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Source link: http://archive.mises.org/5079/the-myth-of-functional-finance-mises-vs-lerner/

The Myth of Functional Finance: Mises vs. Lerner

May 23, 2006 by

While John Maynard Keynes typically receives credit for transforming economics, much postwar Keynesian economics was actually developed by his interpreters and followers. Perhaps the single most important one of these followers was the Romanian born economist Abba P Lerner. Keynes’s book The General Theory of Employment, Interest, and Money popularized the notion that market economies were prone to persistent unemployment. Keynes often receives credit for promoting government deficit spending as a means of combating unemployment. However, Abba Lerner developed this part of the Keynesian program. FULL ARTICLE


Roger M May 23, 2006 at 9:07 am

Great article! This country is in financial trouble because both the Democrats and Republicans are devout Keynesians.

Bill Dowis May 23, 2006 at 10:41 am

No it is not to late: the operatives will sell us on in a most convincing way and implement a “second or alternate” currency to satisfy domestic obligations.

What is left for the average American is to prepare for a much diminished standard of living.

billwald May 23, 2006 at 11:10 am

“According to this proposal government officials would reduce tax revenue and/or increase public spending during times of recession. This policy would push the government budget into deficit.”

One problem is the nature of public financing. Industry depreciates real property and has sinking funds for replacement. If govt did this then constion and repair could be undertaken to generate jobs in times of recession without pushing the budget into deficit. This, of course, would require honest book keeping and there is fat chance of that.

F L. Light May 23, 2006 at 12:20 pm

No Keynesian favors do us, Bush, aware
In shrunken government the world proves fair.

No Keynesian favors do us, Washington,
Who have recessionary taxes done.

No Keynesian cultivators cheer this land,
Impeding our expense as theirs expand.

No Keynesian favors breed competitive
Fruition, copious freedom, if we’d live.

No Keynesian favors needing, seek well-being
In fruitful betterment, fruition overseeing.

No Keynesian preparations to dispose
More public works may palmy times impose.

No Keynesian preparations may evoke
Prosperity in a subjected folk.

No Keynesian preparations have the force
Of interchange ubiquitous in course.

No Keynesian preparations with the will
Of Zeus are parallel but freedom kill.

Bill May 23, 2006 at 12:21 pm

It is definitely not too late. The government had a small surplus not long ago. It could easily do so again. As for a large surplus. You could actually reduce the size of these programs instead of their rates of growth. Sending law enforcement back to the states and ending securities regulation would be two easy places to start.

The biggest issue is the problem of acceptance. The citizenry has accepted that it is all right for government to spend like crazy and deflate the currency to pay nominal debt off. All it takes to undo this mess is a major recession. And thanks to Bush, we may have one right now.

Daniel M. Ryan May 23, 2006 at 12:57 pm

Word from the wised-up: “disinterestedness” covers up a lot of effeteness!

iceberg May 23, 2006 at 3:04 pm

“The government had a small surplus not long ago”

I’m apolitical (and anti-political) in any case, but does *anyone* in their right mind accept this drivel as true?

The so-called surpluses, to my knowledge were but the feat of accounting ledgerdomain (pun intended).

Repeat: There was no surplus, once you properly account for the “social security” liabilities.

DW MacKenzie May 23, 2006 at 3:45 pm

Social security is off budget. Entitlement reform requires special legislation. Discretionary spending has to pass Congress every year. The 1994 Republicans did pass significant spending cuts of discretionary spending, despite the efforts of Clinton. This did lead to a surplus in the discretionary budget. Social Security insolvency is an important issue, but institutional factors make it a separate issue.

Also, the terms for posting here require comments to be civil. I think this iceberg person violated these terms. The Mises Institute owns this blog and you have disrespected these rights, and myself personally. You should learn better respect for property rights, and some manners.

Vince Daliessio May 23, 2006 at 5:00 pm


I wasn’t offended at what iceberg said. It is an arguable point as to whether any surpluses were real or paper, since the liabilities of the federal government are largely hidden and unknown, wheras tax receipts in excess of expenditures were crowed about far and wide by both parties (instead of being applied to the burgeoning SS liabilities, or better yet returned to the suckers, er, taxpayers).

Transient operating surpluses aside, the federal government is as bust financially as General Motors, which also reported an operating surplus last quarter, but is still screwed due to vast, malignant liabilities. One can only hope the federal government succumbs before poor old GM.

DW MacKenzie May 23, 2006 at 5:14 pm

Its not a huge deal, but “does *anyone* in their right mind accept this drivel as true?” does not seem civil. Commies have flung mud at least since Marx. Libertarians should aim higher.

Bill May 23, 2006 at 5:53 pm

You are correct about the reality of the “Surplus”. What is real is that it is remarkably different in size from the current deficits that our current cabal of Congress, President, Supreme Court and Federal Reserve have given us. This group is intent on impoverishing the nation.

I was mearly pointing out that some very minor changes could produce large differences in future of the country. The sad part is that every minute the changes get bigger and bigger and bigger and thus less easy.

Roger the K May 23, 2006 at 6:06 pm

The question is,and always has been,how do we get more true Austrians,into positions of influence,and power?Ron Paul,aside.I am almost tempted to believe there IS a real conspiracy to keep them out(Didn’t Rothbard say something about this at one time?)There are a sizeable chunk of the general populous,who have no idea what Austrian economics is,and the mainstream media is doing nothing to educate them.I am on a newsgroup, meant to promote the state Libertarian Party,and they posted a letter they got,complaining there is noone in the LP, promoting hard money policies,that they act as a rubber-stamp for Dubya,and his big spending ways.My response,was to point out Rothbard,and his split with the LP.(This made them none too happy,to say the least.)I also said,something about how sad it was that Rothbard,Lew Rockwell, or any other notable Austrian,never chose to do a major,syndicated newspaper column,as a means to educate the unwashed masses.Can you imagine Murray on the Sunday talking head shows,ripping George Will,and his statist ilk a new one ? Now THAT would have been great TV!We have all read Mises,but he is not easily accessable,unless, you have read a lot of the shorter pieces,on LRC,first.Most of what I know about Mises,has come from reading this site.What efforts did he make,to get out there,and get on the debating floor with the Keynesians ?

Dennis Sperduto May 23, 2006 at 6:37 pm

I would like to comment on two issues mentioned in Professor Mackenzie’s article, with my comment based on Austrian business cycle theory, and basic price theory. Firstly, the large majority of economists, since to one degree or another they accept the Keynesian framework, have no reasonable explanation as to why planned savings exceeds planned investment. However, when “savings” in the form of fiduciary media can easily be created by the central bank and the banking system, planned savings can easily exceed planned investment. Most mainstream economists do not appear to acknowledge the fact that because the rate of interest, or the price of loanable funds, is constantly being manipulated or distorted from its market level by the government and banking system, the levels of planned savings and investment are prevented from tending towards balance.

Secondly, political manipulation of the labor markets, specifically attempts by governments to prevent wages from falling to their market clearing price, is the root cause of consistent, systematic unemployment. Attempts to legislate, dictate a price that is above the market clearing price will result in a surplus, which in the case of labor is unemployment. This is basic price theory that, for whatever reasons, apparently escapes many economists. Or maybe these economists do understand the consequences of their policies, as Keynes’s comment in “The General Theory” regarding green cheese seems to indicate.

Dennis Sperduto May 23, 2006 at 6:46 pm

My apologies, Professor MacKenzie, for the misspelling of your name.

DW MacKenzie May 23, 2006 at 6:48 pm

It is not the job of the mainstream media to educate the public. The mainstream corporate media should not educate the public. The mainstream media has legal obligations to maximize profits for the shareholders who own media corporations. Mises.org works off of money from those who want to educate the public. Mises.org, FEE, and other such organizations educate. Libertarian ideas can spread through the corporate media only through the efforts of persons like John Stossel. We have to get ratings to attract an audience on commercial media. That’s the way it should be.

M E Hoffer May 23, 2006 at 6:57 pm

DW MacKenzie’s point in reference to civility should be well received. Being Gentlemen costs little, if anything, and garners much. A trade any Economist would find profitable.

iceberg May 23, 2006 at 8:44 pm

To all above,

Point taken and accepted, although I personally disagree as to the degree of harshness projected in those words.

The way I read it, it was a question of incredulity, not a directed insult.

But apologies out to the offended parties in any case.

J. C. May 23, 2006 at 9:55 pm

The other problem with Lerner: He looks like (an old) Woody Allen!

Roger M May 24, 2006 at 8:55 am

How to get the word out about Austrian economics? This is a big problem and I don’t have any great answers. Can anyone tell me if the Mises Insitute, or other libertarian group, has an organized effort to educate journalists?

DW MacKenzie May 24, 2006 at 10:17 am

The Fund for American Studies has an institute for political journalism. They run summer classes for journalism majors.

Georges Lane May 25, 2006 at 7:21 am

Thank you very much for your very interesting article.

I have one question to ask. You wrote :

“Of course, this would lead to the accumulation of public debt. Lerner had a simple solution to this problem. After the economy recovered and prosperity returned politicians could raise more tax revue and/or limit spending. This would produce a budget surplus and pay down the debt. Thus politicians could balance the public budget through the business cycle.”

Behind Lerner’s solution, “inflation solution” is hidden. For example, in France, during a long period, “inflation policy” allowed gouvernments to “rub” public debt.

And this “inflation solution” must be condemned.

Why do not you say anything about this “magic solution” ?

Best regards

Alan Dunn May 30, 2006 at 7:21 pm

Does anybody here know who Abba Lerners PHd supervisor was ? I could tell you but it will take away the suprise.

So look it up, and I guarentee you will be shocked.

As for the functional finance debate – the author has totally taken it out of context. lerner basically argued that the level of spending in the economy should be equal to that required to purchase all the goods and services it was possible to produce with the given technology, capital, and labour.

Once this level of spending was achieved, Lerner actually advocated surpluses.

Nobody here has even mentioned how the exchange rate regime, whether flexible or fixed, or the monetary financial sector arrangements between the central bank and government effect Lerners proposal.

Mises for example totally side-stepped the issue of any speculative demand for money in his “Theory of Money and Credit” and continued to do so until his last breathe. If indeed their is any speculative demand for money,and I suspect there is Mises Monetary theory, and effectively the entire gamut of Austrian economics falls apart because it can no longer claim a stable relationship between saving and investment, and hence cannot fall back on Say’s Law as either an identity or a disequillibrium condition. It pretty much destroys the rhetoric of marginal productivity theory of labour, and the minimum wage debate advocated by the Austrians as well – although Lipsey and Lancaster pretty much explained how such proposals were fruitless with their “Theory of Second Best”.

As for Mises outgunning Lerner well thats a matter of opinion. Both of these men thought outside the box, which is commendable in both cases.

With respect to who was right and wrong Mises would have said “The New Deal” failed because of inflation / market distortion – Lerner would have said it failed because it didnt go far enough.

Both of these positions are philosophical at best and cannot be 3empirically tested and as such in my opinion a total waste of time debating.

Choose the ideology that best fits you and stick with it regardless of its validity – all schools of economics agree on this I’m certain.

My ideology is that economics is a crock regardless of whether its Keynsian, Austrian, Monetarist , or what have you. What I enjoy is seeing people defend the most proposterous ideological positions on nothing more than blind faith – then have the audacity to think their analysis is “scientific”

Cheers everyone.

DW MacKenzie May 30, 2006 at 8:50 pm

1. I know exactly who supervised Lerner’s thesis, so there is no surprise here.

2. Your inability to see that I wrote this in the proper context is amazing.

3. Keynes’ idea (speculative demand) that investors caused a decade long depression by holding cash instead of bonds or goods is laughably wrong. His assumption of wealth being limited to 3 forms- goods, bonds, and money- is absurd, even more so now than back then. The implications of having other financial instruments that bond holders can convert into are obvious.

4. To Mises all money demand is speculative, but not in the narrow way that Keynes saw.

5. Your interpretation of the theory of second best seems defective. Of course markets do not achieve first best competitive equilibrium. Government imperfections are arguably worse. You need to look deeper into Lancaster- or read Demsetz (1969). Demsetz is easier to read.

6. Your claim that all economics is a crock is not only baseless- it contradicts your assertion that Lancaster proved something. The theory of second best is part of what you dismiss as a crock, yet you claim that it proves something. As for empirics- if you think that economics lacks empirical content, then you need to become better acquainted with this subject. Better still, learn some humility. Given your weak understanding of these issues your arrogant tone is pathetic.

DW MacKenzie
SUNY Plattsburgh

Alan Dunn May 30, 2006 at 9:43 pm

Hi DW,

1.I thought you would know who supervised Lerner – but it is quite ironic.

2. Oops, yes you are correct because you did not actually get it wrong and say lerner proposed deficits only. Sorry about that.

3. I wasnt actually refferring to Keynes here, but I still dont beleive the Austrians Monetary theory goes beyond leveraging activities. Would take too long to explain why – and like everyone else I don’t have a solution.

4. I didnt think that Mises thought all money was speculative. If this is correct then how can Say’s Law hold in either of its known forms?

5. The theory of second best is simply “Two wrongs can make a right”. No need to talk about pareto optimal allocations or the like to understand that. An example – if you remove labour unions you must also remove collusion among employers. Thus, its a vicous circle because the removal of one throws the balance of power to the other and vice versa – no real answer for this one .

6. I didnt say Lancaster / Lipsy proved anything beyond a limit to our investigations. They nor I offered a solution – so its gadflys all round – my self included. I didnt say economics lacks empirical content, I asserted that we couldnt conclusively test Mises versus Lerner without resorting to philosophy / value laden banter.

Sorry for my arrogant tone, but I have been a economist / lecturer long enough to know what I’m talking about. Sure theres bits of economic theory that have some validity, but package it all together and it becomes a total mess of contradiction.

P.S you seem to have avoided the following:

“Nobody here has even mentioned how the exchange rate regime, whether flexible or fixed, or the monetary financial sector arrangements between the central bank and government effect Lerners proposal.”

Mises always thought in terms of fixed exrates and in many cases a gold standard. Given financial deregulation, and the massive changes in leveraging instruments its all become a little more complex than many care to admit.

Minsky had a shot at going beyond Lerner, but as interesting as his work was – he falls apart also because the liberty of individuals is neglected – althoiugh again this is only my philosophy not a natural law.

Cheers and yes – I like what you wrote and look forward to more.

DW MacKenzie May 31, 2006 at 9:20 pm

In Austrian monetary theory all money demand is speculative because it always involves the future. Direct exchange, or barter, is different because one good exchanges for another- there is minimal speculation unless it is a spot-forward or forward-forward exchange. With indirect exchange one exchanges a good for money in anticipation of exchanging it for another good in the future. Since one desires to exchange goods for goods this is like a spot-forward contract. Numerous factors regarding the outcome of this indirect exchange are not known with certainty. The bottom line is that money demand means that one exchanges a good for money because they expect that the good that they will buy with this money has greater value than the good they sell. There is an expectation involved so this is speculative. Keynes looked at how one might exchange bonds for money to repurchase bonds after their prices fell. This is not much different. The problem with Keynes is that he is trying to explain persistent unemployment with a routine phenommena. People go back and forth between money and goods all the time, and the fact that they are speculating when this happens in no way implies that people will hoard money so as to decrease aggregate demand. The law of large numbers applies here. Besides, if investors plan to hold money for any length of time while they speculate, they will do so in some kind of liquid account- in the banking system so these funds can be loaned. The real problem during the depression was confidence in the banking system- bank runs, not speculation about bonds. One thing to note about Mises- all relevant decisions are speculative. Every human action is speculative because action concerns the future only. All past events are sunk costs.

As for exchange rates, that is one of many angles I did not get into. This is not issue dodging, but verbal economy. Mises.org articles are short bits on specific issues. Exchange rates are one of many angles not explored here. I don’t recall Lerner getting into erates all that much either. This was a small issue at the time, given the small volume of international trade at the time.

One thing to note about Lerner is that he was critical of the New Deal- farm price controls for instance. So he thought the ND went too far in some ways. He also wanted greater income equality than was actually delivered, so the ND fell short in other ways. The fact still remains that he literally argued that there was a tendency towards budget balancing in an activist state- one that fought inflation and depression. He made very optimistic preditions regarding the potential for modern democratic welfare states, and experience has shown him unduly optimistic. There is more than philosophy to Lerner, and to Mises, and history has shown something about who was right.

I maintain that it is outlandish for you to make blanket statements about monetarists, Keynesians, and Austrians being ideologues whose ideas are a crock. I see merit in specific elements of monetarism and even some Post Keynesian economics. There are reasonable people in all camps. No one has an absolute monopoly on the truth.

DW MacKenzie
SUNY Platsburgh

PS read Bernice Shoul on Say’s Law of Markets

Alan Dunn June 5, 2006 at 8:29 pm

Hi DW,

Thanks for you reply.

I’m not that well versed on Keynes as I have only just started to investigate his writings in recent years. I often struggle to differentiate if I’m talking about Keynes or indeed Hicks / Hansen or the numerous others who bastardised his theory into the mess “Keynesian economics” is in its modern form.

My knowledge of Lerner is indeed second – hand from a group of economists including Minsky (and his followers).

They beleive that given other monetary financial conditions than those Lerner faced, functional finance would be able to create full employment.

They beleive that with a monoplist supplier of fiat, an endogenous money supply, and an exogenously determined interest rate inflation is not a problem until all resources are employed.

I have similar conclusions about functional finance as you do, though founded through a completely different set of assumptions.

The crux of my analysis is that through various operations functional finance would have adverse effects on the exchange rate, which in turn would have inflationary effects.

Anyway, thanks for your reply and I appologise for the tone of my earlier response and my reckless first reading of your article.



Doug MacKenzie June 7, 2006 at 7:54 am

Reading Keynes is almost as hard as reading Mises. Neither is easy to understand. One thing- reading Mises is much easier after having read Menger (1871). Perhaps Keynes would be easier to read after reading Marshal or Wicksell.

Alan Dunn June 10, 2006 at 8:25 am

Hi DW,

I have only browsed through Wicksell’s work. As for Marshall when I first read the “Principles” I thought what a great book. However, after a few years and many readings later (of all editions of Marshalls Principles) I neither understand him or his book .

I could never understand why someone like Marshall said he didnt like mathematical economics – Yet did everything he could to promote it through that dreaded appendix with the half-baked general equilibrium model (not partial equilibrium like the main text uses), or that biological metaphor / analogy for economics he adopted (or did he?).

Furthermore, though his control of the EJ and its later editor F. Y Edgeworth Marshall did all he could to promote mathematical economists, especially his former students.

So I find Marshall and Keynes far too political and topsy turvy. Keynes’ definition of a classical economist was anyone who didnt agree with him…laugh. Marshall was more concerned with book sales and his dictatorship of the anglo-saxon marginalist school of economics.

Mises to me though, said what he meant and held to his convictions. I’m pretty much with him on methodology, but not in total agreement on policy issues – although I’d rather see students read “Theory and History” before they read any other economics book including Marshall or Keynes – although just an opinion I guess.


Tizzer February 19, 2010 at 7:15 am

Bailout of General Motors is a perfect example.

Public decided they didn’t want to pay for GM cars (either their unions or their management) so GM started to go under.

Pres. Obama decides that the Government will “bail out” GM. Now every U. S. taxpayer is an “owner” of GM whether they like it or not.
Now that the government “owns” GM they are attacking it’s main foreign rival, Toyota.
So here we so a classic case of misaligned investment and crony capitalism resulting from our government becoming involved in the U. S. car industry.

The best way to promote full employment is to cut both taxes and the deficit. The result will be high interest rates and deflation, however both high interest rates and deflation reward those who work hard, save and postpone gratification.

Working hard and saving is something the baby boomers never wanted to do. They felt they deserved everything now, with cheap credit and the Federal Reserve and our various U.S. politicians gave it to them. We have to put that culture to bed and get back to working hard, saving and delaying gratification.

Ralph Musgrave, www.moslereconomics.com September 20, 2010 at 10:44 am

The above article is totally irrelevant to the functional finance argument. The article claims basically that there are deficiencies in publically funded investments: lack of profit motive, etc. For example it claims that “Public control over investment meant that the rate of saving would be the concern of “everybody — without distinction — therefore also of the idler and the spendthrift”.

Well we all know that! Despite these blindingly obvious failings, the electorate are quite rightly prepared to vote for a substantial amount of public investment (e.g. in schools, health care, roads, etc) because it is obvious that some of the economic activities of a totally free market are even worse: sale of dangerous drugs, for example. And for another example, the head of the U.K.’s Financial Services Authority (Lord Turner) recently described some of the activities of banks as “socially useless”. (Does the phrase “credit crunch” ring any bells?)

The above article also fails to make the important distinction between Lerner and Keynes’s views, namely that Keynes favoured having government borrow and spend while Lerner favoured simply having government print money and spend it.

D.W. MacKenzie September 20, 2010 at 11:33 am

Well, you are flat out wrong. Dictatorial China saves deliberatly, the democratic US government borrows heavily. This is obvious, and obviously the main point.

Also, I have Lerner’s book right here in my office, and he proposed countercycal fiscal policy- this is a fact. Roads are not a major item in modern budgets. Most health care expenses are in the last year or so of life- more consumption than investment. Furthermore, research by health economists indicates that the marginal productivity of health spending is too low to be considered ‘investment’ (see Robin Hansen’s website). Education fosuses on long run earnings moreso, at least that is the intent. However it should be noted that marginal spending on education is not such a great investment in real productivity either (see Eric Hanushek’s research). Keynes did recomend maintaining a “quasi boom” through low interests (i.e. spending money), and Keynes definately did not propose countercyclical fiscal poilicy. There is little to debate here, you simply need to become better acquainted with the facts.

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