The Federal Reserve’s response to the COVID-19 pandemic has been deeply troubling. Currently totaling $2.3 trillion, the Fed’s interventions include direct lending to large corporations, as well as small- to medium-sized businesses. It is an unprecedented expansion in the kinds of assets the Fed puts on its balance sheet. The central bank is directly allocating resources, which is beyond the rightful limits of monetary policy.
The Fed’s recent actions represent an unnecessary growth of power that significantly expands its presence in credit markets. These actions also increase the risk that the Fed will lose its political independence. Since the Fed is engaging in de facto fiscal policy, Congress could try to strong-arm it into pursuing political goals that cannot be achieved through the budgeting process.
Of particular concern, the Fed’s expanded scope apparently includes propping up borrowing by state and municipal governments. Through its Municipal Liquidity Facility (MLF), state and local governments can borrow from the Fed, which has committed to buying up to $500 billion in investment-grade notes. The Treasury will backstop the MLF for up to $35 billion in losses. The Fed is also supporting municipal debt (munis) through secondary channels. It has expanded the eligible collateral for loans through the Money Market Mutual Fund Liquidity Facility (MMLF) to include munis, and the collateral acceptable through the Commercial Paper Funding Facility (CPFF) to include commercial paper backed by munis.
These measures are concerning because they undermine federalism. In a federal system such as ours, decision-making authority is not solely vested in the national government. Instead, state and local governments have significant spheres of autonomy, including decisions about financing and providing public outputs. However, federalism only works if the “higher” levels of government do not attempt to impinge on the decision-making process of the “lower” governments. The Fed’s interventions into state and local debt markets threatens the efficacy and independence of these lower, more local governments.
Here’s a prudent rule for behavior suggested by fiscal federalism: the jurisdiction that gets the benefits of public output should bear the costs of producing it. For example, policing and emergency response services are public outputs that are not pure private goods. Insofar as they create benefits that accrue to the public at large, collective action through politics may help us provide for these goods better than private action through markets alone. But if a given town benefits from these services, then the town’s residences should pay for it.
A city government can tax citizens directly to finance police and emergency response services. In doing so, it is more likely to behave prudently. Taxing the beneficiaries preserves the link between cost and choice. Citizens can evaluate the worth of the police and emergency response services and decide whether continuing the services is worth the cost.
If, instead, citizens can compel others to bear the cost, then they may demand the output even when it is not worthwhile. Why not, if someone else is helping to pick up the tab?
Apart from electoral competition (city council and state legislature elections), efficiency in the provision of local public outputs is driven by two kinds of competition. The first kind is known as Tiebout competition, named after the economist who first discussed it. The idea is that different localities can pick different mixes of tax schedules and public output offerings, and citizens can choose which jurisdiction to live in, based on their preferences. People who want lots of public output and are willing to pay higher taxes can live in California or New York; those who want less public output in exchange for lower taxes can live in Texas or North Dakota.
The second is called pseudo-Tiebout competition, and is frequently referred to as “voting with your feet.” This is about the discovery process concerning the right mix of taxes and outputs, as well as the feedback mechanism that makes this knowledge known. To make a complicated story as simple as possible, localities that are inefficient—that is, where taxes are too high to justify the quantity and quality of public services provided—will slowly lose citizens to more efficient localities, as people leave the former to live in the latter. This will eventually mean falling tax revenue for the inefficient locality, which will have to adjust its behavior to stop emigration.
Of course, these processes only work if the local and state governments have real budget constraints. When budget constraints bind, there is a tight link between cost and choice. If a governing body can secure a source of funding from resources outside its jurisdiction, however, it loses the incentive to budget prudently. And, more broadly, the information regarding efficiency in public services provision becomes scrambled.
Unfortunately, Washington has been undermining fiscal federalism for years. It grants nearly $700 billion per year in aid to states and local governments for “education, highways, housing, transit, and other activities.” This might seem like a good deal. But it enables states and municipal governments to grant their citizens benefits that are paid for by third party non-beneficiaries. It is a recipe for expensive, low quality public output, which is often what we observe.
The Fed’s backstopping of state and local borrowing should alarm us for precisely the same reason. Remember, the Fed has a monopoly on the creation of base money, the economy’s most liquid asset. When the Fed provides cheap funding to state and local governments and supports their borrowing on secondary markets, it reduces the incentive for state and local governments to budget wisely for public outputs.
From the perspective of a local government, it doesn’t matter whether the money is coming from the Treasury or Fed. It’s “money for nothin’”—or close to it. And it doesn’t matter that state and local governments still have to pay interest on the loans, either. If they weren’t getting a better-than-prime-market deal from the Fed, they would be borrowing from someone else.
When the Fed or Treasury provides cheap credit to state and local governments, it reduces the independence of state and local governments from federal authorities. What happens when lower-level governments come to depend on that funding? As they say, “he who pays the piper, calls the tune,” Politicians in Washington will have much more say in how state and local governments are run. Instead of genuine centers of independent decision-making, lower-level governments become mere administrative bureaucracies for higher-level governments.
Federalism is not a mere political quirk. It is an essential feature of the American constitutional system. Without federalism, a significant source of countervailing authority to Washington loses its force. Everyone who values effective and responsive government should be worried at how the Fed’s new activities threaten federalism. We should do everything we can to make sure City Hall and the state capital are more responsive to the voices of ordinary citizens in their jurisdictions than the whims of central bankers.