The Fed Must Throw a Lifeline to State and Local Governments
We need the full strength of state and local governments to drive a strong and inclusive recovery, yet they are being left behind in terms of federal support. Federal Reserve financing programs are not substitutes for fiscal support provided by Congress, but the $500 billion in Municipal Liquidity Facility program capacity, if redesigned to be broadly accessible, flexible and affordable, can help stop the erosion of human capacity and the degradation of critical services and infrastructure to lay the groundwork for a resilient and sustainable future.
State and local governments are in dire straits.
Congress went into recess without agreeing on the next COVID relief package, leaving state and local governments in an increasingly desperate situation. The Center for Budget and Policy Priorities estimates that state budget shortfalls arising out of the pandemic will total $555 billion from 2020 to 2022. A study of the economic impact of the pandemic on cities revealed that the sum of Gross Metro Product—a measure of the output of cities—would drop by $1.45 trillion in 2020, resulting in precipitous declines in local tax revenues. In reporting on this crisis, the Wall Street Journal notes (paywall) that state and local governments spent or invested $2.33 trillion in 2019, equivalent to 10.9% of U.S. GDP, and that they employ 13% of U.S. workers. In 2020, those expenditures and workers are in free fall.
The data shows that the coronavirus crisis is having a greater impact on state and local government jobs than the 2008 recession. Government jobs have fallen by 1.5 million since March 2020 as compared to the 600,000 government jobs that were lost through the entirety of the Great Recession. It’s not over and it's not just impacting blue states and big cities: a majority of cities and towns anticipate furloughs and many are also anticipating lay-offs, as highlighted through the U.S. Conference of Mayor’s Fiscal Pain Tracker. The impacts will be felt for a long time, since public hiring grows much more slowly than private hiring—state and local government employment didn’t fully recover from the last recession until October 2019.
All of this at a time when cities and towns around the country are coming to grips with the need to make additional investments to deal with the risking risks of climate change.
Congress and the Federal Reserve and can help, but while Congress negotiates, the Fed fights with one hand tied behind its back.
The federal government can meet this urgent need through both direct fiscal support from Congress and flexible and low-cost short-, medium- and long- term facilities from the Fed. Failure to do so at sufficient speed and scale means service cuts, underinvestment, deferred maintenance, and increased unemployment, which further weakens the economy in a self-defeating cycle of austerity and fee and tax increases.
The Coronavirus Aid, Relief and Economic Security (CARES) Act allocated $150 billion in direct grants to states and the largest cities to fund increased costs due to COVID-19. However, we now know that this is far less than the overall need and that smaller cities and counties are not getting their fair share. In addition, these funds are restricted in how they can be spent and cannot support anything at all that the state or local government included as a line item in their budget before March 27th which negatively impacts state and local governments that acted quickly to update their budgets.
Based on estimates by state and local governments, it is clear that something on the magnitude of at least $500 billion to $750 billion in direct funding to states and local governments is needed, similar to what is envisaged in the HEROES Act that passed the House of Representatives, which wisely allocates funding based on not only population but also level of COVID-19 cases and level of unemployment to directly support the hardest hit areas. $915 billion of HEROES Act assistance would be flexible and could be used for any purpose, including to replace revenues.
As noted however, the next phase of COVID response has been stalled in Congress with the prospect of successful negotiations uncertain. Any eventual package may in any event fall short of the need.
The Fed has done much to stem the tide of market dysfunction, but it has failed to support workers and unwisely propped up the fossil fuel sector.
The Fed acted early and decisively under its own authority and has been working diligently with Treasury to implement emergency programs under the CARES Act. Federal Reserve Chairman Jerome Powell and several regional bank presidents have warned of dire consequences for our economy if Congress fails to provide additional fiscal support to state and local governments, emerging as a consistent voices of reasoned action during the crisis.
Still, there have been some serious missteps in the Fed’s response.
For one, the Fed facilities lack binding requirements for private sector recipients to use the funding to preserve jobs, so executives, lenders and shareholders may end up being the primary beneficiaries.
Also, the Fed appeared to cave to political pressure to specifically re-design the terms of corporate programs to bail out fossil fuel companies, and a recent analysis suggests such companies are in fact over-represented in the Fed’s portfolio. Sarah Bloom Raskin, a former member of the Federal Reserve System Board Governors, writes in the New York Times that, “These concessions to the fossil fuel industry are a risky investment in the past.”
Equally glaringly, the Fed has failed to develop a program that meets the challenges facing state and local governments, even though it has the mandate and capacity to do so.
The CARES Act provides Treasury with a $454 billion fund to make loans and loan guarantees to, and other investments in, programs or facilities established by the Board of Governors of the Federal Reserve System for the purpose of providing liquidity to the financial system that supports lending to eligible businesses, states, or municipalities. The Treasury funding is there to absorb some of the facilities’ potential losses, which means that the Fed can leverage the Treasury commitments by at least a factor of 10.
Overall, the Fed has so far established 13 facilities—11 of them exclusively targeting the private sector—with announcements of how $195 billion of Treasury funding will be used to support them. The private sector facilities target short- and long- term corporate debt, asset backed securities, small and medium businesses and nonprofits.
The Fed has set up just one facility—the Municipal Liquidity Facility—to specifically help state and local governments by directly purchasing municipal bonds. The facility has a $500 billion capacity, but, even after multiple revisions to make the program more generous, its terms are still much less generous than the other direct lending facilities, which provide credit at lower rates, with longer terms and the option to defer interest.
By contrast, the interest rates for the Municipal Liquidity Facility have been set higher than market rates to specifically discourage its use unless as a last resort when no market-based option is available. While applying such a “penalty rate” is nominally required under the Fed’s emergency authority, in practice, the Fed has applied this rule loosely in the private sector facilities. For example, in the Primary Corporate Credit Facility, the pricing is “issuer-specific, informed by market conditions” while the Fed has set up strict formulas for the Municipal Liquidity Facility.
As an additional burden, issuers have to demonstrate in their applications that they were unable to secure credit from the market. No such showing must be made under the Primary Market Corporate Credit Facility, for example.
Given the purposefully unattractive terms and despite the tremendous and well documented need for state and local resources, only one municipal issuer, the State of Illinois, (which is in dire straits), has tapped the Facility since its inception, using only $1.2 billion of the facility’s $500 billion capacity. This amounts to .24% of the amounts available in the facility and just over 1% of the total amounts outstanding under all of the Fed facilities as of July 31st, based on figures set out in the Fed's August report.
No, the lack of use of the Municipal Liquidity Facility is not a sign that state and local governments are getting the support that they need.
Some Fed watchers in the financial press note that the Municipal Liquidity Facility has been successful in the sense that it has had the effect of settling the upheaval in the municipal bond market. Interest rates are down and deals are in the market, so, in this view, issuers do not need the expensive Fed money. Another argument for not substantially altering the program is that since any borrowing must be paid back, a more accessible facility might somehow incentivize dangerous levels of public debt. However, this fails to account for the caps on borrowing built into the facility’s rules. There is also question of whether the Fed even has the authority to do more under its emergency authority and the CARES Act.
On the issue of authority, no less of an authority on financial regulation than Senator Elizabeth Warren has stated that the Fed can and should do more. Senator Warren, joined by Senators Van Hollen and Cortez Masto, noted in a letter to Chairman Powell that while not a substitute for direct fiscal support from Congress, “Expanding the MLF and making it a more accessible source of financing is one way that Treasury and the Fed can help ensure that we are not turning a blind eye to the need for a recovery that reaches all Americans”.
In the House, 53 members sent Chairman Powell their own letter offering a complementary perspective, noting that, “Given the severity of the need and the Federal Reserve’s exceptional creativity and flexibility in its corporate lending programs, which have moved the institution’s support of the private sector far beyond what anyone thought was possible, we cannot accept that the MLF remain an outlier when it comes to providing the meaningful fiscal support intended by Congress.” Perhaps in response to some of the criticism or due to the lack of action by Congress, the Fed has continued to tweak the program, by allowing additional numbers and types of issuers and finally lowering the pricing by 50 basis points a full 4 months after the program started. This is a step in the right direction, but it is nowhere near enough.
The Fed can craft a program to ease the fiscal crisis while keeping the debt burden manageable.
For the Fed to effectively support state and local governments in a way that allows them to maintain jobs and invest in recovery and growth, the overriding design principle must be that the Municipal Liquidity Facility and any similarly targeted Fed program should look as much as possible like revenue replacement while remaining a debt obligation in order to stay within the Fed’s authority.
To achieve this, there are four key elements:
- Proceeds broadly usable for any purpose;
- An extremely low base interest rate (for example, the House letter mentioned above suggests setting it at the Fed Funds rate used for overnight lending to banks (currently, 25 basis points));
- Availability of a broad array of maturities—up to thirty years—with no prepayment penalties, the ability to rollover shorter maturities, options for deferred interest payments, and customizable amortization schedules; and
- Easy access to funding by smaller local governments and US territories, perhaps through dedicated facilities.
This is not a risky business.
Municipal bonds default much less frequently than the corporate debt the Fed is already holding.
In fact, lowering the interest rate and extending the available maturities should make municipal credits even less risky, since the debt service and repayment burdens will be more manageable. The extended term and rollover options will provide a true bridge to a world where the public health response is more effective and vaccines are becoming available. As economic activity picks up, along with its attendant taxes, fees and other sources of revenue, state and local creditworthiness will steadily improve, further de-risking these assets.
Furthermore, by starving state and local governments, the Fed is effectively making its private investments more risky, since more severe economic outcomes are fueled by state and local job and spending cuts. In other words, if state and local stress is lowering the capacity of government, it will spill over to and undermine the recovery of the private sector.
To recap, we need the full strength of state and local government to drive a strong and inclusive recovery, yet they are being left behind in terms of federal support. Federal Reserve financing programs are not substitutes for fiscal support provided by Congress, but the $500 billion in Municipal Liquidity Facility program capacity, if redesigned to be broadly accessible, flexible and affordable, can help stop the erosion of human capacity and the degradation of critical services and infrastructure to lay the groundwork for a resilient and sustainable future.
**Many thanks to Bridgett Neely of Firefly Consulting for assistance with this post.