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Can the Fed Help Ease State and Local Fiscal Distress?

In the absence of substantial pandemic aid from Washington, there might be a role for the central bank: longer-term loans. But let's not create another perpetual-deficit machine.

Marriner S. Eccles Federal Reserve Board building in Washington, D.C. (Shutterstock)
With the Senate recessed until after Labor Day, it's a safe bet that state and local governments will have to wait a while to learn whether they will stand any chance this year of getting fiscal aid from Uncle Sam to offset their pandemic-recession revenue shortfalls. It's also a safe bet that anything that does clear Capitol Hill this year will amount to a only a fraction of the $915 billion of intergovernmental fiscal aid contained in the HEROES Act passed by the House months ago. There is almost no hardball advantage for the GOP to provide fiscal relief that extends much beyond the November elections.

So if substantial, longer-term fiscal relief from Washington isn't forthcoming soon, should states and local governments look to the Federal Reserve as their banker of last resort? And if it comes to that, how would — and should — the process work?

Here's the fiscal reality: Layoffs and cutbacks will deepen each month as states and their subdivisions fend for themselves to manage through the budgetary carnage that the COVID-19 recession has inflicted. Rainy day funds and other budget reserves are being drained, except for barrel-bottom dollars saved by some for 2021 since the fiscal outlook for next year is also dour.

For this calendar year, it's indisputable that at least $100 billion of state and local income- and sales-tax revenues will be lost to the recession. It's certainly plausible that the shortfalls will be larger, and that doesn't count revenue hits to mass transit, airports and tourist centers. But at worst, the sector's 2020 shortages should fall within my April estimate of between $100 billion and $250 billion.

The documented historical facts are that state- and local-government layoffs have exacerbated every recession in the past century and retarded the recovery each time. No wonder, then, that top Federal Reserve officials uniformly and repeatedly have urged Congress to provide fiscal aid to states and local governments. But for now at least, their voices are falling on deaf ears in the Senate and the White House.

It's more than a bit ironic that this year's partisan, reincarnated congressional fiscal conservatives are balking at deficit funding of grants to states and localities on the pretense that they have been fiscally irresponsible. Isn't that the pot calling the kettle black? Fact: The states altogether carried $100 billion in unencumbered cash reserves into March, averaging about 12 percent of their annual general fund budgets (for rainy day funds alone, the median balance was 8 percent) — money that was available to offset much of 2020's recessionary red ink. That's infinitely more fiscally responsible than smug Beltway politicians can say for themselves.

Whether or not Congress actually approves some kind of limited fiscal assistance this year, it's pretty obvious by now that any serious therapy for the economy in 2021 will be punted to the next session. Which brings us back to the Federal Reserve, not by brilliance but by default.

The Fed's embryonic Municipal Liquidity Facility (MLF) could expand to serve as a lifeline to some states and local governments, particularly if Congress deadlocks next year as well. At that point, the absence of fiscal stimulus to offset deepening recessionary layoffs could force the Fed to take actions it has thus far resisted. Instead of lending stabilizing cash to a few states and municipalities for three years, as the central bank has tippy-toed with a mere $1 billion now outstanding, the Fed could conceivably extend the allowable repayment period to a full business cycle. Since 1983, these cycles have averaged nine years including the recession and recovery phases, which should provide an average of seven years for the borrowers to repay these loans once an expansion resumes.

This idea is not my brainchild. It first caught my eye in Barron's, the weekly investment magazine published by the ultraconservative owners of The Wall Street Journal. In his Barron's column, Matthew Klein even suggested that the loan repayments could extend for 40 or 50 years, although that brings cringes to anybody with any sense of intergenerational fiscal responsibility: Fiscal integrity requires that any such Fed lending should be repaid before the next recession, or else the entire scheme becomes a perpetual-deficit machine for politicians kicking the can to future generations.

To make such an extended MLF work, these ground rules would help:

• Loan repayments must begin one year after the economy has left recession, with full repayment due in seven years excluding any subsequent quarters of negative GDP growth.

• The interest rate would be zero until and unless the five-year Treasury bond market yield exceeds 1 percent. From that point, the rate would reset annually at the Treasury rate.

• Repayments must be secured by a priority claim on future tax revenues and/or later injections of federal fiscal aid.

• Annual principal-repayment installments would be set at a minimum of 10 percent and calibrated upward to 25 percent in years when GDP growth exceeds 3 percent.

• Borrowers must make an equivalent contribution to a restricted rainy-day fund to be used only in recessions.

• Smaller local governments could borrow through a statewide bond bank or their state treasurer as an intermediary. It's hardly efficient for the Fed to be buried under an avalanche of loan applications from every city and county.

An extended MLF isn't a solution for everyone. In many states, for example, there will be legal, even constitutional, barriers to borrowing (even from the Fed) to cover operating expenses. To meet certain states' legal debt restrictions, annual refinancings could be allowed, but that workaround is only a spotty solution.

And one vexing downside of opening a longer-term Fed lending window for states and localities is that its availability could become a perpetual excuse for congressional opponents of direct counter-cyclical fiscal aid. The hypocrisy, of course, is that when the Fed buys trillions in U.S. Treasury bonds to cover the deficits that irresponsible congressional tax-cutters have spawned, they are never repaid.

States and localities are now trapped financially between a rock and a hard place. But as their Beltway advocates will advise, they must be careful about which solutions they promote in Washington. Never forget the wisdom of the law of unintended consequences.

Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management.

Girard Miller is the finance columnist for Governing. He can be reached at
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