Functional Finance Fantasy

When people discuss the fiscal stimulus package of the Obama Administration they frequently use the word “Keynesian” to label those theories that support this policy. But the reality is that these theories owe more to the economist Abba P. Lerner than to John Maynard Keynes. Lerner, building on Keynes, called it “functional finance.” Lerner, unlike Keynes, was a socialist.

According to the theory of functional finance, periods of expansionary fiscal policy to fight recession must be later followed by contractionary (tightening) fiscal policy to prevent inflation, high interest rates and other forms of distortions. So the period of huge spending and deficits we now have must be gradually unwound as the economy recovers. And ultimately the budgetary deficit must become a surplus. (To be clear, this might not require a surplus in the total spending account but only in those items of spending that are not forms of “social investment.”  This is a slippery concept, however.)

My post today centers not around whether this is a good idea. Instead, I am concerned about whether it is a realistic idea.

Recently Ben Bernanke, the Fed chairman, urged Congress to begin planning to reduce the fiscal deficit.

“But it is very, very important for Congress and the administration to come to some kind of program, some kind of plan that will credibly show how the United States government is going to bring itself back to a sustainable position.” …

If the U.S. were to emerge from its recession and deficits weren’t brought down, Sen. David Vitter (R., La.) asked, “how quickly would that become a major problem in terms of the economy?”

“It could become a problem tomorrow if bond markets are not persuaded that Congress is serious about bringing down the deficit over time,” Mr. Bernanke answered.

Of course, this is easier said than done (as Bernanke knows) for at least three very simple reasons.  First, the political interests that benefit from stimulus spending will not want to give it up. Not all will be successful in keeping their share, but interest groups will have had the time to coalesce around their benefits and lobby for continuation. Second, the Administration is pushing for a healthcare bill that is not adequately financed and will likely add to the deficit. Third, the existing entitlements (Medicare and Medicaid) will be difficult to cut as their costs go out of control when more and more boomers retire.

So what happens to theory of functional finance?

Spending is greatly expanding now but it will not be temporary simply to combat the recession. The reductions later, if any, will be half-measures taken half-heartedly. So over the long run the size and scope of government will expand permanently. Many advocates of fiscal stimulus do not mind this; they want a larger state. But one price we shall pay is that high deficits as well as higher taxes and interest rates in the future will reduce economic growth relative to what it otherwise would have been both now (as the economy anticipates it) and in the future.

Political reality interrupts the fantasy of functional finance.