I am increasingly convinced that the Federal Reserve will have to break a political logjam and make much larger amounts of short-term credit available to the states on highly concessionary terms. This goes against a century of precedent, but the deadlock within Congress and between Congress and the president will make this necessary.
This cannot happen before the election, and would be implemented quickly only if the election results represent a clean sweep for the Democrats. The US president, House and Senate are becoming less able to agree on further economic stimulus the closer the election gets.
There will be a stimulus bill agreed after the elections, and after the confirmation of Amy Coney Barrett as the next associate justice of the Supreme Court. The current House Democrats and Senate Republicans are ready to agree on extended unemployment benefits, aid to airlines and a limited number of other measures, but Democrat demands for transfers to state and local governments turn out to be a deal breaker.
Republicans charge these would be mere giveaways to the state and local employee unions and their pensioners, and there is a lot of truth to that. But at this point the Fed is faced with a collapse of one of its dual mandates, which is employment. US states and localities have balanced budget laws, and at the end of the year they will have to lay off large numbers of employees. The country does not need that. This is a public order question until a vaccine is approved and effectively distributed.
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The Republicans are also right that direct funding of state government budgets by the Fed would disproportionately benefit Democrats. True. It will also directly stigmatise the Democratic states. Greece avoided the early, aggressive reductions in its civil service after its financial crisis began in 2011. Would the Germans want to switch places? I think the northern European countries have a sneaking appreciation for Greece maintaining the border of the EU.
The deal I (and others) am thinking of would offer at least $1tn of loans to state and local governments for six months at a time under Section 14.2(b) of the Federal Reserve Act. The rate would be a minimum of 25 basis points for highly rated states and local authorities and a maximum of 400bp for the lowest rated. There would have to be commitments to maintaining employment for employees and suppliers, and a prohibition against reinvesting proceeds.
These rates would not be “fair”. They are way below the levels that have already been offered to states and localities under the Municipal Liquidity Facility, a $500bn line that was set up under Section 13(3) of the Federal Reserve Act at the beginning of April. The MLF borrowing rates were set to be “punitive”. The punitive part worked, and only a bit more than $1.6bn was borrowed under the MLF by the end of September.
So fiscal prudence was rewarded. And the money was not spent. By the end of this year, though, the economy will be in a deflation trap, and the Fed and Congress will be making up longer lists of assets that can be monetised and jobs that can be saved.
State and local governments can at least maintain social support payments, pay minimum levels of utility bills for the distressed, and maintain public order. The short tenor of the direct Fed lending, and the consequent uncertainty and market stigma, will have some effect in limiting the programme’s obvious moral hazard.
There are a large number of problems that Fed underwriting of muni borrowers does not answer. For example, Democrats and Republicans agree on providing support to keep airlines flying until demand returns. Yet neither party has an idea about how to finance hotels and restaurants without clients. “Pay cheque protection” does not cover any non-labour operating costs.
It would help if the financial markets were providing more reliable signals than they are. Take, for example, commercialised mortgage-backed securities, the $500bn-odd market I have written about in the past.
By the beginning of September, about 40 per cent of the CMBS financed malls and lodging properties were delinquent. Yet the ETF for the asset class, symbol “CMBS”, priced on Thursday at $55.18, has risen close to its all-time high of $56. Why?
If the market does not know anything now, how can we look to market-based solutions? At least until we have a vaccine proven, produced, and administered to almost all the population.