The U.S. government is scrambling to pass a mammoth aid package for the economy, which faces potentially unprecedented destruction from the coronavirus crisis. But the pandemic also threatens a massive financial crunch at the state and local level — one that, if not dealt with, could completely overwhelm national efforts to prevent another Great Depression.
There is plenty Congress can do to aid state and city budgets via new legislation. But the Federal Reserve could also act unilaterally, right now, under its already-existing powers. It needs to do so. Like, yesterday.
To crudely summarize, Section 14(2)(b) of the Fed’s charter empowers the Federal Reserve to buy municipal debt issued by state governments, by local and city governments, and by special districts. (The latter are entities set up by state or local governments to provide particular public needs via their own budget, in a specific area or throughout the whole state, from hospitals and public health, to transportation and even museums.) The one clear legal limit is that the central bank can only buy such debt if it's short-term — specifically, if the bond matures in six months or less. However, if the Fed were to commit to buying all that short-term debt at rock-bottom interest rates for a set span of time, that would allow states and localities to roll over their bonds with the Fed every six months, effectively transforming the short-term debt into longer-term debt.
State governments themselves often have balanced budget amendments to their constitutions that strictly limit their ability to borrow and issue bonds. But in practice, large swaths of state spending are exempted from these restrictions: capital spending on infrastructure projects, spending done jointly with the federal government (such as Medicaid and public education), plus the aforementioned special districts. A lot of this spending could be directly related to the coronavirus response, but any aid the Fed can offer will also free up money elsewhere in the budgets to tackle the current crisis.
As things stand, tax revenue for state and local governments collapses during recessions, which forces them to cut spending, which then makes the downturns even worse. With the Fed's help, however, state and local governments around the country could continue spending on essential services — such as health care, education, unemployment insurance, transit, and social services — and also ramp up the public investment needed to combat the coronavirus specifically, all without fear that big increases in deficits will wreck their finances.
For example, Skanda Amarnath of Employ America and Yakov Feygin at the Berggruen Institute are floating a proposal in which the Fed would commit "to purchasing short-term municipal debt securities... as is necessary to (1) stabilize all state government funding needs and (2) provide them with the appropriate financial flexibility to address the present public health crisis." As they explained to The Week, Amarnath and Feygin envision this offer from the Fed lasting at least a year, and focusing on the municipal debt that funds health care and other public efforts directly related to the coronavirus crisis.
They also point to previous Fed policies that can serve as a framework, such as the Commercial Paper Funding Facility (CPFF): In the Great Recession, the Fed made a similar offer (a "facility," in monetary policy jargon) to buy short-term debt issued by businesses and companies, in an effort to stabilize their finances and cushion the economy. The CPFF ran for roughly 16 months, and in fact the Fed has already brought it back to aid corporate America in response to the coronavirus crisis. The CPFF's history also demonstrates how to wind down the Fed's buying in a constructive way, so that the bonds aren't hit by a sudden spike in interest rates when the Fed exits the market.
Unfortunately, the central bank is reluctant to take advantage of Section 14(2)(b), and extend the same help to states and localities. Even if it's technically legal, the Fed views support of state and local borrowing as a breach of the firewall that's supposed to exist between fiscal policy and monetary policy. The central bank has made some limited moves to help states and cities, but primarily under other powers in Section 13(3), which require both approval and financial assistance from the Treasury Department. Thus far the Fed's only offered to buy municipal bonds in certain categories, rated at certain quality, and from financial markets that are a few steps removed from those that buy these bonds directly.
Amarnath and Feygin's proposal, by contrast, would involve a far more sweeping effort to buy up a much wider array of municipal bonds, and to do so directly from the private market dealers who buy the bonds from the states and such. Other policymakers, such as Rep. Maxine Waters (D-Cali.) want Congress to explicitly instruct the Fed to backstop state and local debt.
We should also consider going further: Have the Fed's lending facility last longer or even on a permanent basis, to empower states and localities to do more for their citizens — or at the very least make it something that can automatically ramp up whenever there's a crisis. The Fed could also buy these bonds directly from state and municipalities as they're issued. A huge problem here is that markets for municipal bonds are extremely underdeveloped: state governments live in fear of the credit rating agencies and private dealers, and thus usually pick austerity over public investment. Getting the Fed talking to state governments, so that the latter recognize the real opportunities they have to safely deficit spend, would go a long way.
History also provides a warning, as the Fed's hesitation to make use of 14(2)(b) proved catastrophic in the Great Recession: By the end of 2009, cutbacks at the state and local level had completely overwhelmed Congress' stimulus, dragging growth back into negative territory, and setting the stage for our brutal, grinding, decade-long recovery. In the here and now, municipal bond markets are already showing dangerously high spikes in interest rates, with many observers fearing a worse route than the markets have seen since at least 30 years. The central bank must not make the same mistake again.
The states and localities are on the front lines of the fight against the coronavirus: Their budgets foot much of the bill for the hospitals, clinics, and public health services that will combat the virus. The unemployment benefits system that will cover the deluge of Americans currently losing their jobs is largely state-funded. As Amarnath and Feygin pointed out, we don't just need to avoid cuts to state and local spending, we need it to go way up, and to go way up immediately. With the central bank's backing, state and local governments can move now, under their power, to protect and aid their constituents.
It's time for the Federal Reserve to treat these public investments with the same care and import it already extends to the federal government.
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