The Preferred Policy Instruments of Functional Finance

In a recent post, JW Mason draws an insightful comparison:

Conventional policy and functional finance represent two different choices about which instrument to assign to which target. The former says the interest rate instrument should focus on demand and the fiscal-balance instrument should focus on the debt-ratio target, the latter has them the other way around. … In this sense, the functional finance position is less radical than either its supporters or its opponents believe.

Scott Fullwiler has explained (for example, in this five-part series) that functional finance, far from being reckless or radical if assessed on orthodox criteria, turns out to be “ricardian” as that term is employed by the mainstream. So, the leading Modern Monetary Theorists would likely agree that functional finance is not radical in this sense. What is “radical” – for want of a better word – is that functional finance, like much of currently heterodox macroeconomics, turns the current conventional wisdom on its head.

The mainstream is basically saying, control demand through interest rates and try to manage public debt-servicing requirements through fiscal policy.

This amounts to saying, government should try to boost demand (i.e. total spending) by doing anything other than actually spend. And it should try to minimize any inflation risk associated with the interest owed on public debt by means other than tailoring interest-rate settings to that purpose.

Functional finance is a “radical” reversal of this logic.

It amounts to saying, the surest way to boost demand (spending) is for government actually to spend. And the best way to ensure that interest payments on public debt pose no inflation risk is through the appropriate setting of interest rates.


The problem with the current mainstream approach is at least twofold.

In terms of demand, the approach is indirect and weak. It tries to influence private spending through variations in interest rates. Not only is this method indirect, but the influence of interest rates on spending is not uniform. For instance, the spending of interest recipients is likely to be negatively affected by a cut in interest rates, whereas a prospective borrower may be more likely to borrow in order to spend. Overall, the effect of interest-rate policy appears not to be large, especially when the aim is to boost demand through cuts in interest rates.

In terms of managing the potential inflation risk involved in making interest payments on public debt, the focus on the fiscal balance is counterproductive. What matters, in terms of inflation risk, is the flow of interest payments as a proportion of GDP. By the prevailing mainstream logic, excessive interest payments call for fiscal contraction, which will have the unfortunate effect of dampening demand and hence GDP. As a consequence, growth in the denominator of the ratio decelerates, making it more difficult to reduce interest payments as a percentage of GDP:


We have witnessed the effects of this kind of approach in the Eurozone, where the imposition of austerity in the most vulnerable member nations has damaged income growth (shrinking or slowing the growth of GDP in the denominator). Even when such policies reduce total debt and interest owed on debt, the ratio of interest payments to GDP may not improve much or may even deteriorate.

Functional finance raises no such difficulties. Demand and GDP are addressed directly through government spending. Whenever there is excess capacity and unemployment, an increase in government spending not only boosts demand (and GDP) directly, but is likely to encourage others to spend as well. Here, the secondary, indirect effects work through higher income and stronger economic activity, which encourage private investment and private consumption expenditure.

If it ever becomes necessary to rein in the interest payments on public debt as a percentage of GDP, interest rates on new issues of public debt can be reduced directly. More importantly, there is little reason for interest obligations to become inflationary in the first place when interest rates are managed specifically with the potential inflation risk kept in mind. Provided nominal interest rates on public debt are kept below the nominal rate of growth in GDP, there is unlikely to be a problem.