Origin of the Idea

The philosophy of functional finance was first articulated by Abba Lerner (1903-1982).

In fact, Lerner devised three laws of functional finance. First, government spending and taxes should be adjusted so that aggregate demand is just sufficient to purchase the full employment level output at current prices. Second, incurring or repaying the national debt should only occur if it is desirable to change the interest rate. Third, the amount of money in circulation should be adjusted to accommodate policies enacted in adherence to the first two laws.⁽¹⁾

He was born in Russia but grew up in London, where he attended the London School of Economics. Over the course of his intellectual development, Lerner changed from a socialist to a neoclassical economist (the conservative mainstream of economic thought) to a Keynesian (the liberal mainstream). Lerner was one of the first to be inspired by John Maynard Keynes' The General Theory of Employment, Interest, and Money, published in 1936, and his idea of functional finance is consistent with the activist spirit of Keynesian economics. Despite Lerner's devotion to expanding and refining Keynes' theories, Keynes himself was not always enamored with Lerner's ideas, particularly in the area of functional finance. As Lerner recounts:

[A]t a lecture to the Federal Reserve in Washington in 1944, [Keynes] showed concern that there might be "too much saving" after the war. When I pointed out that the government [ by increasing its spending or reducing taxes] could always induce enough spending by incurring deficits to increase incomes, he at first objected that this would only cause "even more saving" and then denounced as "humbug" my suggestion that the deficits required to induce enough total spending could always be financed by increasing the national debt. (I must add here that Evsey Domar, at my side, whispered: "He ought to read the General Theory" and that a month later Keynes withdrew his denunciation.)⁽²⁾

In addition to his work on functional finance, Lerner developed the ideas of sellerssellers' inflation, referred to in Chapter 8 as cost-push inflation. He also created an index for measuring monopoly power, aptly named the Lerner Index.

1. Summarized from Tibor Scitovsky's "Lerner's Contributions to Economics," Journal of Economic Literature 22 (December 1984), pp. 1559-1560.
   
2. Abba Lerner, "Keynesianism: Alive, If Not So Well," Fiscal Responsibilities in a Constitutional Democracy, ed. James Buchanan and Richard Wagner (Boston: Martinus Nijhoff, 1978), p. 67.