Government-ordered business shutdowns aren’t flattening just the curve. They’re causing a steep drop in tax revenue for state and local governments.
To ensure the flow of credit to these cash-strapped governments, the Federal Reserve has embarked on a previously unthinkable act: creating up to $500 billion in new fiat currency and lending it directly to states, cities, and counties through its Municipal Liquidity Facility.
For now, this staves off default by local governments on existing debt and allows government services to continue uninterrupted. However, this marks a dramatic departure from the Federal Reserve’s traditional role of equipping solvent financial institutions with the liquidity necessary to meet credit demands.
Unusual times often call for unusual measures. But this unprecedented action brings with it very serious risks—ones that are easy to overlook.
To see why, start with an obvious fact: A bailout of municipal governments—whether through grants, purchasing outstanding debt, or direct lending—shifts the fiscal burden away from the municipality to taxpayers nationally. This reality is quite clear if the federal government directly funds the bailout. The public intuitively understands that federal tax revenue is either confiscated from the earnings of citizens or borrowed from our future with interest attached. Legislators openly debate the bailout proposal and must vote to appropriate funds. Ultimately, the transparency allows constituents to hold their representatives accountable.
On the other hand, spending (lending) by the central bank of newly created fiat money is far less politically problematic. Cranking up the printing presses to fund a bailout requires no immediate tax hikes, minimal official federal spending increases, and little legislative involvement. It therefore more easily slips under the political radar.
For instance, Congress facilitated the municipal bailout now underway by simply allocating $35 billion to a Special Purpose Vehicle (“SPV”) to backstop the $500 billion in new fiat currency lent by the Federal Reserve. Ironically, the SPV itself was financed indirectly by the central bank which purchases government debt in exchange for newly created fiat money.
Perhaps most importantly, this program implements the infrastructure for a future massive bailout of poorly managed governments. The day of reckoning for municipal governments was quickly approaching even before the coronavirus slowdown. Large increases in real per capita spending along with underfunded public sector pension plans constitute financial time bombs. Only a combination of higher taxes, pension reform, or diminished essential government services—such as emergency medical responses and functioning mass transit—will defuse the situation unless local politicians can shift these burdens onto the shoulders of unsuspecting citizens elsewhere.
Of course, some concentrated winners would emerge from this larger bailout. Municipal bond investors would continue to enjoy the tax-free income from investments—but now improved thanks to being implicitly guaranteed by the central bank. State and local politicians could curry favor by delaying painful spending cuts or governmental reforms. Public sector unions and employees would applaud a continuation of outsized pay and cushy retirement benefits.
Such a bailout creates severe economic risks. Longer term, these newly created dollars threaten to increase inflation. The $500 billion spent on municipal debt multiplies into trillions of additional dollars as the funds are deposited at lending institutions and loaned to other borrowers. A greater quantity of money chases existing resources operates as a stealth tax by eroding real savings, diminishing real wages, and driving up the cost of living.
But so long as productivity increases at a faster pace than inflation, the general public fails to realize this negative impact. Inflation denies business owners, investors, and workers from enjoying the full value of productivity created by the combination of innovation and capital investment. Much of the public simply fails to connect the dots between the gusher of new currency and a dollar consistently declining in value. The more the Federal Reserve engages in this type of money creation and asset purchase program, the more difficult the cleanup process later.
Now that the Federal Reserve is actively engaged in creating new fiat currency to fund state and local governments, Congress must step in. These new tools can easily be scaled up to provide a multi-trillion dollar municipal bailout. Pressure is already on the Federal Reserve to go much further. For instance, House Financial Services Committee Chair Rep. Maxine Waters (D-CA) wants the central bank to buy up an array of municipal debt—presumably including junk bonds. Others desire a bailout by the central bank of woefully underfunded public pension plans through the purchase of pension obligation bonds.
Pension obligation bonds are a gamble—using borrowed funds to invest in the stock market and hoping to earn a higher rate of return than the government has to pay on the bonds. Puerto Rico tried that in 2009 right before the stock market tanked, causing funding to deteriorate instead of improve, and pushing the U.S. territory closer to bankruptcy. Unless Congress thinks it is a sound strategy to issue $10 trillion in new debt and invest taxpayers’ money in the stock market in hopes of achieving high returns to reduce its total debt, the Federal Reserve should not purchase pension obligation bonds.
Importantly, although existing law limits emergency Federal Reserve lending to only “solvent” institutions, the central bank appears ready to flout this rule. Illinois, a state notorious for its backlog of more than $7 billion in unpaid bills and barely $1 million in cash reserves (in addition to its long-term unfunded liabilities), will be one of the many recipients of short-term credit over the next few months. The rating agencies currently rate Illinois’ bonds only a notch above junk.
Congress should proactively roll back the authority of the Federal Reserve to directly or indirectly provide credit to state and local governments. A good starting point would be consideration of the proposed State and Local Pensions Accountability and Security Act (HR 2126) which would prohibit the Federal Reserve from providing public pension bailouts or other financial assistance. Without these statutory revisions, the Federal Reserve conceivably could directly purchase longer-term municipal debt in an “exigent” or “emergency circumstances.”
This pandemic-spurred $500 billion bailout should be a wakeup call. If Congress chooses to bailout municipal governments—as ill-advisable as that would be—it should utilize its constitutional spending authority rather than abdicate responsibility to an opaque, economically dangerous fiat money creation process at the Federal Reserve. As former Fed Chair Ben Bernanke stated when explaining his opposition to Fed bailouts of municipal bonds, “This is really a political, fiscal issue.”
It is impossible for the Federal Reserve to maintain its monetary policy independence while pursing these politically motivated bailouts. This is an off-budget trick which allows elected officials to skirt responsibility as voters are confused by the smoke and mirrors.
This piece originally appeared in RealClear Markets