Can and should the Federal Reserve assume public debts to stimulate the economy?

September 14, 2010 8:37 AM

The US states are massively in debt, and public-sector layoffs are causing unemployment to stay high, even while the private sector recovers. The Federal Reserve can create dollars from nothing, and at the moment inflation is apparently a minor concern compared to deflation. What would happen if the Federal Reserve assumed much or all of the debt of the states? They could pay off the debts ex nihilo at a speed of their choosing, while allowing the states to create or save jobs. They could also simply grant money to those states that have relatively little debt. Does anything like this happen, and should it? [Not an economist]
posted by East Manitoba Regional Junior Kabaddi Champion '94 to Law & Government (22 answers total)

You want to take my NY tax dollars and bail out California, in effect rewarding them for poor past decisions? Meh. I say create a tax cut that will flow to every tax payer.

(My NY State is not much better than Cali.)
posted by JohnnyGunn at 8:44 AM on September 14, 2010

Johnny, the dollars would be created out of thin air, so your tax dollars are not involved. The money could be distributed to the states equally based on population, so a state with little debt would recieve cash whereas another would simply has its debt reduced. So it wouldn't be rewarding bad behavior.

Regarding tax cuts, I think the consensus is that they are not very stimulative in the short term.
posted by East Manitoba Regional Junior Kabaddi Champion '94 at 8:49 AM on September 14, 2010

Then I am not so sure I agree with the premise that the Fed can simply create money out of thin air without ramifications, but I am not an economist either.
posted by JohnnyGunn at 8:55 AM on September 14, 2010

Johnny, the dollars would be created out of thin air, so your tax dollars are not involved.

Created by printing money or created by the federal government borrowing money? If the former, then everyone effectively pays for it by having their assets and income devalued by inflation. If the latter, then everyone pays for it eventually in increased taxes or spending cuts.
posted by jedicus at 8:56 AM on September 14, 2010

I think the ramifications of creating money would normally be increased inflation. But at the moment people are more concerned about deflation.
posted by East Manitoba Regional Junior Kabaddi Champion '94 at 8:57 AM on September 14, 2010

You can't stave off inflation forever. From what I understand one of the reasons we are still worried about deflation is simply because there is not enough spending going on. Banks are still not loaning, companies are hoarding their cash and individual saving rates are unusually high. There's still a lot of uncertainty over the state of the economy which is not really inspiring people and companies to spend. So for the moment, the money supply has been increased but it doesn't help very much if all the extra money is just being stashed away and not going back into circulation because people and companies are still very wary about the economy; not to mention the affect that high unemployment has on individual spending rates. If the Federal Government essentially gives the guarantee that they will absolve states of all their debt by creating more money out of thin air to do so, presumably the states (and by extentiosn, consumers) will have the confidence to start spending again, but all of that extra money has to go somewhere. And there you have inflation. If there's tons of money floating around and more spenidng going on, there will be increased demand. And with increased demand comes price increases. The more money there is floating around the more quickly this will happen.

That's my simple explanation anyway. If I'm mistaken or missed anything I'm sure someone will fill in the gaps.
posted by triggerfinger at 9:01 AM on September 14, 2010

The states would continue to spend profligately with the knowledge the Fed would always bail them out.
posted by otto42 at 9:03 AM on September 14, 2010

No, the Feds ability to bail out entities, stops with large private corporations, be it
financial or automotive. This is good for the economy, because executives are able to get the bonuses they need to maintain their way of life. It is vital for the large private companies that no strings are attached to the bailout. It makes no sense for the government or individuals to root around in who the bailout is spent. This is important to ensure the principle of privatizing profits and socializing losses. It is not fair to expect vast corporations to have to suffer for the utter incompetence and short sightedness of their executives.

Now since a state is not a private entity, and that states often provide social services and welfare programs for their inhabitants it is clear that it would be negative for the economy if the Feds were to bail them out. So we really need all those people of welfare programs, on free medical care and so on? By cutting these services, the states become more economical, and should allow them to provide tax cuts that favors big business. In the end it is the individuals fault for relaying on welfare programs, if they had planned better, and gotten that education and paid for their health insurance they would not need welfare. Thus is is imperative for the economy that the individual is made to feel the errors of their ways, and show some responsibility to bail themselves out.
posted by digividal at 9:16 AM on September 14, 2010

QE has never been tried with an economy the size of the US economy, and it has never been done to the scale that they're proposing, so nobody really knows the answer to your question. QE will eventually spur inflation. It might do so dramatically if the banks decide to lend more all of a sudden. Right now American corporations are sitting on absolute ridiculous amounts of cash (all-time record), so if they decide to start spending at the same time that a big QE event happens (which they should since inflation would devalue much of their cash...), then who really knows? The Fed is gambling with a not well understood economic theory by simply creating more money.

Also, I think the states need to be taught a lesson to not F this up again. I also believe that more financial institutions should have been allowed to fail, otherwise you are rewarding bad behavior.
posted by kryptonik at 9:24 AM on September 14, 2010

Thanks for your answers. I think kryptonik makes an interesting point that this is relatively new ground and the natural tendency of the Fed will be not to take the risk, no matter how bad the current situation.

I'm less concerned with teaching the states a lesson, or setting a bad prescedent of assuming their debts. A bail-out of the states would have to be a very rare thing because it couldn't happen while the Fed is concerned about inflation, i.e. most of the time. So I don't think the states would be able to rely on it happening again in the future.
posted by East Manitoba Regional Junior Kabaddi Champion '94 at 9:30 AM on September 14, 2010

By the way, a bailout of the states has happened before. In the 1790s Alexander Hamilton had the treasury assume state debts, creating the national debt. It was considered a major centralizing move, as this would be. Once this occured, why bother having states manage their own budgets at all?
posted by oddovid at 9:42 AM on September 14, 2010

"I'm less concerned with teaching the states a lesson, or setting a bad prescedent of assuming their debts. A bail-out of the states would have to be a very rare thing because it couldn't happen while the Fed is concerned about inflation, i.e. most of the time. So I don't think the states would be able to rely on it happening again in the future."

Do you realize how misguided this is? "It would have to be a rare thing" when it comes to money and politics doesn't exist. Once you wipe the debt out, states would continue to spend profligately, because they can, and it's what states do. It'd be like whiping out a gambler's debts and telling him you won't do it again...so? You haven't changed anything, you've just handed them a big check. In THIS case, it would be even more disastrous. This would spur gigantic amounts of inflation, which means that while you may have paid back debtholders, now EVERYTHING is worth far less. Then you'd start getting weird contradictory forces due to such a disruptive policy. Assuming inflation rises, nominal rates will rise, so that means that money SHOULD cost more...but given that the fed is doing all of this trickiness with the money supply, they'll probably keep the rates low, and that will create a huge surplus of people who want to borrow at artificially low rates, especially states that know they will get bailed out.

I'm not saying that some QE is necessarily a bad thing (we do not know), or that monetary policy isn't important. But if you want to know what happens when you start printing a ton of money, read this
http://en.wikipedia.org/wiki/Hyperinflation

I mean, why stop at state debt? Why not just print money to pay off all public debts, state and federal, so that governments can spend on their people instead of paying interest? It's because people had certain (reasonable) assumptions when they invested and traded these things, and you would be absolutely destroying an important input into basically everything (inflation).
posted by wooh at 9:43 AM on September 14, 2010

I think your question is slightly flawed in its assumptions--unlike the federal government, states cannot generally go into debt; they have to balance their budget every year. That's why states are doing massive layoffs and service cutbacks right now, but federal employees aren't worried about their jobs--the federal government can keep paying its bills even if tax revenue doesn't cover payroll or program costs, but states have to either raise taxes or cut spending every time an economic slowdown happens.

So, what you really should be asking is "why doesn't the federal government take over some state spending and pay for it through monetary expansion [printing money] or adding to the national debt?" The answer is: well, it is doing that to some extent, actually. Over the past 20 years, states have slowly seen the proportion of their budget consumed by Medicaid go up and up and up. (Unlike much state spending, Medicaid isn't very amenable to cutbacks for a whole host of reasons.) Note that a big, big chunk of the stimulus--somewhere around $90 billion of it--was the federal government taking over a larger-than-normal share of Medicaid funding for two years, which was a huge factor in narrowing or closing state budget gaps and letting states lessen or avert layoffs. About a month ago, another bill was passed extending that Medicaid assistance to states for another 6 months, at a cost of about $16 billion.

One could argue that it's not enough (and I would--I think the entire Medicaid program should be federalized already, along with spending on primary and secondary education, which is the other big state budget-buster), but it's definitely been happening, and the layoffs would have been much, much worse had it not happened.
posted by iminurmefi at 9:47 AM on September 14, 2010

Just to clarify a bit what I wrote above--obviously, states can take on debt through bonds or other instruments (which is why you might see some news article about this state or that state being at-risk for defaulting on debt), but this is generally limited to funding capital projects (for instance, building a new airport or highway or what-have-you). A state can also be in what I'd call "projected" debt, in that it looks like it has more pension obligations than it can probably pay for in the near-ish future.

However, every state except Vermont cannot legally go into debt to pay operating costs--that is, payroll + program costs cannot exceed tax receipts in any given year. (See here for an overview.) The reason the Fed can't or won't take over state debt is that there really isn't anything to take over. All the federal government can do is take over state spending.
posted by iminurmefi at 9:56 AM on September 14, 2010

States *could* go into debt, but many have asinine laws and/or constitutions that prevent them from doing so. That's a major part of the problem. Net government spending has been undercut by the fifty Herbert Hoovers.
posted by idb at 9:57 AM on September 14, 2010

An interesting question and there are a lot of different ways to go about answering it.

From the standpoint of economic philosophy, the people who make decisions at the Fed are unlikely to give the money to a government entity. Their philosophy would be that the private sector can make use of the money more efficiently.

The question of the consequences on inflation is more complex. It is my understanding that most money is created by debt. A bank makes a loan and then uses the loan note as collateral to borrow more money. Because they are only required to hold a fractional amount of what they lend in reserve, they act as a multiplier. The amount of money being lent is an important component in the amount of money in the system.

Because of the way that inflation is measured, an increase in the amount of money in the system won't necessarily show up in inflation. Inflation only measures the prices of certain goods and services. If there is a bubble in investments or other things that aren't measured in the inflation numbers, then there can be an increase in the money supply without any inflation. It would be my contention that this is what is happening now, and has been happening for about two decades. Because less money is being invested in actual physical production of goods or services in most Western economies and more money is being invested in financial instruments, there can be a greater increase in the money supply before any corresponding inflation.

Money that is sent to state and local governments is much more likely to show up as inflation because almost all of it is spent on goods and services. The largest exception would be money that is spent to pay off debt.
posted by jefeweiss at 10:05 AM on September 14, 2010

I was under the impression that Hoover actually jacked up government spending (as well as taxes on the rich) with such programs as the RFC - policies for which Roosevelt criticized him until Roosevelt got into office.
posted by IndigoJones at 10:36 AM on September 14, 2010

wooh, I think everyone agrees that severe inflation needs to be avoided. But everyone also seems to agree that increased spending is necessary to reduce unemployment and avoid a deflationary spiral. The only place where people differ is how much spending is ideal, and how it should be achieved. Perhaps no-one can reliably estimate how much spending is "too much", and it's best to let the market take its course. But it's not immediately obvious to me that bailing out the states alongside the corporations would lead to catastrophic inflation.

iminurmefi, thank you for clarifying the nature of the state budgets problem. I hadn't considered the requirement to have a balanced budget (or a temporarily balanced budget) that many states have.

This map and this NY Times story show that nevertheless, many states have significant debts in conjunction with much larger unfunded pension obligations.

I guess my next question would be, in a situation where Congress is unwilling to further fund the states or assume some of their debts or unfunded obligations, is there any possibility of the Federal Reserve doing so using monetary expansion, under their mandate to reduce unemployment? (I'm guessing not.)
posted by East Manitoba Regional Junior Kabaddi Champion '94 at 11:09 AM on September 14, 2010

I guess my next question would be, in a situation where Congress is unwilling to further fund the states or assume some of their debts or unfunded obligations, is there any possibility of the Federal Reserve doing so using monetary expansion, under their mandate to reduce unemployment?

Here's where I think this breaks down: what relationship does state debt (as you note, mostly in the form of underfunded pensions that will have to be paid in the future) have with layoffs / unemployment? Debts and deficits are related, but eliminating debt won't have any effect on deficits unless the cost of servicing the debt (or paying pension benefits) in the current year is a significant part of the deficit. That's just not the situation we're in: states aren't facing deficits because their debt repayments or pension benefits have gotten too large; they're facing deficits because taxable income has fallen. It's the difference between being broke because you've lost your job, and being broke because you took out a huge mortgage you can't service anymore. In one case, a fairy godmother (the Fed) coming in and taking over your debt payments will fix the problem, and in the other it's not going to make any difference, because that's not the root of the problem.

So I don't think the Fed could come up with any rationale related to unemployment that would allow them to do this.
posted by iminurmefi at 12:07 PM on September 14, 2010

iminurmefi, that makes it much clearer, thank you. Though it leaves open the possibility of just handing money to the states. That would certainly reduce unemployment in the short term, at the risk of future inflation.
posted by East Manitoba Regional Junior Kabaddi Champion '94 at 12:21 PM on September 14, 2010

jefeweiss, that is a good point about the philosophies of the Fed pointing them toward lending to the private sector rather than state governments. However, as kryptonik pointed out, corporations are mostly sitting on their money right now because they're understandably unsure of the market. So maybe it would make sense to try to make the federal government give cheap, perhaps zero-interest loans to the states, so spur spending and domestic consumption. After all, no state legislator or governor would hesitate (I think) to use money from the federal government to create jobs and spending at home.

Basically, instead of lending money to corporations, who can decide not to spend it, the Fed should be giving money to the states, who will spend like drunken sailors to create middle- and lower-class jobs on infrastructure projects and the like.
posted by Aizkolari at 1:05 PM on September 14, 2010

I certainly agree that giving money to the states would be a much more effective way to stimulate the economy than trying to force lending by pushing on the interest rate rope. Among the big problems with the current strategy is that most of the cheap money is being funneled into questionable financial transactions. This really highlights the problem with monetary stimulus. You can increase the money supply, but you can't make anyone spend that money on what you want them to spend it on.

Aikzolari's comment above kind of highlights the confusion between what the Federal Government is and what the Federal Reserve is. The government can't spend or lend money without getting the approval of Congress. This is why we can't get more fiscal stimulus, which in my opinion would be more helpful to the parts of the economy that effect most people. Fiscal stimulus is the government spending more money, and it's pretty unpopular among politicians at this time. The Fed works by trying to control the supply of money.

The Federal Reserve is not part of the government, the government can't tell it what to do. It's a private corporation, the members of it's board of governors are appointed by the President. Once they are appointed, they act independently of the government. They work by setting monetary policy. The reason that people are looking for them to do something about the economy is that they can do things without anyone who is running for re-election having to vote to have them done.

The problem with expecting them do anything is that: 1) most of the things they can do (they do have limitations on the types of things that they can do) don't have any direct effect on the economy that most of us experience 2) philosophically they don't really care too much if some people are unemployed.

Most of the things that they can do would benefit people and corporations who already have money to a much greater extent than people that don't have any money. I think that the actions they took to end the dotcom bust contributed a great deal to where we find ourselves today. Most of the people who are appointed to the Fed think that low wages are good, and unemployment is a good way to achieve lower wages. This is just the invisible hand making our economy more efficient.
posted by jefeweiss at 6:38 AM on September 15, 2010