Abba Lerner on Functional Finance and Ricardian equivalence

18 Feb, 2015 at 10:19 | Posted in Economics, Politics & Society | 6 Comments

Commenting on an earlier post of yours truly on Abba Lerner’s Functional Finance view of public debt, Cambridge macroeconomist Pontus Rendahl maintained that “Abba Lerner IS evoking Ricardian equivalence in his argument” and that I didn’t understand “it.”

Hmmm …

According to Lerner, the purpose of public debt is “to achieve a rate of interest which results in the most desirable level of investment.” He also maintained that an application of Functional Finance will have a tendency to balance the budget in the long run:

Finally, there is no reason for assuming that, as a result of the continued application of Functional Finance to maintain full employment, the government must always be borrowing more money and increasing the national debt. There are a number of reasons for this.

dec3bb27f72875e4fb4d4b62daebb2fd161b36392c1a0626f00cfd2ece207d84First, full employment can be maintained by printing the money needed for it, and this does not increase the debt at all. It is probably advisable, however, to allow debt and money to increase together in a certain balance, as long as one or the other has to increase.

Second, since one of the greatest deterrents to private investment is the fear that the depression will come before the investment has paid for itself, the guarantee of permanent full employment will make private investment much more attractive, once investors have gotten over their suspicion of the new procedure. The greater private investment will diminish the need for deficit spending.

Third, as the national debt increases, and with it the sum of private wealth, there will be an increasingly yield from taxes on higher incomes and inheritances, even if the tax rates are unchanged. These higher tax payments do not represent reductions of spending by the taxpayers. Therefore the government does not have to use these proceeds to maintain the requisite rate of spending, and can devote them to paying the interest on the national debt.

Fourth, as the national debt increases it acts as a self-equilibrating force, gradually diminishing the further need for its growth and finally reaching an equilibrium level where its tendency to grow comes completely to an end. The greater the national debt the greater is the quantity of private wealth. The reason for this is simply that for every dollar of debt owed by the government there is a private creditor who owns the government obligations (possibly through a corporation in which he has shares), and who regards these obligations as part of his private fortune. The greater the private fortunes the less is the incentive to add to them by saving out of current income …

Fifth, if for any reason the government does not wish to see private property grow too much … it can check this by taxing the rich instead of borrowing from them, in its program of financing government spending to maintain full employment. The rich will not reduce their spending significantly, and thus the effects on the economy, apart from the smaller debt, will be the same as if Money had been borrowed from them.

Abba Lerner

Much positive wealth effects here — and no Ricardian equivalence …

So — one may wonder who is not understanding what about Lerner and the Functional Finance view of public debt …

But even if today’s mainstream Cambridge economists do not understand Lerner, there once was one who certainly did:

I recently read an interesting article on deficit budgeting … His argument is impeccable.

John Maynard Keynes CW XXVII:320

Added GMT 1400: In a new comment Rendahl now maintains that “the core argument here is that the timing of taxes is irrelevant for servicing domestic debt, which is exactly what Ricardian equivalence says.”

Although the issue of timing is one well-known part of Ricardian equivalence, I still beg to differ on it being “exactly what Ricardian equivalence says.” Let me elaborate on why.

According to the Ricardian equivalence hypothesis the public sector basically finances its expenditures through taxes or by issuing bonds, and bonds must sooner or later be repaid by raising taxes in the future.

If the public sector runs extra spending through deficits, taxpayers will according to the hypothesis anticipate that they will have pay higher taxes in future — and therefore increase their savings and reduce their current consumption to be able to do so, the consequence being that aggregate demand would not be different to what would happen if taxes were rised today.

Robert Barro attempted to give the proposition a firm theoretical foundation in the 1970s.

So let us get the facts straight from the horse’s mouth.

Describing the Ricardian Equivalence in 1989 Barro writes (emphasis added):

Suppose now that households’ demands for goods depend on the expected present value of taxes—that is, each household subtracts its share of this present value from the expected present value of income to determine a net wealth position. Then fiscal policy would affect aggregate consumer demand only if it altered the expected present value of taxes. But the preceding argument was that the present value of taxes would not change as long as the present value of spending did not change. Therefore, the substitution of a budget deficit for current taxes (or any other rearrangement of the timing of taxes) has no impact on the aggregate demand for goods. In this sense, budget deficits and taxation have equivalent effects on the economy — hence the term, “Ricardian equivalence theorem.” To put the equivalence result another way, a decrease in the government’s saving (that is, a current budget deficit) leads to an offsetting increase in desired private saving, and hence to no change in desired national saving.

Since desired national saving does not change, the real interest rate does not have to rise in a closed economy to maintain balance between desired national saving and investment demand. Hence, there is no effect on investment, and no burden of the public debt …

Compairing this crystal-clear statement of the Ricardian hypothesis with what Lerner wrote, it should be obvious to anyone how far-fetched it is to maintain that Lerner is evoking any Ricardian equivalence or that the irrelevance of the timing of taxes is “exactly” what Ricardian equivalence is all about.

Ricardian equivalence basically means that financing government expenditures through taxes or debts is equivalent, since debt financing must be repaid with interest, and agents — equipped with rational expectations — would only increase savings in order to be able to pay the higher taxes in the future, thus leaving total expenditures unchanged.

There is, of course, no reason for us to believe in that fairy-tale. Ricardo himself — mirabile dictu — didn’t believe in Ricardian equivalence. In “Essay on the Funding System” (1820) he wrote:

But the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly. We are too apt to think that the war is burdensome only in proportion to what we are at the moment called to pay for it in taxes, without reflecting on the probable duration of such taxes. It would be difficult to convince a man possessed of £20,000, or any other sum, that a perpetual payment of £50 per annum was equally burdensome with a single tax of £1000.


  1. RE is desperate for some kind of coherent foundation.

    In fact, the deficit creates the saving that would eventually be applied if the debt were repaid by taxes.

    Start there.

    But nobody does.

  2. First of all, I should make clear that I believe in functional finance and I don’t believe in Ricardian equivalence. Also, I find it hard to believe that Lerner believed in RE.

    That said, there is something in what Pontus says here in that it is hard to make sense of that quote without appealing to RE. Let’s assume functional finance is working and is maintaining full employment and price stability. Take someone who earns 1,000 over their lifetime. Barring taxation, they get to spend 1,000. If the government now taxes them 100, they only get to spend 900. Even if they hold bonds during their life, in particular at the time the tax is levied, they don’t get back more than they invested (ignoring the interest). The 100 is a drain of outside money – that’s the whole point.

    However, if this individual inherits, say, 300 of bonds then they can recoup the 100, by only bequeathing 200 on to their successors. This is what RE says they will do. In fact, in aggregate, this is the only way that generation can offset the real cost of the tax.

    If we were to examine the history of an economy following functional finance, and where RE did not hold, we might observe periods of low taxation and periods of high taxation. In general, people living in periods of low taxation would have had higher lifetime consumption than those living when taxes were high. And we would also observe that debt was higher before periods of high taxation than after. So, on the whole, I’d say that what Lerner appears to be saying in that quote is just wrong, unless you believe in RE.

    However, I’m my view, none of this amounts to a valid argument against the use of functional finance.

  3. Ricardian equivalence is one of the stupidest and yet most discussed topic in economics. Economic ‘science’, my a**. Laughable and sad at the same time.

  4. Multiplying confusion
    Comment on ‘Abba Lerner on Functional Finance and Ricardian equivalence’
    To beginn with, there are two fundamentally different economic configurations:

    (1) the pure consumption economy,

    (2) the investment economy.

    And there are three scenarios:

    (a) income tax = gov spending in period t,

    (b) no tax; but household saving=gov spending; H deposits=Gov overdrafts,

    (c) no tax, no saving; but business profit=gov spending; B deposits=Gov overdrafts.

    These are six different configurations. Ricardian equivalence refers to configurations (1a) and (1b).

    The national debt payoff causes losses and depression in configuration (1c) but not in (1a) and (1b). Note that we conveniently start with full employment. Otherwise, the additional discrimination between full employment (F) and unemployment (U) has to be introduced. This then makes in total 12 configurations.

    Functional finance refers to (2aU), (2bU) and (2cU).

    In the discussion, the twelve configurations are constantly played out against each other. With no useful result, of course.

    Lerner’s approach suffers from the same error/mistake as Keynes’s approach. Both do not correctly discriminate between profit and income and therefore apply I=S, which is the worst fallacy of all. For details see (2014; 2015).
    Egmont Kakarot-Handtke
    Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics:
    Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
    Kakarot-Handtke, E. (2015). Essentials of Constructive Heterodoxy: Aggregate
    Demand. SSRN Working Paper Series, 2564590: 1–23. URL http://papers.ssrn.
    See also the preceding post

  5. Since you’re quoting me out of context, let me bring that context back. Your own quote from Lerner was

    “One of the most effective ways of clearing up this most serious of all semantic confusions is to point out that private debt differs from national debt in being external. It is owed by one person to others. That is what makes it burdensome. Because it is interpersonal the proper analogy is not to national debt but to international debt…. But this does not hold for national debt which is owed by the nation to citizens of the same nation. There is no external creditor. We owe it to ourselves.

    A variant of the false analogy is the declaration that national debt puts an unfair burden on our children, who are thereby made to pay for our extravagances. Very few economists need to be reminded that if our children or grandchildren repay some of the national debt these payments will be made to our children or grandchildren and to nobody else. Taking them altogether they will no more be impoverished by making the repayments than they will be enriched by receiving them.”

    I reminded you that the core argument here is that the timing of taxes is irrelevant for servicing domestic debt, which is exactly what Ricardian equivalence says. I never claimed to have understood the full notion of Lerner’s life work, but reflected on the quote itself. And again: It invoked Ricardian equivalence.

    Lastly, if debt does not matter, neither does taxes. Funnily, you only hear people arguing for the former, but never the latter. Weird.

  6. “Functional Finance: What, Why, and How?

    Stephanie Bell
    University of Missouri at Kansas City – Economics
    November 1999

    Levy Economics Institute Working Paper No. 287

    The purpose of this paper is threefold. First, the theory of functional finance, as explicated by its originator, Abba P. Lerner, is put forward. Second, the reader is introduced to the use, standard in money and banking texts, of T-account balance sheet entries. Although no important conclusions will rest solely on the reader’s ability to cope with these entries, comfort with their use will ease the exposition. An appendix therefore is provided to assist those not yet exposed to this method of recording balance sheet changes and for those who merely wish to refresh themselves. The third purpose of the paper is to demonstrate the need for policies governed by the principles of functional finance.”

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