Theory of Functional Finance

The theory of functional finance was given by Russian-born, British-raised economist, Abba Lerner during the course of World War II, in contrast to sound finance. The theory of functional finance involved deliberate actions by the government on matters relating to budgetary deficits and money supply with regard to their functionality, instead of an abstract premise as laid by sound finance.

Abba Lerner proposed a steering wheel metaphor in the debate on how to pull economies out of the Great Depression, in contrast to the then prevailing laissez-faire policy. He argued that the laissez-faire approach was similar to driving a car without a steering wheel, which would naturally be bound to crash the economy, making it veer in one direction and then another. To prevent this, he argued, that it was time for governments to adopt a Keynesian 'economics of control' approach, in which the government would use an explicit 'steering wheel' - functional finance - to maintain smooth economic operations.

Criticizing the laissez-faire policy of sound finance for its lack of proper analysis, he gave his theory of sound finance and argued that when governments understood how the macroeconomy actually functions, they would adopt an alternative 'functional finance' set of rules. Under the rules of functional finance, decisions about the deficit and the money supply would be made with regard to their functionality – their effect on the economy – and not with regard to some abstract moralistic premise that deficits, debt and expansionary monetary policy are inherently bad.

Rules of Functional Finance

Functional finance is based on the following 3 rules:

1. The government shall, through active fiscal actions, maintain a reasonable level of demand at all times and actively fend of against low or excessive demands with the help of fiscal tools. Lowering of taxes or increase in government expenditure are to be used in case of low spending and high unemployment and vice versa.
2. The government shall use borrowing and lending to actively manage the rates of interest so as to maintain such a rate of interest that induces the optimum amount of investment.
3. The government should print or hoard money as required in order to achieve the above goals.

Why functional finance fell out of favour?

The theory of functional finance has lost popularity due to the following reasons:

1. First, Lerner did not consider the involvement of politics in government finance in his discussion of functional finance.
2. Second, inefficiencies in governments in the real world induces significant lag between the recognition of problems, identification of suitable policy measures to solve these problems and implementation of these policy measures. More often than not, the policies would go into effect long after the initial problem had already changed to a significant extent.
3. Third, functional finance assumes that governments know which functional finance policy is the best suited for the existing situations, i.e.,  in inflationary times, increase taxes and decrease the money supply; in recessionary times, decrease taxes and increase the money supply. However in reality situations can arise where the theory would suggest contradictory policy measures. For eg. in the 1970's, when both inflation and recession occurred simultaneously, the functional finance rules were seemingly giving contradictory advice.