The Erosion of Fiscal Discipline: MLF Loans and the Future of Federal-State Financial relations
Recent analysis highlights concerns surrounding the municipal Liquidity Facility (MLF), a program established by the Federal reserve during the 2020 pandemic to support state and local governments. While the loans offered thru the MLF didn’t demonstrably weaken the immediate fiscal strength of states,experts argue they initiated concerning shifts in fiscal and monetary policy with perhaps long-lasting consequences.
A key concern,articulated by economist Joffe in 2020,is the risk of permanently federalizing local debt finance. This could undermine established fiscal rules, like balanced budget requirements, designed to maintain state and local fiscal discipline. The MLF also raised the possibility of crowding out traditional municipal bond market investors and fostering moral hazard, potentially allowing politically favored jurisdictions preferential access to subsidized credit.
These anxieties echo the arguments presented in economist George Selgin’s 2020 book, The Menace of fiscal QE, which warns that the Fed’s creation of emergency lending facilities effectively constitutes a backdoor fiscal policy, increasing the risk of politically motivated credit allocation. State policymakers, historically reliant on federal transfers – receiving, on average, 35 percent of their expenditures from these sources – are incentivized to utilize such avenues to maintain existing fiscal practices.
The MLF introduces a new dynamic to monetary policy, creating a rent-seeking group in the form of state and local governments actively seeking favorable loan terms from the federal Reserve. This is compounded by a tendency within the fed itself to embrace “mission creep,” with some officials already characterizing the MLF as a successful pandemic response.
The long-term implications of this behavior are potentially damaging. These loans risk eroding public trust in the Federal reserve’s independence and undermining its institutional legitimacy, ultimately threatening long-term price stability. Furthermore, they weaken state fiscal discipline by providing an additional means for policymakers to circumvent established fiscal rules.
Addressing the Risks: Proposed reforms
To mitigate these risks and restore sound fiscal and monetary policy, several institutional reforms are proposed:
- Constitutional Monetary Rule: The Federal Reserve should be bound by a constitutional monetary rule to prevent credit allocation driven by either Fed officials or fiscal policymakers.
- No Bailout Commitment: Federal policymakers should explicitly commit to refraining from bailing out financially distressed states.
- Strong Fiscal Rules: Both federal and state governments should adopt robust fiscal rules that constrain spending growth and prioritize budgetary items effectively.
- Legislative Oversight of Federal Funds: State agencies should be required to obtain legislative approval before accepting federal grants or funding.
- Reform of Off-Budget Enterprises: State governments must either fully integrate Off-Budget enterprises into the state budget, subjecting them to the same rules as other entities, or eliminate transfer payments and ensure their complete financial independence.
Implementing these reforms will undoubtedly face political and institutional hurdles. Though, failing to address these issues risks solidifying detrimental policy trends and further eroding fiscal obligation at both the state and federal levels.
