Paul Krugman on Functional Finance

Paul Krugman has an article in the NYT on Abba Lerner’s Functional Finance, which is worth a read.

Krugman’s criticism of Functional Finance is that it has bad consequences when r>g:

What about debt? A lot depends on whether the interest rate is higher or lower than the economy’s sustainable growth rate. If r<g, which is true now and has mostly been true in the past, the level of debt really isn’t too much of an issue. But if r>g you do have the possibility of a debt snowball: the higher the ratio of debt to GDP the faster, other things equal, that ratio will grow. And debt can’t go to infinity.

But earlier he admits this:

From a modern perspective, “Functional finance” is really cavalier in its discussion of monetary policy. Lerner says that the interest rate should be set at the level that produces “the most desirable level of investment,” and that fiscal policy should then be chosen to achieve full employment given that interest rate.

So a Functional Finance policy, cavalier as it may be, would involve setting r to be <g at any time. It would do this, I say, by definition, given that ‘the most desirable level of investment’ is surely not one that concentrates wealth in the hands of creditors and bondholders.

That solves the r>g problem with the stroke of a policymaker’s pen. There is then the question of whether r should be fixed in this way. Krugman writes: ‘What is the optimal interest rate? [Lerner] doesn’t say’. Well, nor does Krugman. But he’s just given what looks like an argument that it’s in any case going to be <g.

What if private investment is going wild and needs restraining? Won’t r need to rise, perhaps above g? No. Exuberant private investment will be restrained by tax. That’s the whole point of Functional Finance. John Kenneth Galbraith explained the policy with admirable clarity in Economics and the Public Purpose:

Although in a proper policy [i.e. Functional Finance] the interest rate ceases to be the instrument for controlling the volume of borrowing, the volume of borrowing does not remain uncontrolled. … Borrowing will be excessive when, along with other sources of demand, it is pulling up prices. It is then curtailed by increasing taxes; this reduces the capacity of people to incur mortgages or other personal debt and, as the demand for goods recedes, it reduces both the incentive and the ability to borrow or use funds for business expansion.

Krugman might have worries about this alternative assignment of fiscal and monetary policy. But he doesn’t share them here, and the promised next post looks to be on a different topic. (I think in any case that r should be fixed at a low level, given the pretty clear causal connection between tight monetary policy and increased inequality.)

Like many other recent criticisms of Functional Finance, Krugman’s criticism reduces to the question: ‘what if r>g?’. But the burden doesn’t lie on the defender of a policy to explain what happens if it isn’t implemented. The idea is to implement it.