Chapter 18

Federal, State, and Local Governments Operating In

The Financial Markets

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Learning Objectives

• To examine the many important roles played by the government’s Treasury Department.

• To identify how the government raises new funds and how it spends the funds raised.

• To understand how the activities of the Treasury Department impact the money and capital markets and the economy.

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Learning Objectives

• To explore the various ways state, county, and city governments raise the funds needed to supply government services to the public.

• To be able to describe the different instruments that state and local governments use to attract money and why these instruments are attractive to millions of investors.

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Introduction

• In the United States (and many other nations), governments exist at several levels – federal or national, state, and local.

• The great majority of these governmental units are legally entitled to enter the money and capital markets at any time and borrow money.

• These fund-raising activities impact the economy and affect market interest rates, asset prices, and overall credit conditions in the financial marketplace.

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Federal Government ActivityIn the Money and Capital Markets

• The U.S. Treasury Department exerts a potent impact on the financial system through its

• fiscal policy – the taxing and spending programs of the federal government designed to promote various economic goals, and

• debt management policy – the refunding or refinancing of the federal government’s debt in a way that contributes to its economic goals and minimizes the debt burden.

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The Fiscal Policy Activities ofThe U.S. Treasury

• Congress dictates the amount of funds the federal government will spend each year on programs like welfare and national defense, and also determines the sources of tax revenue and tax rates.

• When tax revenues are not sufficient to cover expenditures, a budget deficit occurs.

• A budget surplus occurs when government revenues exceed expenditures.

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The Fiscal Policy Activities ofThe U.S. Treasury

Federal Government Revenues, Expenditures, and Net Budget Surplus or Deficit, Selected Fiscal Years, 1969–2005*

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Sources of Federal Government Funds and Federal Government Expenditures

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Sources of Federal Government Funds and Federal Government Expenditures

• In recent years, several changes in U.S. tax and spending laws have been made in an effort to make the government’s fiscal policy a more effective tool for achieving the nation’s goals.

• However, fiscal policy often operates with long and variable lags.

• Many authorities today suggest that fiscal policy should be aimed at longer-range goals, such as promoting greater economic efficiency and greater equity in resource allocation.

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Effects of Government Borrowing on the Financial System and the Economy

The Treasury Borrowing Money from the Public andSpending the Borrowed Funds

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Effects of Government Borrowing on the Financial System and the Economy

• The economy and the financial system are so complex that it is extremely difficult to make any dependable predictions about the ultimate outcome of government borrowing and spending.

• The conventional wisdom has been that new government borrowing and spending may add to planned investment and consumption spending by businesses and households.

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Effects of Government Borrowing on the Financial System and the Economy

• However, it also has been argued that the additional borrowing and spending could eventually set in motion inflation.

• Recent research has introduced yet another argument: Interest rates and security prices in an efficient market may not respond at all to increased government borrowing and spending.

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Effects of Government Borrowing on the Financial System and the Economy

The Treasury Uses Its Surplus Funds to Pay Off andRetire Government Securities Held by the Public

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Effects of Government Borrowing on the Financial System and the Economy

• The effects of debt retirement on the economy and financial system is also uncertain.

• Some argue that running budget surpluses and retiring the government’s debt tends to slow economic activity as funds are transferred from tax payers (who may, on average, have a higher propensity to spend) to government security investors (who may have a higher propensity to save).

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Effects of Government Borrowing on the Financial System and the Economy

• Others argue that the retirement of government debt simply makes more room for private borrowing and spending.

• If markets are truly efficient and the government is transparent about what it is doing with the public debt, there may be little impact at all.

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Management of the Federal Debt

• Today, the U.S. public debt is the largest single collection of securities available in the financial system.

• Corporations, commercial banks, and other institutional investors rely heavily on government securities as a readily marketable reserve to be drawn upon when cash is needed quickly.

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The Size and Growth of the Public Debt

The Public Debt of the United States, 2004 ($ Billions)

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The Size and Growth of the U.S. Public Debt

• On a per capita basis, the U.S. public debt amounts to more than $27,000 for every man, woman and child living in the U.S.

• How did the federal debt become so large?

Wars, economic depressions, and the rapid expansion of military expenditures and social programs have been among the principal causes.

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The Size and Growth of the Public Debt

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The Composition of the Public Debt

• Non-interest-bearing debt consists of paper currency and coins previously issued by the U.S. Treasury Department.

• Note that virtually all paper money in circulation today is in Federal Reserve notes, which are not officially a part of the public debt but are obligations of the Federal Reserve banks.

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The Composition of the Public Debt

• More than 99 percent of all federal debt securities are interest bearing and may be divided into two broad groups: marketable securities and nonmarketable securities.- Marketable securities may be traded any number of times before

they reach maturity. Treasury bills, notes, and bonds are marketable securities.

- Nonmarketable securities must be held by the original purchaser until they mature or are redeemed. Eg. Government Account series securities, savings bonds

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Investors in U.S. Government Securities

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Methods of Offering Treasury Securities

• Treasury debt managers are called on continually to make decisions about raising new money and refunding maturing securities.

• They must decide what kinds of securities to issue, which maturities will appeal to investors, and the form in which an offering of securities should be made.

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Methods of Offering Treasury Securities

• The auction method is the principal means of selling Treasury notes, bonds, and bills today.

• Examples of auction methods used include the yield auction and uniform price auction.

• Today, the marketable public debt is issued in book-entry form only .

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Methods of Offering Treasury Securities

• New Treasury bills, notes, and bonds can be bought directly from the Treasury Department or from the Treasury’s agents – the Federal Reserve banks.

• Many investors also place orders for new Treasury issues through a security broker or dealer, bank, or nonbank financial institution.

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Price Quotations on Treasury Securities

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The Goals of Federal Debt Management

• Housekeeping goals pertain to the cost and composition of the public debt, such as minimizing interest costs.

• Stabilization goals relate to the impact of the debt on the economy and the financial markets.

• The goal of economic stabilization often conflicts with other debt management goals.

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The Impact of Federal Debt Management

• Most experts agree that in the short run, the financial markets become more agitated and interest rates tend to rise when the Treasury is borrowing.

• There is also some evidence that lengthening debt maturities increases long-term interest rates relative to short rates.

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The Impact of Federal Debt Management

• However, most authorities are convinced that the debt management activities of the Treasury do not have a major impact on economic conditions.

• The effects of debt management operations appear to be secondary compared to the impact of monetary and fiscal policy on the economy and the financial markets.

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State and Local GovernmentsIn the Financial Markets

• The borrowing and spending activities of state and local governments have been one of the most rapidly growing segments of the financial system in recent years.

• State and local governments are pressured by rising populations and inflated costs, while many investors are attracted by the high quality, ready marketability, active secondary market, and tax exemption feature of state and local debt obligations.

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Growth of State and Local Government Borrowing

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Growth of State and Local Government Borrowing

• What factors account for the strong growth in municipal borrowing?

- Rapid population and income growth

- Uneven distribution of population growth across the U.S. – smaller outlying communities were transformed into cities

- Upgrading of citizens’ expectations concerning the quality of government services

- Rising construction and labor costs

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Sources of Revenue and ExpendituresFor State and Local Governments

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Sources of Revenue and ExpendituresFor State and Local Governments

State and Local Government Finances:Major Cash Inflows and Outflows

Source: U.S. Bureau of the Census, Census of Governments.

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Motivations forState and Local Government Borrowing

• State and local governments borrow money

- to satisfy short-term cash needs and maintain adequate levels of working capital,

- to finance long-term capital investment like building schools and highways, and

- for advance refunding of higher cost securities.

$

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Types of Securities Issued byState and Local Governments

• Short-term securities are generally issued to provide working capital.

- Tax-anticipation notes (TANs)

- Revenue-anticipation notes (RANs)

- Bond-anticipation notes (BANs) – for temporary financing of long-term projects until the time is right to sell long-term bonds

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Types of Securities Issued byState and Local Governments

• Long-term securities are used mainly to fund capital projects.

- General obligation bonds (GOs)

- Revenue bonds – payable only from a specified source of revenue

• Student-loan revenue bonds (SLRBs)• Life-care bonds• Hospital revenue bonds• Industrial development bonds (IDBs)

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Types of Securities Issued byState and Local Governments

New Security Issues of Tax-Exempt State and Local Governments, 2003 ($ Billions)

Source: Board of Governors of the Federal Reserve System

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Types of Securities Issued byState and Local Governments

• In recent years, several new municipal instruments were developed.

- Floating-rate bonds

- Option bonds

- Lottery bonds

- Securitized bonds

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Key Features of Municipal Debt

• Tax exemption- Less tax revenue can be collected from the high-bracket

investors. However, the interest cost for municipal governments is low relative to the rates paid by other borrowers.

- Because the market for municipal bonds is limited by the tax-exempt privilege to top-bracket investors, prices and interest rates on municipal bonds tend to be volatile.

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Key Features of Municipal Debt

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Key Features of Municipal Debt

• High credit ratings- Most municipal issues are considered to be of investment quality

rather than speculative buys.

• Serialization- Most municipal bonds are serial securities.- Serialization refers to the splitting up of a single bond issue into

several different maturities.

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How Municipal Bonds are Marketed

• The selling of municipals is usually carried out through a syndicate of banks and securities dealers.

• These institutions purchase the securities from the issuing government units and then resell them in the open market at a higher price.

• Prices paid by the underwriting firms may be determined by competitive bidding or by negotiation.

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Problems in the Municipal Market

• Many observers question the social benefit of the tax-exemption privilege.- Although state and local governments can borrow more cheaply,

the federal government must tax more heavily to make up for the lost revenue.

- Many important investor groups (such as pension funds) have little need for tax shelters.

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The Outlook for State and Local Governments

• With slower economic growth and less federal support, more states will be under pressure to force cities, counties, and school districts to deal with their own problems and find their own funding sources.

• At the same time, the need for local government services and the interest of investors are not likely to fade, thus ensuring the future growth of the market for state and local government debt securities.

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Markets on the Net

• Bond Market Association at www.investinginbonds.com• Municipal Bond Insurance at

www.munibondadvisor.com/BondInsurance.htm

• Office of Management and the Budget at www.gpo.gov/usbudget

• State and local Governments on the Net at http://www.statelocalgov.net/

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Markets on the Net

• U.S. Bureau of Economic Analysis at www.bea.doc.gov• U.S. Bureau of the Census at www.census.gov• U.S. Bureau of the Public Debt at www.publicdebt.treas.gov• U.S. Treasury Department at www.treas.gov

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Chapter Review

• Introduction to the Role of Governments in the Financial Marketplace

• Federal Government Activity in the Money and Capital Markets- The Treasury Department in the Financial Marketplace- The Fiscal Policy Activities of the U.S. Treasury- Sources of Federal Government Funds- Federal Government Expenditures

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Chapter Review

• Federal Government Activity in the Money and Capital Markets … continued

- Effects of Government Borrowing on the Financial System and the Economy

- Management of the Federal Debt- The Size and Growth of the Public Debt- The Composition of the Public Debt

• Marketable Public Debt• Nonmarketable Public Debt

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Chapter Review

• Federal Government Activity in the Money and Capital Markets … continued

- Investors in U.S. Government Securities- Methods of Offering Treasury Securities- The Goals of Federal Debt Management- The Impact of Federal Debt Management on the Financial

Markets and the Economy

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Chapter Review

• State and Local Governments in the Financial Markets- Growth of State and Local Government Borrowing- Sources of Revenue for State and Local Governments- State and Local Government Expenditures- Motivations for State and Local Government Borrowing- Types of Securities Issued by State and Local Governments

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Chapter Review

• State and Local Governments in the Financial Markets … continued

- Innovations in Municipal Securities- Key Features of Municipal Debt- How Municipal Bonds are Marketed- Problems in the Municipal Market- The Outlook for State and Local Governments