MMP BLOG #32: MILTON FRIEDMAN’S VERSION OF FUNCTIONAL FINANCE: A PROPOSAL FOR INTEGRATION OF FISCAL AND MONETARY POLICY

By L. Randall Wray

In the context of today’s conventional wisdom about the dangers of budget deficits, Lerner’s views (examined last week) appear somewhat radical. What is surprising is that they were not all that radical at the time. As everyone knows, Milton Friedman was a conservative economist and a vocal critic of “big government” and of Keynesian economics. No one has more solid credentials on the topic of constraining both fiscal and monetary policy than Friedman. Yet, in 1948 he made a proposal that was almost identical to Lerner’s functional finance views. On one hand, this demonstrates how far today’s debate has moved away from a clear understanding of the policy space available to a sovereign government, but also that Lerner’s ideas must have been “in the air”, so to speak, widely shared by economists across the political spectrum. At the end of this subsection we will also visit Paul Samuelson’s comment on this topic—which provides a cogent explanation for today’s confusion about fiscal and monetary policy. As Samuelson hints, the confusion was purposely created in order to mystify the subject.

Briefly, Milton Friedman's 1948 article, "A Monetary and Fiscal Framework for Economic Stability" put forward a proposal according to which the government would run a balanced budget only at full employment, with deficits in recession and surpluses in economic booms. There is little doubt that most economists in the early postwar period shared Friedman’s views on that. But Friedman went further, almost all the way to Lerner’s functional finance approach: all government spending would be paid for by issuing government money (currency and bank reserves); when taxes were paid, this money would be “destroyed” (just as you tear up your own IOU when it is returned to you). Thus, budget deficits lead to net money creation. Surpluses would lead to net reduction of money.

He thus proposed to combine monetary policy and fiscal policy, using the budget to control monetary emission in a countercyclical manner. (He also would have eliminated private money creation by banks through a 100% reserve requirement--an idea he had picked up from Irving Fisher and Herbert Simons in the early 1930s--hence, there would be no "net" money creation by private banks. They would expand the supply of bank money only as they accumulated reserves of government-issued money. We will not address this part of the proposal.) This stands in stark contrast to later conventional views (such as those associated with the ISLM model taught in textbooks) that “dichotomized monetary and fiscal policy. Friedman, too, later argued that the central bank ought to control the money supply, delinking in his later work the connection between fiscal policy and monetary policy. But at least in this 1948 paper he clearly tied the two in a manner consistent with Lerner’s approach.

Friedman believed his proposal results in strong counter-cyclical forces to help stabilize the economy as monetary and fiscal policy operate with combined force: deficits and net money creation when unemployment exists; surpluses and net money destruction when at full employment. Further, his plan for countercyclical stimulus is rules-based, not based on discretionary policy—it would operate automatically, quickly, and always at just the right level. As is well known, he later became famous for his distrust of discretionary policy, arguing for “rules” rather than “authorities”. This 1948 paper provides a neat way of tying policy to rules that automatically stabilize output and employment near full employment.

We see that Friedman’s “proposal” is actually quite close to a description of the way things work in a sovereign nation. When government spends, it does so by creating "high powered money" (HPM)--that is, by crediting bank reserves. When it taxes, it destroys HPM, debiting bank reserves. A deficit necessarily leads to a net injection of reserves, that is, to what Friedman called money creation. Most have come to believe that government finances its spending through taxes, and that deficits force the government to borrow back its own money so that it can spend. However, any close analysis of the balance sheet effects of fiscal operations shows that Friedman (and Lerner) had it about right.

But if that is so, why do we fail to maintain full employment? The problem is that the automatic stabilizers are not sufficiently strong to offset fluctuations of private demand. Below we will examine why that is the case.

Note that Friedman would have had government deficits and, thus, net money emission so long as the economy operated below full employment. Again, that is quite close to Lerner's functional finance view, and as discussed above it was a common view of economists in the early postwar period. But almost no respectable economist or politician will today go along with that on the belief it would be inflationary and/or would bust the budget. Such is the sorry state of economics education today. How did we get to this point? In last week’s blog, Samuelson explained that the belief that the government must balance its budget over some timeframe 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.

A Budget Stance for Economic Stability. In Friedman's proposal, the size of government would be determined by what the population wanted government to provide. Tax rates would then be set in such a way so as to balance the budget only at full employment. Obviously that is consistent with Lerner’s approach—if unemployment exists, government needs to spend more, without worrying about whether that generates a budget deficit. Essentially, Friedman’s proposal is to have the budget move countercyclically so that it will operate as an automatic stabilizer. And, indeed, that is how modern government budgets do operate: deficits increase in recessions and shrink in expansions. In robust expansions, budgets even move to surpluses (this happened in the US during the administration of President Clinton). Yet, we usually observe that these swings to deficits are not sufficiently large to keep the economy at full employment. The recommendations of Friedman and Lerner to operate the budget in a manner that maintains full employment are not followed. Why not? Because the automatic stabilizers are not sufficiently strong.

To build in sufficient countercyclical swings to move the economy back to full employment requires two conditions. First, government spending and tax revenues must be strongly cyclical--spending needs to be countercyclical (increasing in a downturn), and taxes pro-cyclical (falling in a downturn). One way to make spending automatically countercyclical is to have a generous social safety net so that transfer spending (on unemployment compensation and social assistance) increases sharply in a downturn. Alternatively, or additionally, tax revenues also need to be tied to economic performance--progressive income or sales taxes that move countercyclically.

Second, government needs to be relatively large. Hyman Minsky (1986) used to say that government needs to be about the same size as overall investment spending--or at least, swings of the government’s budget have got to be as big as investment swings, moving in the opposite direction. (This is based on the belief that investment is the most volatile component of GDP. This includes residential real estate investment, which is an important driver of the business cycle in the US. The idea is that government spending needs to swing sufficiently and in the opposite direction to investment in order to keep national income and output relatively stable; that, in turn will keep consumption relatively stable.) According to Minsky, government was far too small in the 1930s to stabilize the economy--even during the height of the New Deal, the federal government was only 10% of GDP. Today, all major OECD nations probably have a government that is big enough, although some developing countries probably have a government that is too small by this measure. Based on current realities, it looks like the national government should range from the US low of less than 20% of GDP to a high of 50% in France. The countries at the low end of the range need more automatic fluctuation built into the budget than those with a bigger government.

Looking to the decade of the 1960s in the US, one sees that it was more-or-less consistent with Friedman's proposal and with Lerner’s functional finance approach. Federal government spending averaged around 18-20% of GDP, and deficits averaged $4 or $5 billion a year, except for 1968 when they temporarily increased to $25 billion--but for the decade, deficits ran well under 1% of GDP on average. We could quibble about whether the US was at full employment in the 1960s, but it was certainly closer to full employment during that decade than it was after the early 1970s. From the early 1970s until the boom of the 1990s during the presidency of Bill Clinton, the budget was too tight relative to the recommendations of Friedman and Lerner. How do we know? Because unemployment was chronically too high—even in expansions it never got down to 1960s levels.

Note that this was not because government spending fell much, or because taxes were raised. Indeed, the deficit tended to be much higher after the early 1970s (the high unemployment period) than it was during the 1960s (the low unemployment period).

What went wrong? Briefly, the problem could be attributed to the evolution of the international position of the US that led to a chronic current account deficit. The US emerged from WWII in a dominant position—not only was the dollar in high demand, but so were US exports—needed by war-ravaged Europe and Japan. The US had a trade surplus, and lent Dollars to the rest of the world to buy its output. That added to US demand and—from our accounting identities—kept our budget deficits small and let our private sector run surpluses (save).

Recall that the international monetary system (Bretton Woods) was based on a dollar-gold standard, with exchange rates fixed to the Dollar and the Dollar convertible to gold. By the early 1970s, the US was running a trade deficit and foreign holders were exchanging excess dollars for gold. To make a long story short, the US abandoned gold, the Bretton Woods system collapsed, and most developed countries floated. The dollar fell in value (helping to generate inflation pressures in the US as imports, especially oil, got more expensive), and the US found it harder to compete in international markets (Japan and Europe had largely recovered and were producing for their own markets—and even for the US consumer). The current account deficit turned negative—more or less permanently--during the administration of President Reagan. As we know from our macro identities, that deficit would have to be offset by a growing budget deficit—which had to be large enough to offset both the current account as well as the US domestic sector surplus (saving of households and firms). By the end of the 1980s, Congress and the new president (George Bush) agreed to try to reign-in deficit spending. Hence, an already too-small budget deficit (given the current account deficit and the desire of the domestic private sector to run surpluses, demand was too low to eliminate unemployment) was constrained further by the Gramm-Rudman Amendment that promised to work toward a budget balance.

The economy suffered from weak growth and relatively high unemployment over most of this period. Then, suddenly, economic growth picked up speed during the Clinton administration; indeed it grew so fast that it produced a budget surplus (as tax revenues boomed) that lasted for nearly three years (the first sustained surplus since 1929!). President Clinton actually predicted at the time that the budget surplus would continue for at least 15 more years, and that all outstanding Federal government debt would be retired (for the first time since 1837).

Note that this was not accomplished by reversing the current account deficit—which actually grew. How could the US run a current account deficit and a government budget surplus? Only by running a sustained private sector deficit. Indeed, from 1996 until 2007 the US private sector ran a budget deficit every year except during the recession of the early 2000s. At times, the domestic private sector deficit reached 6% of GDP (meaning that for every Dollar of US national income, the private sector spent $1.06. With such a large “flow” deficit, the stock of private sector debt grew rapidly—both in nominal terms and as a ratio to GDP. By 2007, total US debt reached five times GDP (versus three times GDP in 1929 on the verge of the Great Depression). This huge debt implied a big debt burden—the portion of income that had to be devoted to servicing debt. When the economy collapsed in 2007, a private sector surplus finally returned (the turn-around from private deficits to private surpluses amounted to 8% of GDP—a huge reversal that removed approximately $1 trillion of spending from the economy)—and the government budget deficit grew rapidly to 10% of GDP. Even as the private sector cut down its spending, it was forced to default on debts run up since the Clinton period. A wave of bankruptcies and home foreclosures resulted that drove the economy into a deep recession and financial crisis that spread around the world.

Next week: a budget stance to promote growth.