Spread the Fed, Part II

PUBLISHED

Robert Hockett is the Edward Cornell Professor of Law at Cornell Law School.

PUBLISHED

Robert Hockett is the Edward Cornell Professor of Law at Cornell Law School.

From Federal Disintegration through Community QE to Central Bank Decentralization

In the post immediately preceding this one, I observed that the twinned histories of American ambivalence toward centralized political governance on the one hand and central banking on the other place recent development in the realms of both pandemic response and American public finance into a helpful light. I then devoted the remainder of that post to broadly sketching the two histories just referenced. I now turn to the developments in pandemic response and public finance. Interpreted against their historical backdrop, I think, they tell us much about where American central banking will go – and probably indeed ought to go – next: namely, to a ‘better spread’ Fed.

Picking up where we left off, then, the Trump administration’s unwillingness to mobilize any national productive or mitigation response to the pandemic that might compare to our earlier Wilson and Roosevelt administrations’ responses to the First and Second World Wars has been widely discussed. Also now widely discussed is the dawning awareness that cities, states, and compacts of states are accordingly all we have left where collective address of those collective action challenges which are the national pandemic and its associated economic collapse are concerned. In effect, we have devolved back to a state of our union in which states and their subdivisions are our principal, if not sole, means of concerted national action. They are our new ‘administrative state,’ at least till we once again have a national executive that believes in both national administration and indeed even the national project.

It is against this backdrop – and as a response to the devolution just noted – that the Fed’s new Community and Small Business QE initiatives are best understood, particularly if we’re inclined toward ‘best lights’ or what I think of as ‘potential-optimizing’ styles of interpretation. As noted in introducing the present pair of posts, moreover, this backdrop does more than merely explain the emergence of new facilities. It also suggests what we still have to do if we wish to optimize them. I shall argue that this includes far more extensive distribution of the Federal Reserve System even than Community QE will occasion.

Let’s start with a brief description of what I’ve been calling ‘Community QE’ itself…

The MLF that is Community QE’s most interesting manifestation for now is to operate under color of Section 13(3) of the Federal Reserve Act (again, FRA), which grants the Fed emergency lending authority in exigent circumstances. The Fed exercises this authority through direct purchase and hence ‘monetization’ of financial instruments. In this case the instruments in question will be what the MLF Term Sheet calls ‘Eligible Notes’ issued by ‘Eligible Issuers.’ I’ll say more about how these terms are defined momentarily, but the gist here is simple: the Fed is, in effect, offering to lend to states and their subdivisions faced with temporary budget crises rooted in the simultaneous rising of pandemic response costs on the one hand, and lockdown-caused revenue shortfalls that would ordinarily cover costs on the other hand.

Ordinarily, cities and states finance operations through tax and related revenues as well as through issuance of municipal bonds (‘munis’) on the municipal bond markets. But mounting costs and plummeting revenues wrought both by the pandemic and by the productive shutdowns it necessitated squeezed state and city budgets hard, such that the muni markets began to seize-up in February as investors lost confidence in subnational units of governments’ capacities to stay current on debt obligations. This seizure, which imperiled the holdings of many investors already in this $4 trillion market, was the proximate prompt to the Fed to introduce the MLF. But as I shall argue momentarily, it is critical now to draw out, for the Fed, the larger significance of its new facilities. For the MLF is, as suggested above, now our sole federal means of funding the states and the cities that are becoming, effectively, our federal pandemic response agencies.

Returning, then, to the financial mechanics of the MLF, the Facility’s Term Sheet defines Eligible Notes as ‘tax anticipation notes (TANs), tax and revenue anticipation notes (TRANs), bond anticipation notes (BANs), [or] other similar short-term notes issued by Eligible Issuers.’ Intriguingly, it now permits notes of up to three years’ maturity, after having initially surprised observers already with allowance for notes of up to two years’ maturity in early April. Both moves were surprising because the Term Sheets’ references to revenue-anticipation instruments clearly were meant to underscore perceptions, brought by the MLF’s very name, that the Facility is nothing more than a tide-over liquidity support mechanism. Three-year notes enable far more to be characterized as ‘revenue-anticipating’ in character than anything ordinarily thought meant for ‘liquidity’ – a term usually reserved for instruments of 6 to 12 months’ maturity at most. This is but one surprising feature of the MLF – a feature that offers a pathway to further optimization. But there are more.

Eligible Issuers’ under the MLF authority are defined with surprising breadth as are ‘Eligible Notes.’ The Term Sheet stipulates that they comprise all US States and the District of Columbia, US Counties with populations exceeding 500,000, and US Cities with populations exceeding 250,000 – in effect lowering the thresholds to ¼ of what they were when the MLF was first announced. In addition, the Term Sheet allows each state to designate four additional subdivisions as Eligible Issuers, permits ‘States [to] request that the SPV purchase [additional] Eligible Notes in excess of the applicable limit in order to assist political subdivisions and instrumentalities that are not eligible for the Facility,’ and expressly provides for Multi-State Entities established by interstate compacting among any two or more States.

In addition to the breadth with which Eligible Notes and Eligible Issuers are defined, there are several further features suggesting that the MLF can become a critically important new part of state and municipal finance in coming months. One is the Fed’s having postponed the closing of the MLF window by months even before the Facility had gone operational – from the end of September, as planned in early April, to the end of the year, as announced at the end of April.

Another indicator appears in the Fed’s own interpretive announcements in the week’s after the MLF’s first announcement. Chairman Powell and the Board publicly encouraged a ‘flexible’ interpretation of the conditional language found in the Term Sheet. They also repeatedly stated that they would be monitoring the municipal debt (‘muni’) markets for signs of resumed volatility, with an eye to intervening yet further to stabilize them if and as necessary. Combined with the Term Sheet terms themselves as described above, and with the many Term Sheet openings for possible extension and exception that I’ll seize on below, these amount to suggestions that the MLF is a work in progress whose scope can in theory expand if and as the need for it expands.

It would be difficult to read the MLF Term Sheet and the sundry statements made by the Fed around it, then, without concluding that the Fed has been eyeing the federal non-response to our national pandemic and drawn at least a tentative policy conclusion. The conclusion is that our states and cities have, as I put it above, become in effect our new federal agencies, and might accordingly have to be funded as federal agencies. If this read is correct, than we can likely anticipate even more expansion in future – including extension of the Facility to Tribes and Territories as Congress prescribed in the CARES Act, and extending eligible maturities to five or more years as bond market analysts and the smart money in muni markets already anticipate and even call for.

But we should not just anticipate more if this read on Community QE is plausible, particularly now that (a) only one issuer – the fiscally desperate state of Illinois – has availed itself of the MLF thus far, and (b) Congress has effectively made clear, as of August 2020, that it will itself not be aiding our states or their subdivisions any further. We should also demand it. For Congress’s not renewing the CARES Act means cities and states soon will be bankrupt, muni and other financial markets will panic and freeze, tens of millions of additional public employees will join the nation’s already unprecedented unemployment rolls, and private sector firms will fail in cascading fashion as their home cities fail and all public services cease.

Here, then, is what must happen next, and why …

To begin with MLF as it is currently operating, it is now time for the Fed to dispense with the fiction that MLF is a ‘liquidity’ facility, in any immediate-term sense of that word, altogether. Even the terms of the Term Sheet as presently constituted give the lie to that notion, and effectively indicate that the Fed is now thinking of liquidity, at least where public finance is concerned, as far more medium-term than short-term. In effect, the current terms offer a manner of Draghiesque ‘what ever it takes’ promise.

Insofar as this is the case, the Fed must also now resume the successive term liberalizations it made from April to June, and do so in ways that include, at a minimum, three categories of change – what I’ll call ‘rate and rating requirements,’ which oddly require that MLF borrowers pay ‘penalty rates’ over ‘market rates,’ and have their bonds rated by rating agencies; ‘artificial thresholds and deadlines,’ which limit MLF eligibility and operations by reference to numerical population thresholds and calendar dates; and ‘improvidently centralized administration’ of the program in the New York and Boston Feds. MLF optimization will require progress on all three of these fronts, while MSL optimization will require progress on the third.

To start with the MLF Term Sheet’s language of ‘penalty rates,’ this stems from Walter Bagehot’s canonical articulation of what has since come to be known as central banks’ ‘lender of last resort’ (LOLR) function. The thought behind LOLR is that sometimes a financial institution will land itself in trouble through reckless practices or other mistakes of its own, while the public in turn will not have the luxury of letting it fail in light of the negative externalities that its failure would occasion. This is, of course, the ‘too big to fail’ (TBTF) problem.

‘Penalty rates’ are the familiar answer to this dilemma. One rescues the firm, but does so in manners that leave the firm wishing it hadn’t had to seek help. In this sense, the penalty rate functions as a kind of ‘deductible’ or ‘coinsurance’ that we charge for use of the liquidity risk ‘insurance’ that is the central bank’s LOLR function. It is a means of reducing the moral hazard that attends all insurance.

But this is also why it amounts to a category error to assess ‘penalty rates’ for use of the MLF. The MLF is not a Bagehot-style LOLR facility. Our Cities and States are not responsible for the Covid pandemic in the way reckless hedge funds might be responsible for their own liquidity crunches. Nor can anyone think that our States and their Subdivisions are responsible for the remarkably modest character of such federal executive responses to the Covid pandemic as we have seen thus far. From the States’ and their Subdivisions’ point of vantage, both the pandemic and the weak federal executive response to it are sheer force majeure – ‘Acts of God’ – not things that they could have foreseen or prevented. To assist them now only on condition that they pay penalty rates is thus simply gratuitous penalization. Functionally speaking such a rate isn’t a fee, it’s a ransom.

Like remarks hold of the MLF Term Sheet’s requirement that States and their Subdivisions pay ‘market rates’ of interest on MLF funding, as well as its requirement that City and State paper be well-rated by recognized rating agencies. For one thing, the fact that pandemic-wrought spikes in demand for municipal financing were raising market interest rates on munis to alarming new heights was part of what drew Fed attention in the first place. For another thing, ‘market rate’ would not even seem to bear any intelligible meaning when Fed intervention itself is the source of current rates.

The MLF Term Sheet’s requirement of good bond ratings is similarly out of place, and again for similar reasons. States and Subdivisions without prior ratings histories are both the ones that have not required muni financing in the past and the ones that are now most in need of off-market Fed help. Cities that seek ratings now, moreover, will get ratings reflecting the currently precarious municipal financing environment – precisely what the Fed is endeavoring through MLF to remove precarity from. The ratings requirement accordingly, like the ‘market’ and ‘penalty’ rate requirements that are its conceptual cousins, registers a category error.

Turning next to artificial thresholds and deadlines, current Eligible Note maturities and Eligible Issuers should be more liberally delimited than were their post-2008 predecessors – the profligate financial institutions that were the beneficiaries of MLF’s antecedents during our previous crisis. Since our States and their Subdivisions, unlike the distressed banks of 2008, are our de facto federal pandemic response agencies now, any public sector entity in the US now faced with Covid-sourced fiscal distress that federal agencies, States, or larger State Subdivisions are not fully covering should be eligible for MLF funding. That means not only Cities of a quarter-million inhabitants or more, Counties of a half-million inhabitants or more, and a few additional State-designated entities as currently permitted, but truly any public sector entity handling tasks that in the recent past would have been handled by federal agencies.

It also means US Territories and Tribes, as explicitly named in the CARES Act, which if anything are more pressed for funding even than States and their Subdivisions. It is surprising that these public instrumentalities still remain ineligible for MLF funding. Similarly, Eligible Note maturities should be extended beyond the current 36 months, and the window for MLF funding should remain open past the end of this year. For again, federal agencies are not constrained by such deadlines, and our subnational units of public sector action are now, for all practical intents and purposes, our national instrumentalities of pandemic response.

The Fed need not worry, moreover, about inefficient duplications of funding in acting as here advised. For the criterion that I’ve just proposed – again, any public sector entity now faced with Covid-sourced fiscal distress that federal agencies, States, or larger State Subdivisions are not fully covering – suffices to delimit eligibility to no more than what is necessary.

Turning finally to centralized administration, the Covid pandemic is highlighting not only the rot that has been underway in our federal administration, but also the lingering differences between our many local and regional communities and economies that either remain or have been re-implicated by the crisis. New York City’s Covid has been very different from Bismarck, North Dakota’s Covid. And both of those Covids have been very different from Atlanta’s and Ithaca’s Covids. And the same is true of the many thousands of small businesses struggling to stay financially afloat in those locales.

These differences are not, of course, differences in the genetic structure of coronavirus as manifest in different locations. They are differences in impact, rooted in differences among local practices, local cultures, population densities, primary industries, and other determinants of what boil down to differing local communities, local economies, and consequent local needs. In this sense, the national economy isn’t unlike what it was in 1913 – subject to significant regional variation along newly salient dimensions. The federated structure of our Federal Reserve ‘System’ was designed precisely to allow for differing responses, even by a central bank, to such differing conditions.

What would it be, then, to restore in part that once significant latitude of variation among Regional Fed Banks? I think that it means at least two things, one of which I am working to make happen now, and the other of which I believe we must push to make happen next.

The first thing I have in mind is quite humble, which is the sole reason I’m able to do anything about it from my end. It is for all Regional Feds to initiate ongoing ‘town hall’ sessions in all cities in their regions – at the very least all cities in which the Fed maintains branch offices. These could of course be in ‘Zoom Rooms’ where necessary for the time being – a modality that not only comports with social distancing, but also enables participation even by people located in cities where the Fed lacks branch offices. In future, moreover, the Fed should hold these in literally all cities now eligible for MLF and MSL funding – and open additional branch offices accordingly.

The purpose of these meetings will be two-fold. First, they will facilitate two-way information flows between the Fed on the one hand and our cities and small businesses on the other hand where MLF and MSL funding are concerned. And second, they will ‘break the ice’ and set the stage for more fulsome, regular, and permanent Fed/local/small-business communication. In this way they’ll make the Fed much more useful an institution to our people, their enterprises, and their states and towns than it currently is. It will begin the long march toward fully becoming what I have elsewhere called ‘A People’s Fed.’

As I say, I am working to set this particular process in motion right now. That process is eased somewhat by much past work with cities after the last crash in connection with my eminent domain plan for underwater mortgage loans on the one hand, and my previous employment by the New York Fed, along with sundry consulting jobs for the Fed and Treasury, on the other hand. But as I also say, this is quite humble work, and will be but a humble achievement once it’s achieved. Something more difficult must also be done.

The more difficult thing that needs doing is to end the practice of housing all new liquidity facilities in the New York Fed or, in the case of MSL, the Boston Fed, and instead housing them in all of the regional Feds. Community and Small Business QE as operative in Atlanta, for example should be administered by the Atlanta Fed. In Detroit it should be the Detroit branch office of the Chicago Fed, in Hawaii a (newly established) branch office of the San Francisco Fed, and so on. The reasons should be obvious. Fed folk on site will have a much better understanding of needs and of ways to help. They will also be more approachable, and reachable by locally affected parties. This is precisely why we opted for a federated Fed in the first place, and whatever regional differences prompting that which have receded since then are more than replaced by differential needs now in the midst of our crisis.

Again, these observations hold as much of the Main Street Lending facilities as they do of the Municipal Liquidity Facility. And they do of pretty much any Fed facility meant to assist parties for whom regional differences translate into needs differences. Indeed we can go one further: The Regional Feds should have branch offices in all cities that qualify for Fed assistance – not only for present needs, but for future needs too. In time, we might even imagine a proliferation of public banks, patterned more or less after the highly successful Bank of North Dakota model, spreading across multiple states. These banks could then both afford nonprofit banking services to all, and assist the Fed Regional Banks in identifying appropriate recipients of Fed liquidity assistance.

Think of what this will mean… It will mean a Fed restored to its original purpose, a Fed responsive to varying local conditions in a sprawling continental republic, a Fed no longer over-involved with banks whose principal if not sole activities are in gambling on price movements in secondary and tertiary markets rather than investing in the primary markets that constitute our ‘real’ economy. It will mean, in short, something approaching a true people’s bank, not just a banks’ bank. And this, were it to happen, would amount to at least one silver lining round that very dark cloud which is our federal government’s disintegration during the Trump years.

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