Milton Friedman, Functional Finance and the Government Budget Constraint
Last week we examined Milton Friedman’s version of Functional Finance, which we found to be remarkably similar to Abba Lerner’s. If the economy is operating below full employment, government ought to run a budget deficit; if beyond full employment it should run a surplus. He also advocated that all government spending should be financed by “printing money” and taxes would destroy money. That, as we know, is an accurate description of sovereign government spending—except that it is keystrokes, not money printing. Deficits mean net money creation, through net keystrokes. The only problem with Friedman’s analysis is that he did not account for the external sector: he wanted a balanced budget at full employment, but if a country tends to run a trade deficit at full employment, then it must have a government budget deficit to allow the private sector to run a balanced budget—which is the minimum we should normally expect.
Somehow all this understanding was lost over the course of the postwar period, replaced by “sound finance” which is anything but sound. It was based on an inappropriate extension of the household “budget constraint” to government. This is obviously inappropriate—households are users of the currency, while government is the issuer. It doesn’t face anything like a household budget constraint. How could economics have become so confused? Let us see what Paul Samuelson said, and then turn to proper policy to promote long term growth.
Functional Finance versus Superstition. The functional finance approach of Friedman and Lerner was mostly forgotten by the 1970s. Indeed, it was replaced in academia with something known as the “government budget constraint”. The idea is simple: a government’s spending is constrained by its tax revenue, its ability to borrow (sell bonds) and “printing money”. In this view, government really spends its tax revenue and borrows money from markets in order to finance a shortfall of tax revenue. If all else fails, it can run the printing presses, but most economists abhor this activity because it is believed to be highly inflationary. Indeed, economists continually refer to hyperinflationary episodes—such as Germany’s Weimar Republic, Hungary’s experience, or in modern times, Zimbabwe—as a cautionary tale against “financing” spending through printing money.
Note that there are two related points that are being made. First, government is “constrained” much like a household. A household has income (wages, interest, profits) and when that is insufficient it can run a deficit through borrowing from a bank or other financial institution. While it is recognized that government can also print money, which is something households cannot do, these is seen as extraordinary behaviour—sort of a last resort. There is no recognition that all spending by government is actually done by crediting bank accounts—keystrokes that are more akin to “printing money” than to “spending out of income”. That is to say, the second point is that the conventional view does not recognize that as the issuer of the sovereign currency, government cannot really rely on taxpayers or financial markets to supply it with the “money” it needs. From inception, taxpayers and financial markets can only supply to the government the “money” they received from government. That is to say, taxpayers pay taxes using government’s own IOUs; banks use government’s own IOUs to buy bonds from government.
This confusion by economists then leads to the views propagated by the media and by policy-makers: a government that continually spends more than its tax revenue is “living beyond its means”, flirting with “insolvency” because eventually markets will “shut off credit”. To be sure, most macroeconomists do not make these mistakes—they recognize that a sovereign government cannot really become insolvent in its own currency. They do recognize that government can make all promises as they come due, because it can “run the printing presses”. Yet, they shudder at the thought—since that would expose the nation to the dangers of inflation or hyperinflation. The discussion by policy-makers—at least in the US—is far more confused. For example, President Obama frequently asserted throughout 2010 that the US government was “running out of money”—like a household that had spent all the money it had saved in a cookie jar.
So how did we get to this point? How could we have forgotten what Lerner and Friedman clearly understood?
In a very interesting interview in a documentary produced by Mark Blaug on J.M. Keynes, Samuelson explained:
"I think there is an element of truth in the view that the superstition that the budget must be balanced at all times [is necessary]. Once it is debunked [that] takes away one of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and inefficiency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires. We have taken away a belief in the intrinsic necessity of balancing the budget if not in every year, [then] in every short period of time. If Prime Minister Gladstone came back to life he would say "uh, oh what you have done" and James Buchanan argues in those terms. I have to say that I see merit in that view."
The belief that the government must balance its budget over some timeframe is likened to a “religion”, a “superstition” that is necessary to scare the population into behaving in a desired manner. Otherwise, voters might demand that their elected officials spend too much, causing inflation. Thus, the view that balanced budgets are desirable has nothing to do with “affordability” and the analogies between a household budget and a government budget are not correct. Rather, it is necessary to constrain government spending with the “myth” precisely because it does not really face a budget constraint.
The US (and many other nations) really did face inflationary pressures from the late 1960s until the 1990s (at least periodically). Those who believed the inflation resulted from too much government spending helped to fuel the creation of the balanced budget “religion” to fight the inflation. The problem is that what started as something recognized by economists and policymakers to be a “myth” came to be believed as the truth. An incorrect understanding was developed. Originally the myth was “functional” in the sense that it constrained a government that otherwise would spend too much, creating inflation. But like many useful myths, this one eventually became a harmful myth—an example of what John Kenneth Galbraith called an “innocent fraud”, an unwarranted belief that prevents proper behaviour. Sovereign governments began to believe that the really could not “afford” to undertake desired policy, on the belief they might become insolvent. Ironically, in the midst of the worst economic crisis since the Great Depression of the 1930s, President Obama repeatedly claimed that the US government had “run out of money”—that it could not afford to undertake policy that most believed to be desired. As unemployment rose to nearly 10%, the government was paralysed—it could not adopt the policy that both Lerner and Friedman advocated: spend enough to return the economy toward full employment.
Ironically, throughout the crisis, the Fed (as well as some other central banks, including the Bank of England and the Bank of Japan) essentially followed Lerner’s second principle: it provided more than enough bank reserves to keep the overnight interest rate on a target that was nearly zero. It did this by purchasing financial assets from banks (a policy known as “quantitative easing”), in record volumes ($1.75 trillion in the first phase, with a planned additional $600 billion in the second phase). Chairman Bernanke was actually grilled in Congress about where he obtained all the “money” to buy those bonds. He (correctly) stated that the Fed simply created it by crediting bank reserves—through keystrokes. The Fed can never run out “money”; it can afford to buy any financial assets banks are willing to sell. And yet we have the President (as well as many members of the economics profession as well as most politicians in Congress) believing government is “running out of money”! There are plenty of “keystrokes” to buy financial assets, but no “keystrokes” to pay wages.
That indicates just how dysfunctional the myth has become.
A Budget Stance to Promote Long Term Growth. The lesson that can be learned from that three decade experience of the US is that in the context of a private sector desire to run a budget surplus (to accumulate savings) plus a propensity to run current account deficits, the government budget must be biased to run a deficit even at full employment. This is a situation that had not been foreseen by Friedman (not surprising since the US was running a current account surplus in the first two decades after WWII). The other lesson to be learned is that a budget surplus (like the one President Clinton presided over) is not something to be celebrated as an accomplishment—it falls out of an identity, and is indicative of a private sector deficit (ignoring the current account). Unlike the sovereign issuer of the currency, the private sector is a user of the currency. It really does face a budget constraint. And as we now know, that decade of deficit spending by the US private sector left it with a mountain of debt that it could not service. That is part of the explanation for the global financial crisis that began in the US.
To be sure, the causal relations are complex. We should not conclude that the cause of the private deficit was the Clinton budget surplus; and we should not conclude that the global crisis should be attributed solely to US household deficit spending. But we can conclude that accounting identities do hold: with a current account balance of zero, a private domestic deficit equals a government surplus. And if the current account balance is in deficit, then the private sector can run a surplus (“save”) only if the budget deficit of the government is larger than the current account deficit.
Finally, the conclusion we should reach from our understanding of currency sovereignty is that a government deficit is more sustainable than a private sector deficit—the government is the issuer, the household or the firm is the user of the currency. Unless a nation can run a continuous current account surplus, the government’s budget will need to be biased to run deficits on a sustained basis to promote long term growth.
However, we know from our previous discussion that fiscal policy space depends on the exchange rate regime—the topic of the next blog.
Further, we want to be clear: the appropriate budget stance depends on the balance of the other two sectors. A nation that tends to run a current account surplus can run tighter fiscal policy; it might even be able to run a sustained government budget surplus (this is the case in Singapore—which pegs its exchange rate, and runs a budget surplus because it runs a current account surplus while it accumulates foreign exchange). A government budget surplus is also appropriate when the domestic private sector runs a deficit (given a current account balance of zero, this must be true by identity). However, for the reasons discussed above, that is not ultimately sustainable because the private sector is a user, not an issuer, of the currency.
Finally, we must note that it is not possible for all nations to run current account surpluses—Asian net exporters, for example, rely heavily on sales to the US, which runs a current account deficit to provide the Dollar assets the exporters want to accumulate. We conclude that at least some governments will have to run persistent deficits to provide the net financial assets desired by the world’s savers. It makes sense for the government of the nation that provides the international reserve currency to fill that role. For the time being, that is the US government.