Five years ago, The CARES Act authorized the Federal Reserve to create emergency lending facilities in the name of aiding the US Economy during the COVID-19 economic downturn. In a 2021 appraisal of the Fed lending facilities, several AIER Sound Money Project (SMP) scholars observed:
Although some facilities likely helped to promote general liquidity, others were primarily intended to allocate credit, which blurs the line between monetary and fiscal policy. These credit allocation facilities were unwarranted and unwise.
One such facility was the Municipal Liquidity Facility (MLF), which loaned money to state and local governments. In my recent AIER White Paper “Enabling Bad Behavior,” I examined the two entities that took loans from the MLF: the State of Illinois and the New York Metropolitan Transportation Agency (MTA). I find that, while the MLF loans do not show any effect on the fiscal health of these entities during or after 2020, the MLF distorted the boundary between fiscal and monetary policy.
How Did the Fed’s MLF Work? How Did It Compare to What a Central Bank Should Do?
The MLF loaned to state and local governments by purchasing municipal bonds directly from state and local governments, a historic first for the Fed.
For context, in their 2021 book Money and the Rule of Law, economists Peter Boettke, Alexander Salter, and Daniel Smith outline and discuss “Bagehot’s Principles,” for a central bank serving as a lender of last resort:
Only lend to solvent banks.
Accept only marketable collateral.
Lend at above-market interest rates to discourage unnecessary borrowing.
Publicly and credibly commit to this role before a crisis occurs.
When it comes to Bagehot’s Principles, the Fed establishing the MLF did not meet any of those standards:
Non-bank lending: this facility extended credit to non-bank entities, namely state and local governments.
High-risk borrowers: the MLF was open to loans on municipal entities with below-investment grade ratings. As financial analyst Marc Joffe noted in 2020,
Although the lending program is called a ‘liquidity facility’ – suggesting that it is a device for creditworthy governments to secure funds in difficult market conditions – it is open to junk-rated entities, meaning that the Fed could be taking on credit risk as well.
So much for only lending to solvent banks with collateral that is “marketable in the ordinary course of business.” Fed officials, however, did not lose any sleep about taking on such risk because the CARES Act promised that the US Treasury would cover the Fed’s losses up to $35 billion, passing the risk over to taxpayers.
Perverse Interest Rate Structure: The MLF structured borrowing rates so that the worse a government’s credit rating, the more favorable the interest rate it would receive. AAA-rated entities would face above-market interest rates (in line with Bagehot’s principle) while BBB-rated entities would receive below-market interest rates.
Crisis-Driven Creation: the facility was created in the midst of the pandemic and ceased operations December 31, 2020. Its sudden emergence amid the crisis failed to meet the criterion of pre-crisis credibility.
Moreover, the SMP scholars found that the MLF was among several emergency lending facilities that were fiscal policy tools, not monetary ones. If Congress wanted to enact those fiscal policies, they argue, these policies should have been approved by Congress and executed by the proper executive branch agency. Having the Fed handle something like loans to state and local governments “blurs the line between monetary and fiscal policy.”
Lending to the Worst of the Worst and Changing the Rules Along the Way
The MLF first purchased general obligation bonds from the State of Illinois. Illinois’s general obligation bonds were BBB-/Baa3, one notch above junk. This was due to years of fiscal mismanagement leading up to 2020, not the pandemic.
Using the Hoover Institution Municipal Finance Database, I found that Illinois entered 2020 with poor fiscal strength relative to states with similar economy sizes, population sizes, and poverty rates. By the time the MLF closed, the State of Illinois borrowed $3.2 billion from the facility.
Originally, the MLF was set to lend only to state and local governments. In April 2020, however, Senator Charles Schumer (NY) pressured the Fed to expand the MLF’s list of eligible borrowers to multistate entities, specifically the Port Authority of New York and New Jersey (PANYNJ). In the end, the PANYNJ did not take an MLF loan, but the financially distressed New York MTA did.
The entity, which serves New York State and City, Long Island, Southeastern New York State, and Connecticut, is what is known as an “Off-Budget Enterprise” or a “Component Unit,” which operates outside New York State’s formal budget yet depends heavily upon transfer payments from governments whose areas they serve. New York State’s financial reports describe component units (including the MTA) as:
“[F]iscally dependent upon, and has a financial benefit or burden relationship with the State…the nature and significance of their relationships with the State are such that it would be misleading to exclude them.”
I applied Hoover’s Fiscal Strength calculations to the New York MTA and PANYNJ, as well as Chicago Transit Authority (CTA), and the Washington Metropolitan Area Transportation Authority (WMATA) for comparison. From 2012-2020, the MTA consistently ranked at or near the bottom in fiscal strength.
In addition to the Hoover Fiscal Strength variables, I examined operating revenue (revenue earned through normal business operations) as a percentage of total transit authority revenue for all agencies. This is a sign of an agency’s dependence on debt-financed spending and transfer payments from governments.
The MTA’s operating revenue made up a smaller share of total revenue than all but one other agency in the sample (CTA), underscoring financial vulnerability. By the end of 2020, the MTA borrowed $3.35 billion from the MLF.
The Aftermath: Bad Behavior Enabled
While both Illinois and the MTA paid the MLF loans back, they did so by paying back the debt by issuing new bonds sold on the municipal bond market, akin to someone using their Visa card to pay their MasterCard bill. The loans did not require Illinois or the MTA to make structural reforms or budget changes, allowing the same problematic fiscal behavior to continue unchecked.
Fiscal strength indicators showed no significant improvement in Illinois or the MTA compared to peers in their designated samples. Interestingly, the PANYNJ, the reason for the expanding MLF eligibility, did not borrow from the facility and is in a much stronger position than the MTA.
I also examined each mass transit authority’s total ridership as a percentage of 2015 ridership (a pre-pandemic benchmark for stable transit use). None of the authorities in the sample have fully recovered ridership except the MTA’s Bridges and Tunnels. While external factors influence demand for transit, ridership trends are a key variable for revenue forecasts and budget planning.
While the MLF loans did not seem to have a noticeable impact on fiscal strength, it did make waves in fiscal and monetary policy. In the same 2020 commentary mentioned earlier, Joffe also noted that the MLF risked permanently federalizing local debt finance, undermining the discipline of balanced budget requirements and other fiscal rules keeping state and local fiscal policy in check. He also noted that the program could crowd out traditional municipal bond market investors and invite moral hazard by enabling politically favored jurisdictions to access subsidized credit.
Joffe’s concerns align with economist George Selgin’s 2020 book The Menace of Fiscal QE, specifically that the Fed creating these emergency lending facilities creates a backdoor fiscal policy and raises the risk of political credit allocation. State policymakers (incentivized to look outside their own sources of revenue by decades of dependence on federal transfers) are more than happy to use these backdoors to ensure the status quo in fiscal policy is maintained.
While the federal government is infamous for interfering with monetary policy, the MLF creates a new rent-seeking group in monetary policy: state and local governments. Seeking favorable loans from the Fed again will come naturally for state and local policymakers who, on average, receive 35 percent of their expenditures from federal transfers. Meanwhile, Fed officials who regularly embrace mission creep and consider the MLF “a clear success story of the pandemic policy response” will likely be happy to oblige.
Ultimately, this behavior will damage fiscal and monetary policy. These loans will come at the cost of the Fed’s public perception as an independent agency and damage institutional legitimacy, threatening long-term price stability. Additionally, these loans will weaken state fiscal discipline by providing yet another avenue for state policymakers to circumvent fiscal rules.
What Can Be Done?
The best way to rectify these mistakes is to establish strong institutional rules among federal and state fiscal policy as well as for monetary policy.
The Federal Reserve must be bound by a constitutional monetary rule to prevent Fed officials and fiscal policymakers from engaging in credit allocation.
Federal policymakers must make an explicit commitment not to bail out financially distressed states.
Both federal and state governments must embrace a strong fiscal rule that constrains spending growth and encourages policymakers to properly prioritize budget items.
State policymakers must establish rules that require state agencies to seek legislative approval before accepting federal grants or funding.
State policymakers must reform their relationship with Off Budget Enterprises. State leaders must either bring these entities fully on-budget and subject them to the same budget rules as other state entities, or end transfer payments and make them truly independent. These entities can no longer have their cake and eat it too.
These reforms will face political and institutional resistance. Without them, however, we risk further entrenching bad policy.