Research Topics

Debt, Central Banks, and Functional Finance

The scientific reassessment of the economic role of the state after the crisis has renewed interest in Abba Lerner’s theory of functional finance (FF). A thorough discussion of this concept is helpful in reconsidering the debate on the nature of money and the origin of the business cycle and crises. It also allows a reevaluation of many policy issues, such as the Barro–Ricardo equivalence, the cause of inflation, and the role of monetary policy.

FF, throwing a different light on these issues, can provide a sound foundation for discussing income, fiscal, and monetary policy rules in the right context of flexibility in the management of national budgets, assessing what kind of policies should be awarded priority, and the effectiveness of tackling the crisis with the different part of public budget. It also allows us to understand ways of increasing efficiency through public investment while reducing the total operational costs of firms. In the specific context of the eurozone, FF is useful for assessing the institutional framework of the euro and how to improve it in the face of protracted low growth, deflation, and weak public finances.

A Case Study of the Canadian Economy, 1935–75

Historically high levels of private and public debt coupled with already very low short-term interest rates appear to limit the options for stimulative monetary policy in many advanced economies today. One option that has not yet been considered is monetary financing by central banks to boost demand and/or relieve debt burdens. We find little empirical evidence to support the standard objection to such policies: that they will lead to uncontrollable inflation. Theoretical models of inflationary monetary financing rest upon inaccurate conceptions of the modern endogenous money creation process. This paper presents a counter-example in the activities of the Bank of Canada during the period 1935–75, when, working with the government, it engaged in significant direct or indirect monetary financing to support fiscal expansion, economic growth, and industrialization. An institutional case study of the period, complemented by a general-to-specific econometric analysis, finds no support for a relationship between monetary financing and inflation. The findings lend support to recent calls for explicit monetary financing to boost highly indebted economies and a more general rethink of the dominant New Macroeconomic Consensus policy framework that prohibits monetary financing.

The Advantages of Owning the Magic Porridge Pot

Over the past two decades there has been a revival of Georg Friedrich Knapp’s “state money” approach, also known as chartalism. The modern version has come to be called Modern Money Theory. Much of the recent research has delved into three main areas: mining previous work, applying the theory to analysis of current sovereign monetary operations, and exploring the policy space open to sovereign currency issuers. This paper focuses on “outside” money—the currency issued by the sovereign—and the advantages that accrue to nations that make full use of the policy space provided by outside money.

Myth and Misunderstanding

It is commonplace to speak of central bank “independence” as if it were both a reality and a necessity. While the Federal Reserve is subject to the “dual mandate,” it has substantial discretion in its interpretation of the vague call for high employment and low inflation. Most important, the Fed’s independence is supposed to insulate it from political pressures coming from Congress and the US Treasury to “print money” to finance budget deficits. As in many developed nations, this prohibition was written into US law from the founding of the Fed in 1913. In practice, the prohibition is easy to evade, as we found during World War II, when budget deficits ran up to a quarter of US GDP. If a central bank stands ready to buy government bonds in the secondary market to peg an interest rate, then private banks will buy bonds in the new-issue market and sell them to the central bank at a virtually guaranteed price. Since central bank purchases of securities supply the reserves needed by banks to buy government debt, a virtuous circle is created, so that the treasury faces no financing constraint. That is what the 1951 Accord was supposedly all about: ending the cheap source of US Treasury finance. Since the global financial crisis hit in 2007, these matters have come to the fore in both the United States and the European Monetary Union, with those worried about inflation warning that the central banks are essentially “printing money” to keep sovereign-government borrowing costs low.

This paper argues that the Fed is not, and should not be, independent, at least in the sense in which that term is normally used. The Fed is a “creature of Congress,” created by public law that has evolved since 1913 in a way that not only increased the Fed’s assigned responsibilities but also strengthened congressional oversight. The paper addresses governance issues, which, a century after the founding of the Fed, remain somewhat unsettled. While the Fed should be, and appears to be, insulated from day-to-day political pressures, it is subject to the will of Congress. Further, the Fed cannot really be independent from the Treasury, because the Fed is the federal government’s bank, with almost all payments made by and to the government running through the Fed. As such, there is no “operational independence” that would allow the Fed to refuse to allow the Treasury to spend appropriated funds. Finally, the paper addresses troubling issues raised by the Fed’s response to the global financial crisis; namely, questions about transparency, accountability, and democratic governance.

A Dubious Success Story in Monetary Economics

This paper critically assesses the rise of central bank independence (CBI) as an apparent success story in modern monetary economics. As to the observed rise in CBI since the late 1980s, we single out the role of peculiar German traditions in spreading CBI across continental Europe, while its global spread may be largely attributable to the rise of neoliberalism. As to the empirical evidence alleged to support CBI, we are struck by the nonexistence of any compelling evidence for such a case. The theoretical support for CBI ostensibly provided by modeling exercises on the so-called time-inconsistency problem in monetary policy is found equally wanting. Ironically, New Classical modelers promoting the idea of maximum CBI unwittingly reinstalled a (New Classical) “benevolent dictator” fiction in disguise. Post Keynesian critiques of CBI focus on the money neutrality postulate as well as potential conflicts between CBI and fundamental democratic values. John Maynard Keynes’s own contributions on the issue of CBI are found worth revisiting.