MMP Blog #35: Functional Finance: A Conclusion

Share on facebook
Share on twitter
Share on linkedin
Share on email
Share on reddit
Share on whatsapp

Originally published February 5, 2012 on the New Economic Perspectives blog.

Let’s finish up the discussion of Lerner’s functional finance approach addressing two issues: functional finance and developing nations and also the functional finance approach to trade deficits.

Functional Finance and Developing Nations

Most of the developing nations have a sovereign currency—which means they can “afford” to buy whatever is for sale in the domestic currency, including unemployed labor. As Lerner would put it, unemployment is evidence that there is an unmet demand for domestic currency that can be filled by additional government spending. At the same time, many developing nations have fixed or managed exchange rates that reduce domestic policy space to some degree. They can increase policy space either through policies that generate foreign currency reserves (including development that increases exports), or they can protect foreign currency reserves through capital controls.

In addition, they can favour policy that leads to employment and development without increasing imports (import substitution policies, for example). They can create jobs programs that are labor intensive (so that foreign made capital equipment is not needed) or programs that provide the output that the newly employed workers need (so that they do not spend their new incomes on imports).

Government can favour domestic producers over foreign producers. It can limit its purchases of foreign goods and services to export earnings. It can try to avoid borrowing in foreign currency in order to limit its need to devote foreign currency earnings to interest payments.

As discussed, ability to impose and collect taxes can be impaired in a developing nation. This will limit government’s ability to directly command domestic output. And even if it finds plenty of unemployed labor willing to work for its currency, those workers might find it difficult to purchase output with that currency at stable prices. More diligent tax collection will help to increase demand for the currency (since taxes are paid in the domestic currency). In addition, government needs to focus job creation in those areas that will lead to increased production of the kinds of goods and services the new workers will want to purchase. That can relieve inflationary pressures resulting from rising employment.

For the long run, avoiding foreign currency indebtedness and moving toward floating exchange rates would be conducive to expansion of domestic policy space. Full utilization of domestic resources (most importantly, labor) will allow developing nations to maximize output while reducing inflation caused by insufficient supply. Full employment of labor also provides many other well-known benefits that will not be detailed here.

A sovereign currency provides more policy space to government—it spends by crediting bank accounts and thus is not subject to the budget constraint that applies to a currency user. A floating exchange rate (or a managed rate with capital controls) expands the policy space further—because the government does not need to accumulate sufficient reserves to maintain a peg. Well-planned use of this policy space will allow the government to move toward full employment without setting off currency depreciation or domestic price inflation. To that end, the employer of last resort or job guarantee model is particularly useful, a topic pursued in more detail elsewhere in the Primer.

Exports are a cost, Imports are a benefit

In real terms, exports are a cost and imports are a benefit from the perspective of a nation as a whole. The explanation is simple. When resources including labor are used to produce output that is shipped to foreigners, the domestic population does not get to consume that output, or use it for further production (in the case of investment goods). The nation bears the cost of producing the output, but does not get the benefit. On the other hand, the importing nation gets the output but did not have to produce it. For this reason, in real terms net exports mean net costs; and net imports mean net benefits.

Now there are several caveats. First, from the perspective of the producer of output, it does not matter who buys the produced goods or services—the firm is equally happy selling domestically or to foreign buyers. What the firm wants is to sell for domestic currency in order to cover costs and reap profits. If the output is sold domestically, the bank accounts of purchasers are debited, and the accounts of the producing firm are credited. Everyone is happy. If the outputis sold to foreigners, the receipts will need to go through a currency exchange so that the producer can receive domestic currency while the ultimate purchasers are using their own currency. We will not concern ourselves with the details, but usually a domestic bank or the central bank will end up holding reserves of the foreign currency (this will normally be a credit to a reserve account at the foreign central bank). The fact remains, however, that in terms of real resources, the “fruit of the labor” is enjoyed by foreigners when the output is exported, even though in financial terms the producing firm receives a net credit to a bank account and the nation receives a net financial asset in terms of foreign currency.

Second, net exports add to aggregate demand and increase measured GDP and national income. Jobs are created to produce goods and services for export. Hence, a nation that would otherwise operate below full employment can put resources to work in the export sector. Wages and profits are generated, families receive incomes they would not have received so that they are able to purchase consumption goods, and firms stay in business that otherwise might have gone bankrupt. This is probably the main reason why governments encourage growth of exports. In the midst of the economic downturn, President Obama announced that his goal for the US economy was to double its exports. This is a common strategy for nations that want to grow. However, note that for every export there must be an import; for every trade surplus there must be a trade deficit. Obviously it is not possible for all countries to simultaneously grow in this manner—it is fundamentally a “beggar thy neighbour” strategy.

To the extent that resources are mobilized to produce for foreigners, the domestic population does not receive any net real benefit. True, labor and other resources that would have been left idle are now employed; workers who would not have received a wage now get income; owners of firms who would not have sold output now receive profits. Yet, if the produced output is sent abroad, there is no extra output for domestic residents to purchase. What happens is that existing output gets redistributed to these additional claimants—who now have wage and profit income. Thus, if we have only put unemployed resources to work in order to produce exports, there is no net benefit—the domestic population is working “harder” but not consuming more in the aggregate because the “pie” available for the domestic population has not increased. The redistribution process itself will probably require inflation as those who now have jobs compete for a piece of the pie, bidding up prices. To be sure, this could be a desirable social outcome—output gets redistributed from the “haves” to the “have-nots”, and putting unemployed people to work has numerous benefits for families and society as a whole (in terms of crime, family break-ups, and social cohesion).

But note that this relied on the presumption that the nation had excess capacity to begin with. If it had been operating at full capacity of labor, plant, and equipment, then it could only increase exports by reducing domestic consumption, investment, or government use of resources. Labor and other resources would be shifted from producing for domestic use toward satisfying foreign demand for output. Clearly it would usually be preferable to achieve full employment by producing for domestic use rather than for export. The additional employment would provide both income as well as more output. The domestic “pie” would be larger, so that rather than redistributing from “haves” to “have-nots”, the newly employed would get pieces of the larger pie.

Another obvious caveat is that producing output for foreigners can be in a nation’s economic and political interests. A nation might produce goods and services that are sent abroad for humanitarian reasons—to aid in disaster relief, for example. It might produce military supplies to aid allies. Foreign direct investment could aid a developing country that might become a strategic partner. And there is certainly no reason for a nation to balance its currenta ccount on an annual basis—something that would be nearly impossible in a highly globalized economy with international links in production processes. Hence we would not want to ignore various strategic reasons for exporting output and running trade surpluses.

We conclude that we should also take a “functional” approach to international trade: it makes no more sense for a sovereign government that issues its own floating currency to pursue a trade surplus than it does for that government to seek a budget surplus. Maximization of a current account surplus imposes net real costs (given the caveats discussed above). Instead, it is best to pursue full employment at home, and let the current account and budget balances adjust. That is far better than the usual strategy—which is to pursue a trade surplus in order to get to full employment.

We now turn to a policy that will generate full employment at home. Next week: more on the employer of last resort proposal.

Blog comments and responses

Leave a Comment

Your email address will not be published. Required fields are marked *

Share this post

Share on facebook
Share on google
Share on twitter
Share on linkedin
Share on pinterest
Share on email
Scroll to Top Skip to content