Wednesday, December 3, 2008

Dealing with Deflation and Ameliorating a Recession, Part I

A number of columns have been written recently about dealing with the threat of deflation, including this one by Nouriel Roubini in today's Financial Times, "How to avoid the horrors of deflation". In that column, Roubini writes approvingly of the Fed's programs to purchase commercial paper, mortgage-backed paper and similar programs to increase liquidity and drive down borrowing costs for businesses and consumers.

With the bond market willing to lend the U.S. government funds at such low rates (e.g., 10-year Treasury yields at ~2.7%), why not take maximum advantage of that to stabilize asset prices and support aggregate demand? One fear is that, eventually, this orgy of borrowing will lead to a surge in inflation and interest rates when economic growth recovers, but it would seem that one way to ameliorate this would be to focus on buying assets rather than increasing outright spending.

For example, with many states facing budget shortfalls, instead of just giving money to the states, why not have the federal government buy a special class of 10-year municipal bonds from the states? The rate could be set at 50bps or 100bps over the U.S. government's current borrowing costs, which would still be a huge discount over the states' current borrowing costs in the municipal bond market. According to Bloomberg, yields on 10-year general obligation municipal bonds currently average 4.2%, so if these special municipal bonds sold to the federal government had a coupon rate 50bps higher than current 10-year Treasury yields (2.7%), they would still yield a full 100bps less than current 10-year municipal bond yields1. The proceeds from these special municipal bonds sold to the federal government would enable the states to make payroll, fund already-scheduled local infrastructure projects, and -- if the federal government purchased a large enough order of these bonds (say, an amount equal to double each state's current budget shortfall) -- to call some of their callable municipal bonds, thus lowering their overall interest expenses and taking further pressure off state budgets.

According to the the Center on Budget and Policy Priorities, estimated shortfalls in state budgets for fiscal '09 total about $80 billion, so it would cost the federal government about $160 billion to buy an amount of special municipal bonds equal to double the states' estimated '09 budget shortfalls. Since these bonds would represent assets for the U.S. government, and the U.S. government would recoup its investment (with interest) in ten years, that ought to temper concerns about this expenditure's long-term impact on inflation and interest rates and assuage the Treasury market.

1The coupon rates on the municipal bonds are of course what the states are actually paying in interest costs, but I'm using Bloomberg's yields as a proxy, for simplicity's sake.

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