The Fed Can and Should Help States and Localities Right Now

There is no time to lose in heading off large, destructive and unnecessary state and local budget cuts.

[UPDATE: For further discussion of this proposal, see here.]

States and localities have already started planning for dramatic cuts to make up for plummeting tax revenues. This is a disaster for many reasons, including that many of these services are desperately needed and that what is not needed are more layoffs in the midst of a deepening recession. But state and local governments cannot have operating deficits and so cut they must. (For more on this background, see here.)

Ideally, the federal government, which can borrow, would act, and it has, but the money it has provided to states and localities is not nearly sufficient. One prominent estimate of what the states would need is $500 billion in support. There will apparently be no significant additional aid in the next round of relief bill. One can hope that Congress will eventually do the right thing, but enormous damage is being done right now. Can the Fed step in?

The Federal Reserve has, helpfully, started a program to lend the states $500 billion, but only through purchasing short-term (up to 2 year) notes. This program might be helpful in getting states and localities through the end of the fiscal year, but it will not suffice to prevent the big cuts that states are planning, because where will the states come up with $500 billion in two years?

The Federal Reserve can act more decisively and helpfully right now. There are, at least, two ways the Fed could proceed.

1. The current loan program is based on the Fed’s powers under Section 13 of the Federal Reserve Act. There is no limitation on the length of the loans permitted under this section. There is, however, a requirement that the Secretary of the Treasury approve the program. This should not be an obstacle because of the desperate need for the program. But politics seems to be preventing the current federal government from offering sufficient aid to the states. And so there is another option.

2. The Fed can act under its Section 14 powers to purchase short-term state and local notes. Now, it might be objected that short-term notes are not going to help for the same reason as short-term loans, but this is not necessarily so. After all, the Fed can commit to re-purchasing these notes every six months for twenty years. The Fed can also devise rules so that the notes only fund operating deficits and not, for example, long-term pension liabilities. There is precedent for how this might be done buried in the federal tax law governing tax-exempt bonds. Further, the Fed can warn that, once the crisis is over, it will permit only steadily declining principal to be carried over so as to create a kind of amortization schedule.

(Ideally, the federal government will eventually do the right thing and forgive the loans).

It could be objected that the states cannot take advantage of these programs because they cannot carry operating deficits. Whether states can use these programs will ultimately be a matter of state law, but there at least three reasons why the states could potentially use these programs. First, states and localities could hold elections that would permit them to borrow outright. Second, there is a short-term borrowing exception that states and localities could use to borrow without an election, and these would be short-term borrowings. Third, there a special fund exception that could be used; this exception, in brief, requires that the borrowing be secured by revenue other than general tax revenue. The details will matter and planning is important, but the point is that there is a way forward. [Forgive the California-centric links to the law of state debt limitations, most states have similar rules.]

As with so much in this crisis, the time to act is yesterday.