, this was a policy to be followed unhesitatingly and boldly.

Now on the question of printing money, this is generally considered to be highly dangerous by those who draw mistaken analogies from, for example, Latin America. They recommend great caution against the growth of national debt.

Lerner disagrees. Instead he argues: "If prosperity and stability are more important than balancing the budget when the debt is small, they are also more important than balancing the budget when the debt is large. The objection to a large or growing debt is based on the belief that it would cause some vaguely defined economic harm. To sacrifice Functional Finance for the sake of preventing the national debt from growing is therefore to embrace the definite economic harm of depression or inflation for the sake of avoiding a possible cause of economic harm in the future""to jump into the lake in order to avoid a threatening shower" (Lerner, op. cit., page 275).

Proponents of "sound finance" ignore the fact that many countries, for example, Argentina, considered fixed exchange rates as fundamental to stability. Lerner at least had no doubt that exchange rates should be allowed to find their own level, for they were not critical either to the pursuing of full employment or even to domestic price stability.

He regards depreciation as a better alternative to deflation, import restrictions, and depression. No doubt Indian administrators realise this now; it is a pity that they did not realise it in the sixties, seventies, and even eighties.

In Lerner's analysis, whenever there is unemployment it is not resources that are scarce, but jobs and money. It is lack of money that prevents people from buying all the goods and services that are available to society. Now money is a "creature of the State."

The notion therefore that a state can go bankrupt because of a lack of money, over which it has monopoly power, is absurd, according to Lerner. It is once again an error that conventional economics conventionally falls into.

This implies that the state should print money. It is however a common belief that in order to maintain price stability various administrative measures are required, the most important of which is ensuring that printing money is not resorted to.

However, Lerner advocated with equal vigour the need to ensure full employment. He considers printing money just one option to be considered along with borrowing or taxing. He argues that borrowing and taxation are deflationary and therefore necessary if investment grows too fast""not a problem that India seems to be suffering from at present.

In fact, Lerner prefers printing money, for he believes that the danger of having too great a stock of money in the hands of the public is exaggerated and that a society can cope with variations in money supply as a modern society for "convenient operation" without succumbing to the inconvenience of hyper-inflation (page 278, op. cit.).

Indeed, if that be so, instead of starting a cost-push inflation with rising oil prices, the government might well have done better if it had reduced indirect taxes to compensate for the hike in oil prices and financed the resulting deficit by printing money.

So long as society, including the state itself, accepts that fiat money, or money created by the state, is acceptable in payment for goods and services, there is no point in not printing more when resources are unemployed.

In advocating this role of money, Lerner curiously echoed Adam Smith, who was the first to warn us that creating money was not the foundation of wealth.

Yet Adam Smith had recognised that it was an essential instrument to enable the exchange of goods and services that would otherwise be idle. He particularly praised the opening of new banks in Scotland, which served to stimulate economic activity through credits.

The framework used by Adam Smith had emerged from free enterprise; but in a modern society full employment, price stability, and a decent standard of living have to become government goals that will not wait for natural development.

Those who have not participated in the process of development now force the pace upon us. Lerner provides a rule book for governments to use within Adam Smith's framework.