Will The Fed Rescue State And City Budgets If Congress Won’t?

Will The Fed Rescue State And City Budgets If Congress Won’t?Increased federal aid is essential as public budgets collapse and jobs are lost, and Congressional deadlock has some looking to the Fed for relief.  But the central bank is not acting aggressively to help states and cities.

The Federal Reserve building is seen on April 2, 2020 in Washington, DC. (Photo by Olivier DOULIERY … [+] / AFP) (Photo by OLIVIER DOULIERY/AFP via Getty Images)

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As the economy stumbles into the summer, state and city budgets continue declining due to falling tax revenues.  This is leading to employee furloughs and layoffs and reduced government contracting and spending, cutting into essential services and also reducing our chances for economic recovery.  Mayors and governors have been calling on Congress to act, but Washington remains in a partisan deadlock, with Democrats advocating major aid to states and cities, and Republicans thus far refusing.

Without Congressional action, and with uncertain and contradictory statements from the Trump Administration, some analysts are hoping the Federal Reserve can plug these budget gaps.  But having states and cities cover immediate needs with short-term borrowing could set up future crises when the debt must be repaid.  And the Fed is setting harsh borrowing terms for states and cities in their new municipal debt purchasing policy, so it won’t help very much.

People are looking to the Fed because we aren’t seeing any major budgetary impact from states and cities reopening the economy, which some hope will generate significant state and local tax revenue from sales, payroll, and other sources. As a result, layoffs and furloughs are accelerating.

The US Conference of Mayors has a “fiscal pain tracker” that reports from the front lines of American cities, and it is filled with bad news.  Hiring freezes, employee furloughs and layoffs, reducing or stopping capital spending, and even possible tax increases are reported from around the country.  State revenues are falling for this new fiscal year, with reports from 25 states estimating revenue declines from 4% (Arkansas) to as high as 35% (New Mexico).  No state is estimating increased or even level tax revenue.

If Congress won’t provide money, and tax revenues aren’t turning around, what about the Federal Reserve?  Earlier this year, the Fed took a historic step and established a new $500 billion Municipal Liquidity Facility (MLF).  For the first time, the central bank will purchase state and local debt directly, a step they have long avoided for fears of being involved with local politics and “picking winners and losers” among state and local governments.

But the MLF is off to a slow start.  In early June, Illinois (one of the states in the worst fiscal condition) announced it will sell $1.2 billion of one-year general obligation bonds to the Fed.  The state’s poor financial condition means the Fed will likely charge Illinois a relatively high interest rate, an estimated 3.83%.

That’s a pretty high rate for a one-year state bond, and high rates are leading cities and states to avoid the Fed’s MLF in favor of the regular market.  Washington state treasurer Duane Davidson concluded that “not being a substitute for direct aid, the program’s above market ‘penalty rate’ makes the MLF a non-starter for the state and, frankly, for all highly-rated municipalities across the country.”

So the MLF in its current form will not help many state and local budgets.  The Fed is using it as a classic “lender of last resort” program, charging high rates relative to the market.  This virtually insures governments won’t use it, except in desperate circumstances.  And because most state and local governments want to keep their higher credit ratings, they also won’t engage in significantly more borrowing in the market, which would hammer those ratings downward.

Some advocates are calling on the Fed to restructure the MLF.  David Dayen wants the Fed totweak the MLF, eliminating the interest rate and making principal payments optional or extending the maturities to 200 years or some other function that makes them effectively grants.”  And Nathan Tankus wants the Fed to use its 14.2(b) “’non-emergency’ authority to establish unlimited credit lines for every state & local government” and take away the “onerous” pricing of the MLF.

These advocates and others are particularly angry because they see the Fed using other authority to help profit-making corporations and “vulture funds” without forcing them to take on significantly higher priced debt or suffer other severe costs.

The Fed isn’t signaling it will reform the MLF in this way. The only significant adjustments to the MLF so far have been opening it to more jurisdictions with smaller populations.  This was very probably due to political pressure from advocates for smaller cities, several of which have majority non-white populations.  The original MLF criteria excluded all of “the thirty-five most African-American cities in America.”

But burdening those cities—or any city and state in the midst of a financial meltdown—with higher debt and interest costs is no solution to the fiscal and economic problem.  It would be great if the Fed would reform the MLF along the lines suggested by Dayen, Tankus, and others.  But that doesn’t look very likely.

Fighting for direct federal aid still seems like the only game in town.  House Democrats have passed legislation calling for $1 trillion in aid to state and local governments, but the Republican-led Senate has refused so far to negotiate over that.  We have to hope Congress will provide significant aid without being pushed by a major economic decline caused in part by sinking state and local budgets.   By all appearances, the Fed is not going to help us solve this problem.

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