a public option for public finance

image: crop from a National Investment Authority whitepaper.

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May 31, 2023

Most public investment is privately financed: a government raises money from investors today on the bond market to spend on services, and returns the cash at a later date, plus interest. Unsurprisingly, private investors are more likely to lend their cash on better terms to governments they believe are more likely to return more cash. The tragic consequence of this public dependence on profit-seeking private credit, as Destin Jenkins documents in Bonds of Inequality, is that these investors will forcibly constrain governments from less profitable longer-term investments in nonwhite communities, in free public services, and in social welfare. This is not to say that these investments are impossible—rather, that their speed and scale will remain constrained by privately held judgments of their risks and returns.

In short, public investment is privately financed and privately disciplined. Breaking this dynamic requires public intervention. The Federal Reserve’s COVID-era Municipal Liquidity Facility, for example, promised to buy American municipal debt when private investors looked ready to exit the market entirely, stabilizing the market and preventing private investors from disciplining cities into bankruptcy. Thanks to the Fed’s liquidity support, city governments could keep their local economies running even if the pandemic prevented doing so from being profitable in the short-term. Quantitative easing, the Fed’s liquidity support for US Government debt, worked similarly on a much larger scale.

At the time, progressives suggested that the Municipal Liquidity Facility usefully re-politicized the distribution of credit across the American economy. Why should public market-makers like the Fed, they argued, stop at temporary market stabilization when they have the opportunity to permanently backstop public spending on social services? The massive scale of America’s pandemic-response stabilization programs gave rise to a litany of proposals that took this question seriously. Two stand out for their ambition.

Of course, the first is Saule Omarova and Robert Hockett’s proposal for a National Investment Authority (NIA). The NIA charters a National Infrastructure Bank that issues loans and guarantees to socially critical public infrastructure projects to ensure that they receive cheap and long-term credit where the private sector may otherwise fail to provide it. The Bank would raise the money to do so by issuing bonds to private investors, backed by its pooled infrastructure loans. Crucially, these bonds must be treated as an asset that the Federal Reserve is willing to purchase in its open market operations, comparable to US Treasury bonds and other kinds of state-backed debt, to ensure that institutional investors treat them as safe and liquid assets. 

The second is Yakov Feygin and Pooja Reddy’s slightly smaller-scale but no less transformative proposal for a sort of Freddie Mac for muni bonds. Their institution would purchase muni bonds, securitize them, and issue debt backed by these muni securities to private investors, incentivizing greater municipal spending while lowering the cost of municipal debt. These securities must also be treated as “high quality liquid assets” eligible for Federal Reserve purchases, as Freddie Mac bonds already are. This proposal, like the NIA, provides a liquidity backstop for public investment that the private sector will not. [1]

Both these proposals technically leave public investment privately financed. Crucially, however, a government guarantee prevents private investors from disciplining debt-financed public investment. This strategy more than defangs private investors. A federal backstop that translates public expenditures into high-quality liquid debt instruments actually serves to bribe the private sector into surrendering their control over the speed and scale of investment. It enlists them into supporting publicly guided industrial policy.

This insight comes from Zoltan Poszar’s older work on the rise of shadow banking. In the aftermath of the Great Recession, some analysts saw the rise of market-destabilizing shadow banks as a consequence of regulatory arbitrage and a search for high returns, which assets like mortgage-backed securities could provide. Poszar countered that the meteoric rise of institutional investors and shadow banks more generally―the likes of asset managers, pension funds, hedge funds, private equity funds, and other nonbank financial corporations―was instead a function of financial institutions’ search for assets as close as possible to cash.

These investors wanted cash-like assets so badly in the first place not for transactions, Poszar argues, but for “liquidity and collateral management as well as investing purposes, which aren’t best met by deposits, but by Treasury bills and repos.” The only problem was that institutional investor “demand for insured deposit alternatives exceeded the outstanding amount of short-term government guaranteed instruments not held by foreign official investors by a cumulative of at least $1.5 trillion; the “shadow” banking system rose to fill this gap.”

Put simply, Poszar is arguing that institutional investors’ demand for government-guaranteed safe assets like insured bank deposits and short-term Treasury bills exceeded their supply: FDIC insurance on bank deposits is capped and short-term government debt is finite. Hence the rush to turn mortgages into cash-like securities for liquidity-seeking institutional investors.

Shadow banks transformed less liquid assets into liquid, cash-like assets by stripping risks from those assets and offloading them to risk-seeking counterparties through derivatives and swaps. 2008 was the disaster it was thanks in large part to the risky derivatives these shadow banks spread through the global financial system.

Poszar’s solution: the US Government should issue more debt―essentially fronting the cash-like assets that institutional investors are hunting for. It’s not a stretch to argue that debt-financed government spending could have mitigated the 2008 financial crisis. Investors that can access high-quality government debt markets don’t need to create cash-like assets themselves through the opaque, systemically risky derivative markets that characterize shadow banking.

In the context of today’s crises, then, turning government spending on climate adaptation, public housing, and other social goods into high-quality debt assets serves a crucial financial stability objective: in a crisis, private investors will not discipline public investment. 

Neither the NIA proposal nor Feygin and Reddy’s plan explicitly feature this line of argument, although they hint at it. Integrating Poszar’s arguments into theirs reveals that their proposals succeed not just because they unlock cheap financing for public goods, but because they also nip in the bud the financialization of social services. Bribing investors with high-quality debt draws them away from milking rents from or building opaque, fragile derivatives markets out of necessary public investments―and it insulates public spending from financial crises that would otherwise tie the speed and scale of critical projects to boom-bust financial market cycles.

Perhaps it’s disappointing that these proposals allow private investors to continue expanding their balance sheets and lending activities. It sure would be nice to eliminate public dependence on capricious private finance altogether. But a key lesson of Jenkins’ Bonds of Inequality is that investors depend on public spending as much as governments rely on private finance. Enlisting investors into a massive, rapid public investment program would weaponize this dependence in favor of the public sector, and Poszar’s work implies that doing so could help stabilize our crisis-prone financial system, too.

[1] Nathan Tankus and I discussed the issues with fragmented government debt markets and the efficacy of a backstop on Twitter after I published. Check out our thread.