There is a lot of talk nowadays about returning to “real capitalism” as opposed to the perceived state of socialism which many conservatives imagine that they live in today.  I’m certain that I could shock nearly anyone by explaining the economic rules which we governed our nation by during the time which is referred to as “the golden age of capitalism” in the US.  (roughly defined as the years between the WWII and the early ’70s)

Hows this for a quote…

“An interesting, and to many shocking, corollary is that taxing is never to be undertaken merely because the government needs to make money payments.”

Let’s take a look at the three basic rules, defined by one of the fathers of Modern Monetary Theory (MMT), Abba Lerner, in a paper he wrote about Functional Finance in 1941.  (taken from mmtwiki)

The rules

  1. The government shall maintain a reasonable level of demand at all times. If there is too little spending and, thus, excessive unemployment, the government shall reduce taxes or increase its own spending. If there is too much spending, the government shall prevent inflation by reducing its own expenditures or by increasing taxes.
  2. By borrowing money when it wishes to raise the rate of interest, and by lending money or repaying debt when it wishes to lower the rate of interest, the government shall maintain that rate of interest that induces the optimum amount of investment.
  3. If either of the first two rules conflicts with the principles of ‘sound finance’, balancing the budget, limiting the national debt or other dogmas of traditional economics, so much the worse for these principles.
How is it that we can have such a romanticized view of this part of our history (as indicated by naming it a golden age of capitalism) and yet common knowledge of its basic principles have been fully forgotten?  We’ve fallen into the exact trap that Lerner warned of 70 years ago.  Here are some other interesting quotes from Lerner’s paper,  Functional Finance and the Federal Debt from 1943.  Note the extent Lerner focuses through this entire paper on getting his audience to give up traditional (and inapplicable) intuition of “sound finance”.  This was clearly the biggest threat to maximum prosperity in his view.

A few quotes from Lerner

“Apart from the necessity of winning the war, there is no task facing society today so important as the elimination of economic insecurity.  If we fail in this after the war, the present threat to democratic civilization will arise again.  It is therefore essential that we grapple with this problem even if it involves a little careful thinking and even if the thought proves somewhat contrary to our preconceptions.”
“The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all 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 or unsound.”
“… the government may find itself collecting more in taxes than it is spending, or spending more than it collects in taxes.  In the former case it can keep the difference in its coffers or use it to repay some of the national debt, and in the latter case it would have to provide the difference by borrowing or printing money.  In neither case should the government feel that there is anything especially good or bad about this result.

What in the world is this guy on about?

“In brief, Functional Finance rejects completely the traditional doctrines of “sound finance” and the principle of trying to balance the budget over a solar year or any other arbitrary period.”

“First there were the pump-primers, whose argument was that the government merely had to get things going and then the economy could go on by itself.  There are very few pump-primers left now.”

“The unfounded assumption that current interest on the debt must be collected in taxes springs from the idea that the debt must be kept in a reasonable or manageable ratio to income (whatever that may be).”

And these might get the prize for top shockers…

“it had to be recognized that the result might be a continually increasing national debt… At this point two things should have been made clear:  first, that this possibility presented no danger to society, no matter what unimagined heights the national debt might reach, so long as Functional Finance maintained the proper level of total demand for current output; and second (though this is much less important), that there is an automatic tendency for the budget to be balanced in the long run as a result of the application of Functional Finance, even if there is no place for the principle of balancing the budget.  No matter how much interest has to be paid on the debt, taxation must not be applied unless it is necessary to keep spending down to prevent inflation.”

“There are four major errors in the argument against deficit spending, four reasons why its apparent conclusiveness is only illusory…”  (I’ll leave it to readers to read the reasons in the paper, some of the arguments apply to issues which are not very relevant today.)

“Functional Finance is not especially related to democracy or to private enterprise.  It is applicable to a communist society just as well as to a fascist society or a democratic society.”

A quick analysis

That’s a lot to deal with… for anyone who hasn’t completely written Lerner off as a mad man and want to understand why this process actually worked, and why we moved away from his ideas somewhat, keep reading.

The argument is that principles of “sound finance” are derived from intuitions applied from one’s understanding of a household or company’s finances.  Reality is far from this, and “sound finance” applied to a government with a fiat currency is far less sound than a government which practices Functional Finance.  The fundamental idea is that government spending be large enough to buy goods and services at a rate which encourages maximum employment and therefore maximum output, maximum economic growth, and hence maximum prosperity.  The cost of any government debt would easily be covered by growth from the investment.  This assumes that the average investment made from government spending was done on productive projects.  This is one area that also needs to be modeled better, as we currently seem to have a significant proportion of non-productive spending.  For example, war spending might never be considered a financially productive investment, but its likely to be a requirement from time to time.  An MMT model would then be able to better tell us the real economic impact of such spending.

One important area of improvement we could offer for an MMT/Functional Finance model would be to include a metric for government vs. private investment efficiency.  I’ll post more on this some other time, but public sector inefficiency is a serious concern and should be factored into these models.   Once modeled, this feature would allow us to determine the impact and importance of efficiency improvements, and it would bring to light the difference between effectiveness of public vs. private investment.  I’ll do this soon, along with a few other obvious improvements.

As demonstrated in my previous post… seemingly simple systems can display baffling nonlinearity.  The modestly simple model which I use to run economic simulations is based on a system of roughly 15 differential equations.  Anyone who claims intuition can predict the output of such a complex system is either lying or a fool.  A far deeper understanding of the system is required.  We seem to have lost the basic understanding of what government spending, taxation, and borrowing represents.

There are a few problems with this approach which have been identified over the years.  One of the major problems was related to the unexpected supply-side inflation related to oil price shocks in the 70′s.  This issue is now more understood and can be applied to a Functional Framework model, however this was one of the major downfalls of Functional Finance… as a result, the problem of stagflation at that time was causing the rules of Functional Finance to suggest contradictory policies.  This has been improved, and I’ll have to write something else about this later.

I’ll close with a quote from the Functional Finance page on the future of Lerner’s legacy

“Global financial concerns in 2010 that surround national debt, national and global aggregate demands, and proposed inconsistent applications of austerity and reduced government spending, on the one hand, and quantitative easing and increased government spending on the other hand, have made functional finance relevant again. If unemployment is minimized rapidly by application of functional finance (modified to require green production of the material wants that prevents unacceptable environmental stress and/or financial inflation,) and its principles would in fact achieve freedom from want, Lerner will be one of the fathers of reforms suggested in the 20th Century that finds favor in the 21st.”

  6 Responses to “Economics in the “Golden Age of Capitalism””

  1. Thanks to Lerner’s protege David Colander, we know that in the wake of the stagflation of the 1970s, Lerner added a 4th rule.
    4. The government must establish policies which stabilize the price level and coordinate both the money supply rule and the aggregate total spending rule with this stable price level at the unemployment level it prefers.

    Colander writes, “To integrate the necessity of dealing with the institutional problem of sellers’ inflation by changing institutions rather than accepting whatever unemployment was required to stop inflation, Lerner and I arrived at [this] modification of the rules of functional finance… With this fourth rule the rules of functional finance can once again be relevant to modern economic problems”.
    “Functional Finance, New Classical Economics and Great Great Grandsons”

    As to how to make rule 4 workable, Colander and Lerner proposed a market anti-inflation plan, which their mutual friend– and all-around good egg– Bill Vickrey, immediately endorsed..;col1

    • Fantastic… I’d seen references to addition to the rules to handle stagflation, but I hadn’t managed to pin down the details yet. My long term goal is to build a detailed enough model to accurately incorporate functional finance, and MMT, and applythese rules. Then I can compare functional finance rule based scenarios to current policy or suggested future policy.

      • I’ll add Warren Mosler’s caveat ( from when we discussed the above at his site)
        “post keynesianism died with its various proposals for controlling mark up pricing.
        the question they were addressing was that the problem in the 70’s was deemed to be that corps had pricing power and therefore didn’t resist unions.”

        Controlling cost-push inflation is certainly not part of the MMT paradigm, so that is one area that Lerner parted company (well he died in the early 80s so, would have parted company) with MMT. I’m a lawyer so naturally I think in terms of “what should be in the Modern Monetary Theory Act of 2011?”. I think the bill would lose nothing and would gain political support if it provided standby authority for the President to enact anti-inflation tools by executive order. Its almost beside the point if its out of paradigm. After all, if the standby authority is never needed, it has no effect on the real economy.
        To that end, I’d give him authority to set up a Vickrey anti-inflation market. Likewise, I’d give him authority to create a tradeable gasoline rights system (of the sort Marty Feldstein proposed 5 years ago). Related to this somewhat, because the trade deficit adds to the budget deficit dollar for dollar– something Congress is quite oblivious to, incidentally– I’d zero that out with Warren Buffett’s import certificate market (that is, the bill would mandate its creation instead of standby authority).

        In theory, all of the above could be more efficiently accomplished by tax policy instead of by cap and trade markets. However, because the market transactions would be between private sector actors and would have no direct effect (so far as Congress could see) on the federal budget, paradoxically, Congress would be more willing to grant discretionary power for the President to organize cap and trade markets than they would to give him discretion to adjust federal tax rates (“why, that’s real money!” is how congressmen think). Once a cap and trade market is set up, of course, the President could put his thumb on the scale in a dozen different ways. :o )

        • Beo,

          Have you seen the Kucinich Bill HR 6550 – National Emergency Employment Defense Act of 2010. It is a bill aimed at guaranteeing full employment. How would you modify it in light of your understanding of MMT. Remember that Michael Hudson, along with the crew at AMI had input into the draft. Hudson has been the economic policy adviser to Kucinich. He is a close associate of the UMKC MMT group, as well as having worked closely with Steve Keen.

          • Apologies for the too-long comment… I’m a fan of Harry Hopkins’s belief that a govt reformer can find legal precedent for just about anything. If Congress does have to pass a new law along the way, better to amend an old law (or at least draft a new one that looks similar to the old law) instead of starting from scratch. Kucinich apparently disagrees, I share his goal of putting the central banking inside the Tsy. But why does he even bother?… OK, I just deleted a mini-essay I wrote on its unconstitutional sections…
            Let me summarize that with the problem with the Fed is it exercises federal executive power yet is outside the supervision and control of the President or his Tsy Sec. In recent years, federal courts have had a problem with that. An appeals court opinion (Kavanaugh’s concurrence) this summer in the Yucca Mountain case explains the ins and outs of the issue.

            Anyway Kucinich’s bill eliminates the Federal Reserve system, then reconstitutes it (except for the private banks, of course) inside of Tsy as a separate Fed bureau and a Monetary Authority– yet both would still be independent of Tsy or presidential control (i.e. fixed terms and can’t be fired except for cause, generally that means “indictment”). Plus there’s an emergency board consisting of the President’s cabinet AND members of Congress to determine when emergency lending programs are needed, this is as clean-cut a violation of the separation of powers clause violation as could be imagined.

            Kucinich’s goal (besides abolishing private lending banks) is for the govt to spend Tsy-created US Notes instead of borrowing (platinum coinage would work just as well, but leave that aside) and to put the Fed inside of Tsy. Kucinich could accomplish those two things (though any change to the Fed will unavoidably give the President more power) by simply amending two existing laws– actually just by deleting existing words.
            1. Federal Reserve Act, section 10, STRIKE the words in brackets
            .”..and [wherever] any power vested by this Act in the Board of Governors of the Federal Reserve System or the Federal reserve agent [appears to conflict with the powers of the Secretary of the Treasury, such powers] shall be exercised subject to the supervision and control of the Secretary.”
            2. United States Currency Notes statute, STRIKE subsection (b).
            “(a) The Secretary of the Treasury may issue United States currency notes. The notes—
            (1) are payable to bearer; and
            (2) shall be in a form and in denominations of at least one dollar that the Secretary prescribes.
            (b) The amount of United States currency notes outstanding and in circulation—
            (1) may not be more than $300,000,000; and
            (2) may not be held or used for a reserve.”

            Done and done, any emergency lending that is required (whether to state govts or private corporations) can be carried out by the Fed by order of the Secretary. Actually, if the President brought a case testing the constitutionality of independent agencies (say, by challenging the “independent” NRC claim of authority over the President and his Energy Sec in the Yucca Mountain case), which he’d win; coupled with Tsy’s existing coin seigniorage powers, would gives you the same result without the fuss and bother of Congress actually changing the law. Harry Hopkins would be proud.

          • Beo,

            Thanks for the feedback. very useful!

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