H.R. 1452, which was introduced by Representative LaHood on April
15, 1999, is designed to provide interest-free loans to state and local
governments to fund capital projects (such as school facilities, streets,
bridges, water and sewer systems, public buildings and facilities, and other
listed projects) and for cleanup of toxic waste sites or other environmental
improvements. The Federal Reserve, for reasons that will be discussed below,
opposed certain features of this bill. For this, and perhaps for other
reasons, the bill was not passed. However, there now seems to be growing
support for a new bill that would retain most of the features of H.R. 1452. In
our view, this is a particularly appropriate time to renew discussion of the
need for greater public infrastructure investment.
BACKGROUND
Under H.R. 1452, a Loan Agreement would be established between the Treasury
and the Board of Governors of the Federal Reserve System (BOG) such that the
BOG would lend a maximum of $72 billion to the Treasury each year for a total
of five years (hence, up to $360 billion). The bill, introduced as The State
and Local Government Economic Empowerment Act, found that Congress has the
constitutional authority to create government credit funds in the form of
non-interest bearing credit to fund a legislatively approved program. Further,
it found that this method of finance would allow projects to be built for
one-half to one-third the normal cost, hence, allowing a greater number of
necessary projects to be built. The funds created pursuant to this Act would
be distributed according to a formula that takes into account the 1990 census
population as well as the type of jurisdiction (state, county, incorporated
municipality, township, school district, or Indian tribe). The novel features
of this Act include the following:
- The BOG would be required to lend funds to the Treasury at zero interest,
while the Treasury would in turn lend these funds to state and local
governments without charging interest;
- Any United States Government checks issued under the terms of
this Act would not be counted as Treasury expenditures for the purposes of the
Balanced Budget And Emergency Deficit Control Act of 1985, the Budget
Enforcement Act of 1990, or any other provisions of law; and
- c) Any principal payments received by the Administrator as
governments begin to retire their debts created pursuant to this Act will
similarly be excluded from calculation of United States Government revenue for
the purposes of the above-named budget acts.
We will not consider the arguments in favor of increased provision of public
infrastructure, as these arguments have been examined in detail in a number of
publications issued by the Jerome Levy Economics Institute over the past few
years (Aschauer 1993, 1997a, 1997b; Erenburg 1994; Regan 1994; and Levy and
Cadette 1998). Instead, we will focus on the stated concerns of the BOG.
OBJECTION RAISED BY THE BOG
The BOG, arguing that there is no such thing as a "free lunch," has objected
that the program masks the true economic costs that will be incurred.
It is our position that if H.R. 1452 manages to put unemployed resources to
work to provide valuable public infrastructure and environmental clean-up, it
will indeed have provided the nation with a real "free lunch"
regardless of the way the accounting is kept on the books of the Treasury and
Fed. The objections raised by the BOG, however, seem to stem from the notion
that there is no financial "free lunch" since the Fed will earn less
interest income than it would have earned by holding interest-bearing
obligations rather that interest free loans. Thus, as the BOG has correctly
pointed out, the Fed would likely turn over a smaller volume of net earnings
to the Treasury (the Fed transfers net earnings in excess of a return of 6% on
equity to the Treasury).
We can obtain an estimate of the maximum loss entailed by applying a weighted
average of about 5.5% – what the Treasury is paying on its outstanding
securities – to the maximum quantity of loans permitted by the legislation –
$72 billion per year for five years. Thus, if the Fed had to offset all
spending created by H.R. 1452 through sales of its interest-earning
securities, thereby forgoing the interest it would have earned on these
securities, its earnings could be reduced by an annual total of about $20
billion by the fifth year. The "financial" lunch is thus not free. But for an
annual expenditure of $20 billion, Congress would increase state and local
government spending on capital by $360 billion.1
It might be suggested that an alternative financing method (i.e. one that does
not result in a $20 billion loss of interest income) might be preferable.
However, as we demonstrate below, these losses are not contingent on the
method chosen to finance the program. Below, we examine three alternative
funding scenarios, demonstrating that regardless of the method chosen, the
costs would be exactly the same (i.e. $20 billion) as under the method
proposed under H.R. 1452.
i.) Direct "money creation" by the Treasury
Suppose the Treasury simply created a new legal tender note that it lent at
zero interest to qualifying state and local governments. As these notes were
spent to finance capital construction, they would flow into bank deposit
accounts–just as Federal Reserve Notes and United States Government checks are
deposited into such accounts. The receiving banks have their reserves at the
Fed credited by the same amount (ignoring the small amount that might be held
as vault cash). As the money and banking textbooks teach, if the banks had
previously been in "equilibrium," holding the quantity of reserves desired
(mostly, this is determined by legal reserve ratios), they will now hold
undesired excess reserves. Banks with excess reserves will offer them in the
fed funds market. However, this can only shift the excess around (from bank to
bank); the system as a whole cannot rid itself of the excess. Thus, downward
pressure will be placed on the fed funds rate–the overnight lending rate
charged by banks for loans of excess reserves. Since this is the Fed’s primary
target rate, its decline triggers an automatic sale of Treasury securities by
the Fed. Hence, the Fed will end up with fewer Treasury securities held, lower
interest earnings, and less profit to turn over to the Treasury–just as the
BOG (correctly) claims it would under the scenario envisioned in H.R. 1452.
2
ii.) Use of Treasury "Overdrafts"
What if the Treasury simply issued checks, drawn on its accounts at the
Fed (which is the way the Treasury actually spends in the U.S.) Suppose
further, that the Treasury does this without having any "money" in its deposit
accounts. As it turns out, the results would be exactly the same as creating
new notes or borrowing interest-free from the Fed. Those who received the
Treasury’s checks would deposit them in their bank, causing these banks to
gain (excess) reserves at the Fed, which would trigger an open market sale by
the Fed. Again, the Fed would hold fewer Treasury securities, would earn less
interest, and would turn over fewer profits to the Treasury. The results are
exactly the same because the use of an "overdraft" essentially amounts to an
interest-free "loan" from the Fed.
iii.) Borrowing from the Private Sector
If the Treasury tried to finance H.R. 1452 loans by first selling
interest-earning Treasury securities, this would cause the banking
system to lose desired reserves. That is because security buyers will pay for
the securities by writing checks on their deposit accounts, which leads the
Fed to debit the reserve accounts of banks. This places immediate upward
pressure on the fed funds rate and triggers open market purchases by the Fed.
The Fed then holds more Treasury debt, earns more interest, and can turn over
more profits to the Treasury. These profits will more-or-less compensate for
the interest cost incurred by the Treasury to finance its H.R. 1452 spending.
This seems to be the financing method preferred by the BOG, and so far it
looks like the Treasury has avoided the $20 billion cost. But the story
doesn’t end here, for the Treasury only sold the securities in order to raise
the funds to be spent by state and local government borrowers. Once these
funds are spent, the banking system will find itself with undesired excess
reserves (as in the cases just examined), which will cause the fed funds rate
to decline. The Fed will automatically drain these funds through an open
market sale so that it can hit its fed funds rate target. This means it will
have fewer securities and fewer profits to turn over to the Treasury. Thus,
the net financial impact on the Treasury is actually no different from the
previous cases examined. The extra interest it pays out will not come back to
it from Fed payments of profits because when all is said and done, the Fed
will not hold any of the newly created Treasury debt.
In sum, it appears that it makes no difference whether the Treasury creates
and issues new notes, writes "overdraft" checks, or borrows at zero interest
from the Fed. In all three cases, the increased spending by state and local
governments (financed by Treasury lending at zero interest) would increase
bank reserves, force Fed open market sales, lower Fed earnings, and, hence,
lower payments made by the Fed to the Treasury. It is therefore difficult to
find any economic reason to favor one alternative over another.
CONCLUSIONS
Our analysis has shown that each of the following four alternative methods of
"financing" public infrastructure investment has the same impact on the
Treasury:
* BOG "loans" at zero interest to the Treasury (as in H.R. 1452);
* Creation of new Treasury "notes";
* Treasury "overdrafts" written on accounts at the Fed; or
* Treasury sales of interest-earning securities to the public.
Each of these is likely to result in a net financial cost to the Treasury of
about $20 billion annually. Only Congress can determine whether an expenditure
of this magnitude is justified in order to increase state and local government
capital spending by $360 billion. 
ENDNOTES
Note, however, that we have performed a
"static" analysis, ignoring any secondary effects that might be induced by
such spending. It is usually estimated that the government spending multiplier
for the U.S. is about two, indicating that $1 of government spending induces
another dollar of private spending. Hence, the $360 billion capital spending
by state and local governments might conceivably generate a total increase of
GDP equal to $720 billion. Federal tax revenues amount to something on the
order of 20% of GDP, thus, increasing GDP by $720 billion could generate an
additional $144 billion of Federal tax revenue. This easily offsets the losses
due to lower earnings by the Fed. Obviously, this is a very rough calculation;
it is inherently difficult to calculate secondary effects of budget changes,
and in any case, Washington budget policy does not usually include such
dynamic analysis.
This is actually not quite the end of the
story. Holding all else equal, if H.R. 1452 causes the Fed to sell $72 billion
of securities each year for five years, the Fed’s portfolio of securities
would be reduced by $360 billion. Thus, the required sales are too large to be
undertaken by the Fed alone, so the Treasury will be enlisted to drain some of
the excess reserves through its own sales. Because the Federal government is
currently running budget surpluses, and is expected to continue to do so, the
Treasury will not need to actually sell additional securities. All that will
be required is for the Treasury to reduce its retirement of outstanding debt
below what it would have otherwise retired. In order to completely avoid
impacts on the Fed’s holdings of securities, the Treasury could retire $360
billion fewer securities over the next five years. In this case, the Fed’s
earnings would not be affected so that it would not be forced to reduce its
payment of net earnings to the Treasury. However, these earnings are offset by
the higher interest payments the Treasury will make because it will not retire
as much debt. Thus, while impacts to the Fed’s balance sheet can be avoided by
reduced Treasury retirement of outstanding debt, this still results in a net
cost to the Treasury of $20 billion over the four years. Note, also, that this
result is obtained regardless of the method of "finance" for H.R. 1452 chosen.
Thus, we will ignore this in discussion of the other alternatives.
REFERENCES
Aschauer, David A. 1993. "Public Capital and Economic Growth." Public
Infrastructure Investment: A Bridge to Productivity Growth? Public Policy
Brief no. 4. Annandale-on-Hudson, N.Y.: The Jerome Levy Economics Institute.
------. 1997a. "Do States Optimize? Public Capital and Economic Growth."
Working Paper no. 189. The Jerome Levy Economics Institute,
Annandale-on-Hudson, N.Y.
------. 1997b. "Dynamic Output and Employment Effects of Public Capital."
Working Paper no. 191. The Jerome Levy Economics Institute,
Annandale-on-Hudson, N.Y.
Erenburg, Sharon J. 1994. Linking Public Capital to Economic Performance.
Public Policy Brief no. 14. Annandale-on-Hudson, N.Y.: The Jerome Levy
Economics Institute.
S. Jay Levy and Walter M. Cadette. Overcoming America’s Infrastructure
Deficit: A Fiscally Responsible Plan for Public Capital Investment, No. 40,
1999.
Regan, Edward V. 1994. Infrastructure Investment for Tomorrow. Public Policy
Brief no. 16. Annandale-on-Hudson, N.Y.: The Jerome Levy Economics Institute.
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