Keynes’s view of deficits and functional finance: a Modern Monetary Theory perspective

Abstract

The immediate aftermath of the global financial crisis (GFC) was characterised by a resurgence of interest in the work of Keynes. Fiscal policy became at least temporarily acceptable again, in turn leading to government deficits and debt, as a proportion of GDP, reaching levels not seen since before the onset of the neoliberal period. Keynes’s own pronouncements on deficit financing generated renewed interest. Despite the strength of the neoclassical counterattack – which has been relatively successful in reassessing the crisis as a government failure – confidence in orthodox economics has not been fully restored, at least outside the confines of academia. Although the hopes of heterodox economists – that the GFC might mark the beginning of the end of the neoclassical hegemony – have not been realised, the upswing in interest in Keynes’s views has not entirely died away. This paper considers Keynes’s views of deficits and debt and then looks at the controversial area of Keynes’s position vis-à-vis functional finance. The paper concludes by considering how Modern Monetary Theory might increase our understanding of the nature of deficits and debt and thus provide valuable insights which might underpin the use of fiscal policy to pursue public purpose.

Keywords:

• Keynes
• budget deficits
• functional finance
• modern monetary theory

Acknowledgements

The author would like to express his gratitude to Warren Mosler and Geoff Harcourt whose detailed commentary on earlier drafts of a larger paper on which this article is based (Armstrong, 2016) is much appreciated. The author would also like to thank Paul Davidson, David Colander, L. Randall Wray and Tony Aspromourgos (who disagrees with the view I express concerning Keynes and deficit-budgeting) for helpful criticism and comments on the earlier paper.

Notes

1. Paul Davidson provides a compelling analysis of the story behind the less-than-full acceptance of Keynes’s ideas in US universities after the Second World War and how this left the door ajar for the neoclassical counterattack that was to follow (Davidson 2009, 161–179).

2. Keynes agued in a memorandum to James Meade, written on 25 April, 1943, that this would not be the case, referring to Lerner’s article of the same year, I recently read an interesting article by Lerner on deficit budgeting, in which he shows that, in fact, this does not mean an infinite increase in the national debt, since in the course of time the interest on the previous debt takes the place of the new debt which would otherwise be required. (He is, of course, thinking of a chronic deficiency of purchasing power rather than an intermittent one.). (CW 27, 2013, 320)

Domar (1957, 35–69) addresses the nature of the debt problem, as seen through the eyes of contemporary conservative thinkers on the topic. He sees the major problem as one of misrepresentation of the problem and that this group implicitly assumed a stationary economy and explained why, in fact, this is unlikely to be the case in practice. For Domar, the real problem was one of achieving economic growth, ‘If the [debt] burden is to be light there must be a rapidly rising income. The problem of the debt burden is a problem of an expanding national income’. (Domar 1957, 57, parentheses added, emphasis in the original) If economic growth exceeded the deficit as a proportion of national income, the absolute size of the debt would rise but, as a proportion of national income, it would decline meaning the real burden of the national debt would fall over time. His concluding paragraph, which resonates just as well today as it did more than fifty years ago, is worth quoting in full, ‘When post-war fiscal policy is discussed, the public debt and its burden loom in the eyes of many economists and laymen as the greatest obstacle to all good things on earth. The remedy suggested in always the reduction of the absolute size of the debt or at least the prevention of its further growth. If all the people and organisations who work and study, write articles and make speeches, worry and spend sleepless nights – all for fear of the debt – could forget about it for a while and spend even half their efforts trying to find ways of achieving a growing national income, their contribution to the benefit and welfare of humanity – and to the solution of the debt problem – would be far greater.’ (Domar 1957, 64).

3. Keynes would naturally have preferred his own plan to the actual Bretton Woods system. However, he was prepared to accept an agreement primarily founded upon American ideas and objectives and become an advocate of it because he believed it was imperative to prevent a return to pre-war nationalism. Even though the Bretton Woods agreement was based on the US preference for ‘debtor adjustment’ rather than the ‘creditor adjustment’ Keynes preferred, his deeply held conviction that the US had to be constructively involved in the post-war development of Europe underpinned his priorities. (Skidelsy 2002, 337–372; 444–458).

4. Having considered the literature I might argue that Keynes rejected functional finance primarily for practical policy reasons. However, I must admit that the view that Keynes generally accepted the logic of functional finance but rejected its use as a basis for policy due to a combination of political considerations and technical issues is far from universally accepted. In particular, Tony Aspromourgos was critical of this view as expressed in an earlier paper of mine (2016), considering my assessment of JMK’s position to be ‘wishful thinking’ and that I may be trying too hard to reconcile his views with my ‘MMT-is-the-truth narrative’; Aspromourgos stresses that beyond ‘false consciousness’/politics, JMK had intrinsic and objective reasons for qualifying his endorsement of functional finance.

5. Post-Keynesians in general and advocates of MMT in particular reject loanable funds theory. The risk-free rate is treated as an administered rate and provides a benchmark, underpinning the rate banks charge customers. MMT contends that central banks necessarily supply the volume of reserves required by the banking system – at the same time as the bank loan creates the deposit – by accounting for a reserve requirement as an overdraft or loan. Failure to do so would be an error of accounting. The volume of loans per se will not affect interest rates and banks will advance credit in response to increased demand at current rates, acquiring reserves, as required, at a price determined by the central bank (Wray, 1990, 2007). This ‘accommodative’ view contends that the central bank acts in a passive manner; banks can always access the quantity of reserves they require but it is the central bank that chooses the price. ‘If banks in aggregate are short of required reserves, the central bank must supply them either through open market purchases or at the discount window; trying to restrict reserves through fewer open market purchases merely forces banks to the window. If a bank fails to meet legal requirements, this is booked as a loan of reserves. It is simply impossible for the Fed to refuse the reserves needed by the system. (Wray 1998, 118).

6. In the current situation in the UK and US, for example, the state could use its position as monopoly issuer of the currency to control the whole spectrum of risk-free rates; or to put it another way it could determine the shape of the yield curve. If a policy of exerting control over long term risk-free rates was decided upon then it could be put into practice by the central bank by agreeing to buy unlimited quantities of government debt at a price consistent with its interest rate target at each maturity level. This would result, potentially, in significant central bank balance sheet expansion. Alternatively, the Treasury could offer securities that yield no more than the government’s target for the term structure of risk-free rates.

7. MMT recognises that inflation can occur as a result of cost pressures and advocates the use of an employed labour buffer stock policy which – through the provision of a strong ‘price anchor’ – represents a superior alternative to the use of monetary policy. Warren Mosler and Silipo (2016) provide a ground-breaking analysis of the policy options available to the European Central Bank in achieving its price stability mandate, and develop a compelling argument for using an employed labour buffer stock policy as an alternative to the current framework.