Blanchflower: The Fed Should Buy Munis And Monetize State Debt
A few months ago I was running through some out of the box thinking for how the Fed might be able to give quantitative easing more of an impact. Not that I think the Fed should go QE, but if they do, the question is what should they do. Here’s what I came up with: The Fed could buy municipal bonds.
There has been a lot of talk about the anti-stimulus being provided by states and local municipalities (see Federal largesse was countered by state and local cutbacks). I have noted on a few occasions that Illinois and California bonds are trading with a high degree of default risk. But Michigan is up there too. New York has serious problems as does New Jersey to name the largest and most problematic states. Most every large state in the union is in fiscal trouble, which is why I have been warning that municipal bonds should be labelled buyer beware.’
But what if the Federal Reserve started QE2 with munis as the asset class of choice for credit easing? When the European experiment threatened to unravel, the ECB chose the nuclear option and stepped into the breach to start buying up the debt of its weakest debtor states. Now, the ECB claims these actions are unsterilized i.e. it is not just printing money. But, I have my doubts. In any event, the ECB is the New "United States of Europe" as Marshall Auerback puts it. And while the limited measures the ECB has taken have not caused the credit spreads or interest rates to decline for these debtors, I guarantee you a full effort of credit easing would do.
As I wrote in the Hussman-inspired post recently, normal quantitative easing is an asset swap of freshly minted non-interest bearing assets (money) for interest-bearing assets (bonds). As such, it can really only help the economy via a reduction in interest rates since reserves do not create loan demand. And QE drains interest income from the economy to boot. In short, QE is not going to have an appreciable effect on the real economy unless you really jam it on: $8-10 trillion worth as Paul Krugman was saying – or more.
Atlanta Fed President Dennis Lockhart says the US will get $1.2 trillion over the next year. Again, I have to reiterate that I don’t favour QE because some might take this paragraph as an endorsement. The point is that fiscal is better than monetary at reflating the economy – especially at the zero bound. Monetary works via interest rates and asset prices while fiscal affects the real economy. And, sorry $1.2 trillion of monetary easing ain’t gonna get it done in a $14-$15 trillion economy.
The U.S. economy is caught in a classic liquidity trap. With additional fiscal stimulus no longer a viable political option, even though the government is better equipped to deal with many of the structural hurdles to growth than monetary policy, Mr. Bernanke clearly feels that the Fed is the only game in town.
Enter David Blanchflower. He is a former MPC member at the Bank of England but also an American-British dual citizen professor who is very plugged in at the Fed. Here’s what he writes at Bloomberg (emphasis added):
I was at the Fed last week in Washington for one of its occasional meetings with academics…
The Fed is especially concerned about unemployment and the weak housing market. Chairman Ben Bernanke made that clear in his speech last week. It would be a major surprise if the Fed didn’t do more quantitative easing — creating money by enlarging the central bank’s balance sheet with the purchase of securities — at its next meeting. Failing to act now with such high expectations may throw the markets into a tailspin.
Out of Question
The economic models are telling us that we need more stimulus. Lowering interest rates and more fiscal stimulus are out of the question. Quantitative easing remains the only economic show in town given that Congress and President Barack Obama have been cowed into inaction.
The major questions about quantitative easing aren’t so much if, but how much will the Fed buy and of what type? There is little point in moving slowly. So $100 billion a month for six months seems a reasonable amount.
What will they buy? They are limited to only federally insured paper, which includes Treasuries and mortgage-backed securities insured by Fannie Mae and Freddie Mac. But they are also allowed to buy short-term municipal bonds, and given the difficulties faced by state and local governments, this may well be the route they choose, at least for some of the quantitative easing. Even if the Fed wanted to, it couldn’t buy other securities, such as corporate bonds, as it would require Congress’s approval, which won’t happen anytime soon.
Did you catch that. The Fed can legally buy as many municipal bonds as it wants without congressional approval. Talk about burying a lead. This is a big story. Blanchflower is essentially saying that the U.S. government can bail out both the housing market via Fannie and Freddie paper purchases and the state governments via Muni purchases. And, of course, the banks get to dump these assets onto the Fed who will hold them to maturity. I guarantee you this will have a very nice kick since it is the states where the biggest employment cuts are.
This is the Fed doing fiscal, friends. And I think it’s going to happen. Meredith Whitney take note.
How is this even helpful? They’d be buying the bonds from the banks so the banks get the cash – not the states. It’s no different from buying treasuries.
It goes to state liquidity constraints because of deficits. It’s an implicit backstop – which would make job cuts less critical and could also lower funding costs.
This is less helpful than you think. They wouldn’t be buying bonds directly from the states which would be pseudo financing. They’d buy them from banks which would really just reduce future interest costs. It wouldn’t impact state budgets much in the near-term.
It’s helpful because the money goes to municipalities which immediately spend it. Trading a bad asset for a good asset and trading balance sheet spots is a wash (TARP), but giving a printed dollar to a ready spender is exactly what they want. The money gets spent into circulation immediately because the municipalities don’t have any cash. The Fed going fiscal is an abomination. Please print me one too Federal Reserve because I’ll spend it!!
Exactly. Incremental funding that go to States and municipalities is much more likely to be spent than money that goes to the bank and is dependent on credit demand. I would also add that whether the states get the funding in the primary or secondary market is of less importance because the bid for the bonds in the private sector increases with knowledge that there is a government backstop. This is what we see in Europe.
Last point: I assume that once the Fed starts buying minis it can’t just stop if and when the States in particular get into trouble so this would be an extra bid for their bonds and an implicit guarantee for the States. Once you start buying it will be hard to stop.
Scott, this is not accurate. The bonds already exist which means the states already have the funding from the bond sales. Buying the bonds only extinguishes the states future interest costs. It doesn’t give the states cash to spend. They would not be buying new bonds at auction. They would be buying bonds from banks who would the. Release the states from their future liability. It’s not a big deal.
You’re missing the big picture. The Fed buying minis is functionally equivalent to the ECB buying Greek debt which has helped prevent disaster near term. It takes liquidity issues down a long way. I never said it was a panacea. Look at Ireland. But clearly this has a lot more fiscal dimensions than just buying treasuries.
Edward: good point in the above article. Here’s another idea for working round those economically illiterate politicians, who are the root cause of the problem.
1. Reverse QE, i.e. the Fed sells the bonds it has bought. 2. The Fed says to the economically illiterate politicians “look, we’ve got all this lovely money for you – why not spend it on, schools, roads etc, or just do a payroll tax reduction and feed the money straight into consumers’ pockets?
The economically illiterate politicians cannot reply with “inflation” because no extra money has been created. Plus they cannot claim the deficit has been increased: all that happens here is that money is shifted from wealthy former bond holders to ordinary households or schools & roads.
Interesting prediction!
Do you think balanced budget requirements would be a meaningful obstacle? I don’t know much about them but a quick search suggests the majority of states (37 to 43 depending on how you count) have this requirement, but that only the operating budget (aka general budget) has to be balanced, not the capital budget. Is it a given that states can categorize enough under the capital budget to run the debt-funded deficits they need? i.e., how flexible is this category?
On the Fed monetizing state debt, I do think balanced budget requirements are an obstacle. I think they would be relaxed in some cases in extremis, knowing that the Fed would be a secondary market buyer. But all of this is pure speculation at this point. The mere fact that it has now been broached by a former central banker makes it significant. I was just brainstorming when I wrote about it. I didn’t even know if buying munis was legal.
This story implies that there is a funding crisis at te state levels. That’s not true. The states believe they’re bankrupt and the budgets are largely in place. The fed buying munis might lower rates, but it won’t change state budgets materially. Therefore, no real economic change.
Right, unless the states actually change their budgets as a result of the muni QE – let’s call it MQE – then it has no fiscal impact. I don’t think this is a can of worms you want to open (moral hazard being a principal reason) but it sounds like this is being discussed. As for the interest rates, it depends on how much breathing room states get as to whether it will lower rates. I use Ireland as an example of how having the central bank buy your bonds doesn’t necessarily lower rates if people think you’re going to default.