The Concept of Functional Finance

Functional finance is a macroeconomic theory, developed by economist Abba P. Lerner, in relation to public finance policies during the second World War, that promoted government intervention in the economy in the form of deliberately unbalanced budgets to eliminate economic insecurity i.e., adverse business cycle effects in the economy. 

Although Keynes is known to have contributed the most to the development of the ‘functional finance’ concept, it was Prof. A.P. Lerner who first coined the concept. In his words, “The principle of judging fiscal measures by the way they work or function in the economy, we may call functional finance.” 

Prof. A.P. Lerner argued that the fiscal operations of the government should be designed in such a way so as to fulfill certain objectives which have an immediate bearing and far reaching effect on the economic system as a whole, like attainment and maintenance of full employment with economic stability in the economy.

As pointed out by Prof. Chelliah, the concept of functional finance implies that:

1. The fiscal operations of the government should be implemented on a functional basis and public finance should not be used solely as a means of securing social goods.
2. The budget need not always be balanced. The fiscal norms preached by the theory of functional finance, in a complete antithesis to the orthodox rule of balanced budget, suggests the formation of large budgets with a wider functional coverage of government spending to promote basic economic goals like optimal allocation of scarce resources at full employment levels, achieving economic stability that brings about equitable distribution of wealth and income, etc.

Opposing the classical  notion, the theory of functional finance suggests that the state needs to assume an active role in the economic affairs of the nation, implying that public spending may be used not merely for its direct benefits but also for its indirect effects that it produces like raising the income level, increasing employment and output etc. These effects can be used to bring about stability in the economy. In short, the main principle of functional finance is the formation of an unbalanced budget from time to time for perfecting the counter-cyclical goal of fiscal policy. A surplus budget is recommended during inflation and a deficit budget for recovery through excessive public spending during a deflation or depression. Thus, an unbalanced budget is to be used as a means of ensuring economic stability and attaining and maintaining full employment in the economy.