Today, amidst other contagious diseases, the Federal Reserve announced the creation of a new lending facility for state and local governments. The Federal Reserve, our central bank, serves as a “lender of last resort” – but normally, to banks and other depository institutions, not state and local governments.
For the new facility announced today, the “Municipal Liquidity Facility,” the Fed asserted the program was legally grounded in the emergency lending provisions of the Federal Reserve Act (Section 13(3)). These provisions were last used by the Fed for extraordinary lending to entities the Fed deemed “too big to fail” in the financial crisis of 2007-2009.
The new municipal facility announced today enables cities with populations over 1 million, counties with populations greater than 2 million, and all 50 states to develop “eligible issuers” through which Federal Reserve lending may be obtained. On these terms, based on the latest available Census data, there are 10 “too big to fail” cities – New York City, Los Angeles, Chicago, Houston, Phoenix, Philadelphia, San Antonio, San Diego, Dallas, and San Jose.
In the banking world, critics of policies supporting “too big to fail” institutions cite incentives arising from moral hazard problems. Institutions aware that extraordinary support from general sources can be available in hard times may not work as hard to manage themselves responsibly in the good times. They may also be prone to undertaking higher risk. This can actually be rational behavior, in the sense that rational means “self-interested,” if potential losses are socialized outside the organizations.
But the policies undertaken to feed the largest beasts may be less than fair, if they make responsible parties assume the cost of riskier and/or less responsible enterprises. And while the powers that be often stress they are trying to maintain financial stability, the regular exercise of bailouts arguably undermines financial stability – and the sustainability of government finances – in the long run.
How about those 10 “too big to fail” cities? How responsibly did they manage their financial affairs in the decade since the bailouts from the 2007-2009 financial crisis? What financial condition were they in before the latest crisis hit?
Looking across the 75 largest cities in the United States, the tendency is – the larger the city, the worse the financial condition, as indicated by Truth in Accounting’s latest “Taxpayer Burden” measure of the cities’ net financial position. Size is significantly (and negatively) correlated with financial health. At $17,000, the average “Taxpayer Burden” for those 10 cities is roughly three times the average for the other 65 cities.
In the “last resort,” central bankers should lend, at least in theory, to illiquid but solvent (positive capital) institutions. Note that Truth in Accounting’s “Taxpayer Burden” is a measure of net financial position, and it was negative (a “burden”) for all 10 of those too-big-to-fail cities.
How did these 10 cities do, financially, in the decade before the current crisis? These were good years, economically. Looking at the 65 cities who didn’t make the cut for the Fed’s new facility, they managed to truly balance their budget, in the sense that they kept accrual expenses below accrual revenue, nearly 90 percent of the time in the four latest fiscal years. But for those 10 cities, they abided by “balanced budget” principles only about half the time.
Those 10 cities also tend to be in larger states, where similar tendencies appear. State governments in larger states tend to be in worse financial condition than those in smaller states, and truly “balance the budget” less frequently.
The new Fed facilities will no doubt support state and local governments in a time of need. But the need for this extraordinary new central bank behavior may have been driven by expectations it would arrive as needed, undermining financial discipline and potentially socializing losses and directing resources through less-than transparent avenues outside of more politically-accountable fiscal policy arenas.
Looking ahead, the pricing and implementation of these new lending facilities deserve scrutiny.