Since the Great Recession began, the federal government has bailed out commercial banks in the hope of encouraging lending to small businesses in the U.S. But the banks have failed to do so. Even before the economic crisis, the U.S. lacked an adequate system for leveraging private capital to promote the needs of the 21st century U.S. economy.
Other advanced industrial countries, including the Federal Republic of Germany, as well as industrializing nations like China, rely on specialized public or quasi-public credit institutions to carry out public purposes such as lending to small and medium enterprises (SMEs) and directing credit to areas of the economy that are important for overall growth but unable to attract adequate private capital. By acting as intermediaries between private capital markets and SMEs, public development banks in other nations complement, rather than compete with, their private commercial and investment banking sectors.
We need not look to other countries for examples of successful public purpose finance systems. In the 20th century, the U.S. created highly successful public development banks that enabled a majority of Americans to own their own homes and turned American agriculture into the most productive in the world.
President Obama has spoken of laying a new foundation for the American economy. Part of that new foundation must be an innovative system of public purpose finance, combining new and existing economic development banks to promote innovation and growth in the areas of manufacturing, infrastructure, R&D, energy, skill development, housing and agriculture.
The Seven Siblings
We propose a new American public purpose finance system centered on seven economic development banks. Each federally-chartered development bank would be a decentralized system of several regional development banks. Each of the member banks would be organized as a cooperative owned by the member banks and other lending institutions in its assigned region of the United States. Each development bank system as a whole would be authorized to issue its own tax-favored agency bonds to promote its particular mission.
The seven economic development banks of the proposed public purpose finance system include two which already exist, the Federal Home Loan Bank System and the Federal Farm Credit System, and five proposed new credit systems:
- The Federal Home Loan Bank System (FHLB)
- The Federal Farm Credit System (FFCS)
- The Federal Manufacturing Credit System (FMCS)
- The Federal Infrastructure Credit System (FICS)
- The Federal R&D Credit System (FRDCS)
- The Federal Energy Development Credit System (FEDCS)
- The Federal Skill Development Credit System (FSDCS)
The missions of each of these development bank systems can be briefly described.
The Federal Home Loan Bank System (FHLB)
Fannie Mae and Freddie Mac, now in federal receivership, might be merged into a single entity, which would be incorporated into the existing, successful Federal Home Loan Bank System, which would retain its sound cooperative structure (see below). To avoid a recurrence of the sub-prime lending problem, lending to homeowners should become as safe and boring as it was in the 1950s and 1960s, with standardized “plain vanilla” loans offered only to credit-worthy borrowers. The Government National Mortgage Association or Ginnie Mae (GNMA) would continue to carry out its mission of guaranteeing securities backed by government agencies like the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA).
The Federal Farm Credit System (FCS)
The existing Farm Credit System, organized as a member-owned cooperative, is a success and should serve as a model for other public purpose finance institutions. In contrast, the Federal Agricultural Mortgage Corporation (Farmer Mac), a stockholder-owned, publicly-traded company, shares the design defects of Fannie Mae, Freddie Mac and Sallie Mae that led them into reckless behavior. Farmer Mac should be completely privatized like Sallie Mae and should not benefit from implicit federal backing. Over time the public purpose of reducing the cost of lending to farmers in the U.S. should be the sole prerogative of the FCS.
The Federal Manufacturing Credit System (FMCS)
The mission of the Manufacturing Credit System would be to lend to manufacturing enterprises located in the U.S. The emphasis would be on lending to promising SMEs that have difficulty raising private capital. The manufacturing credit system would also be empowered to lend to large corporations in industries with increasing returns to scale, like automobiles and aerospace that are important for national security and prosperity.
The Federal Infrastructure Credit System (FICS)
The Infrastructure Credit System would be a version of the national infrastructure bank supported by Felix )Rohatyn (1) and Bernard Schwartz (2), proposed by Representative Rosa DeLauro and Senators Chris Dodd and Chuck Hagel (3), and endorsed by President Barack Obama.(4) The primary mission of the regional infrastructure development banks would be to finance routine, relatively small-scale state and local infrastructure projects. Large, one-time infrastructure projects of national significance—“megaprojects”—might be financed by different methods, depending on the project specifics.
The Federal R&D Credit System (FRDCS)
The R&D Credit System would seek to correct the bias of federal R&D spending toward military and health care research. It would supplement rather than compete with existing federal R&D programs like those of the National Science Foundation and the National Institutes of Health. The R&D Credit System would provide grants to universities and other public and private entities to enable them to carry out basic and applied research in science and technology which might not have immediate applications but might lead to fundamental breakthroughs.
The Federal Energy Development Credit System (FEDCS)
The mission of this development bank system would be to finance energy research and development by universities and public agencies, nonprofits and corporations. The energy development bank system should fund all innovative energy research and not be limited to particular technologies like renewable energy or certain kinds of businesses like small businesses. The existence of an independent development bank capable of assessing and funding energy research projects on their merits would avoid the influence of special interests and fads on direct congressional appropriations for energy research.
Can We Learn from Germany’s Development Bank?The Federal Republic of Germany manages to be an export superpower while maintaining a flourishing small- and medium-sized manufacturing sector in part because of its successful public development bank system. The Kreditanstalt fur Wiederaufbau or KfW (Reconstruction Loan Corporation) was created in 1948 to promote the use of Marshall Plan funds in the rebuilding of postwar West Germany. One of Germany’s largest banks, the KfW is owned in part by the German federal government (80 percent) and in part by Germany’s Länder or states (20 percent). Like the “agency debt” issued by American GSEs, the bonds that the KfW issues to raise funds from domestic and global capital markets are considered to be as safe as obligations of the German federal government. Through specialized banks the KfW system provides low-cost finance to thousands of projects in Germany and developing countries. KfW plays a critical role in providing credit for Germany’s highly successful Mittelstand (middle category) of small and medium enterprises (SMEs), as well as for Germany’s steel, coal and energy industry, infrastructure, housing and environmental protection. British Business Secretary Peter Mandelson has proposed a British public investment bank modeled on the KfW as a source of inexpensive finance for SMEs and infrastructure in Britain.
The role of an energy bank in the proposed new public purpose finance system might be played by the Green Bank, proposed on March 24, 2009, by Representative Chris Van Hollen (D-MD) and five cosponsors in the Green Bank Act of 2009, which would establish a Green Bank “to assist in the financing of qualified clean energy projects and qualified energy efficiency projects.” (5) The proposed Green Bank would be chartered for 20 years as a federally-owned independent corporation, with initial capital (never to exceed more than $50 billion outstanding) provided by Green Bonds issued by the U.S. Treasury and guaranteed by the federal government. The Bank would provide loans, loan guarantees, debt securitization, insurance, and other forms of financial support and risk management services to qualifying clean energy and energy efficiency projects, in order to achieve energy independence, abate climate change, improve energy efficiency, create jobs in the clean energy industry, and complement other clean energy initiatives. The Bank would operate independently of state law relating to corporations and would be exempt from all state and local taxation except for real property taxation. According to the Coalition for the Green Bank, the Bank would serve “as an essential catalyst for the successful development and implementation of clean and renewable energy.” (6)
The Federal Skill Development Credit System (FSDCS)
The Skill Development Credit System would provide loans and grants to employers to enable them to train both entry-level and mid-career workers. By funding employers rather than students, the Skill Development system would address the mismatch between workers and needed job skills from the demand side, rather than the supply side, as in current models of student financial aid and workforce training. The new demand-side approach to subsidizing vocational training would complement, not compete with, existing federal education programs such as students loans and Pell Grants.
Designing the Development Banks
While the details of their organization would be tailored to their particular missions, all seven of the proposed economic development banks would share five characteristics: they would be government-sponsored enterprises; they would be organized as networks of regional development banks; they would loan money to borrowers indirectly, not directly; they would be secondary market makers, using their ability to issue bonds to leverage private capital for public purposes; and, most important, they would be organized as member-owned cooperatives.
Government-Sponsored Enterprises. The proposed economic development banks would be government-sponsored enterprises (GSEs). GSEs are federally-chartered corporations created by Congress to fulfill public purposes that are not being met by markets or the nonprofit sector, and which government agencies might be too politicized to carry out successfully over time. Throughout its history America’s economic development has been promoted by GSEs, from the Bank of the United States in the 19th century to the Tennessee Valley Authority (TVA) in the 20th. Our proposal would consolidate the three existing housing GSEs—the Federal Home Loan Bank System, Fannie Mae and Freddie Mac—into one, retain the Farm Credit System but not Farmer Mac, and add five new public purpose GSEs to promote national economic development by providing loans and grants in the areas of infrastructure, manufacturing, energy, basic R&D, and workplace skill development.
A National Network of Regional Development Banks. Each of the development banks would consist of regional banks, in order to promote development in every part of the country and to minimize the danger of capture by particular regions or special interests. The decentralized, regional model has worked well for the Federal Reserve as well as the Farm Credit System and the Federal Home Loan Banks. Congress might decide to create development banks in the twelve existing Federal Reserve districts, or a smaller number of regions.
Lend indirectly. The development banks would not make loans directly to borrowers. Instead, they would engage primarily in lending either to commercial banks and other financial institutions, as the Federal Home Loan Banks do, or to associations of producers, as the banks of the Farm Credit System do.
Secondary Market Makers. The new and old GSEs in the new public purpose finance system would play an important role in the U.S. economy by creating or deepening secondary financial markets in their assigned areas. They can do this in two ways: by buying and holding loans or by selling them to private investors, such as large institutional investors in search of safe bonds. By bundling and selling large numbers of small private loans or government bonds, the GSEs can act as intermediaries between small borrowers and private capital markets that do not fund small borrowers directly.
Organized as Member-Owned Cooperatives. GSEs have acquired an unjustly bad reputation, as a result of the reckless and corrupt behavior of Fannie Mae, Freddie Mac and Sallie Mae. Fannie Mae and Freddie Mac are now under government receivership and Sallie Mae has been completely privatized and was stripped of its federal charter in 2004. However, other GSEs such as the Farm Credit System and the Federal Home Loan Bank System have been prudent and successful. So has the Government National Mortgage Association (GNMA), a wholly-owned government corporation. The difference in behavior results from a difference in design.
Fannie Mae (after 1968), Freddie Mac and Sallie Mae were organized as publicly-traded, for-profit corporations. The desire to maximize shareholder value and the compensation of executives who were remunerated partly in stock options led those organizations to lower their standards and engage in reckless and corrupt behavior. Fannie and Freddie sought to boost their share prices by risky lending, while Sallie Mae, having been fully privatized but still enjoying assumed government backing, tolerated systematic corruption.
GSEs: The Good, the Bad and the Ugly
Government-Sponsored Enterprises (GSEs) are federally-chartered corporations that can be structured in different ways. History shows that GSEs structured as investor-owned, publicly-traded companies, like Fannie Mae and Freddie Mac, have incentives for reckless or corrupt behavior because of the combination of an implicit federal guarantee with pressures from the market to maximize shareholder profits. Much more prudent behavior has been exhibited by GSEs that are organized as member- or bank-owned cooperatives, like the Farm Credit System and the Federal Home Loan Bank System, or as wholly-owned government corporations, like Ginnie Mae.
- Government owned: Ginnie Mae
- Member- or bank-owned cooperative: Farm Credit Banks, Federal Home Loan Banks
- Publicly-traded, shareholder-owned: Fannie Mae, Freddie Mac, Farmer Mac
- Completely privatized (stripped of federal charter): Sallie Mae
In contrast, the Farm Credit System and the Federal Home Loan Bank System did not suffer from similar pathologies because they are organized as cooperatives. The Farm Credit System is owned by farm associations. The Federal Home Loan Bank System is owned by banks and other lending institutions. Members of member-owned cooperatives have no incentive to engage in reckless lending. If they did so, they would only damage the organizations which they partly own. (Farmer Mac is organized like Freddie, Fannie and Sallie as a publicly-traded, shareholder-owned corporation, rather than a cooperative, and that design is not appropriate for a GSE with its important public purpose).
The three failed GSEs ran amok because of the dangerous combination of implicit government backing with the drive to maximize shareholder value and executive compensation. The perverse incentives which wrecked Fannie, Freddie and Sallie can be avoided if the new GSEs are organized as member- or bank-owned cooperatives, like the Federal Home Loan Banks and the Farm Credit System banks.
Funding the Development Banks
Each of the development bank systems would be authorized to issue its own bonds, as the existing GSEs already do. There would be no formal federal guarantee of their debt, but the implicit guarantee would ensure that their bonds are rated only slightly less highly than U.S. Treasuries.
Wouldn’t it be cheaper for the Treasury to issue debt directly? The answer is that it is politically impossible for the federal government to use debt to finance large-scale lending directly on a regular basis on the scale that is required in the areas of infrastructure, manufacturing and energy, among others. Proposals for a federal capital budget have repeatedly been rejected by Congress. In light of concern about federal deficits and debt, such proposals are less likely to succeed than ever, leaving agency debt as the most realistic form of federally-backed borrowing for purposes of economic development.
Each of the proposed new development banks would be associated with a funding corporation that issues a variety of debt securities, with different structures and maturities, on behalf of the banks in the system. This role is played by the Federal Farm Credit Banks Funding Corporation in the Farm Credit System.
The federal government could provide the initial capital reserves for the banks in the manufacturing credit system through direct congressional appropriations or by issuing special Treasury bonds. If these approaches were politically unpalatable, the manufacturing credit system banks might be funded indirectly, by means of tax credit bonds for particular purposes like infrastructure, energy, manufacturing and R&D. States, local governments, and other entities qualified to issue tax credit bonds under state and federal law would be allowed to use some of the proceeds of sales of those bonds to fund the cooperative regional manufacturing credit banks. Once they were funded, the development banks would sell co-op shares to commercial banks and other lenders in their regions, which in return for their investments would be entitled to loans.
The Role of New State and Local Tax Credit Bonds
In addition to issuing their own agency debt, some of the development banks could create or deepen secondary markets for state and local bonds that are used to promote the purposes of particular development banks. For example, a national infrastructure bank, however organized, could purchase and hold or resell Build America Bonds (BABs), a new class of tax credit and direct pay bonds subsidized by the federal government and issued by state and local governments to finance infrastructure. Tax credit bonds are taxable bonds for which investors receive a tax credit against a certain percentage of the interest income, at a rate set by the Treasury. (7) The development banks could buy and hold or resell both tax credit bonds and traditional tax-exempt municipal bonds.
We propose that the federal government create the following four new kinds of state and local tax credit bonds, modeled on Build America Bonds and associated with particular economic development banks:
Made in America Bonds (MABs) / The Manufacturing Credit System
Made in America Bonds (MABs) would be issued by state and local governments to promote manufacturing in their areas. MABs could be used to fund state-level manufacturing development banks which could provide loans and grants to manufacturing enterprises. In addition, states could use some MABs as private activity bonds, in order to directly aid particular manufacturing corporations in creative public-private partnerships. (8)
American Innovation Bonds (AIBs) / The R&D Credit System
American Innovation Bonds would be a class of tax credit bonds that state and local governments could issue to fund R&D and technology extension programs. Maine provides a model for R&D bonds issued by the states. Following an evaluation of the impact of the state’s investments in R&D that criticized the earmarking of R&D funds (9), in 2007 Maine’s voters approved the issuance of $50 million in bonds to be distributed to private or non-profit organizations for R&D projects on a merit basis. The Maine Technology Asset Fund, part of the Maine Technology Institute, awards the funds for capital and related research expenditures in areas that are projected to have economic benefits for the state. (10) In June of this year voters were asked to approve more bonds.
Ohio provides another example. In 2005, Ohio voters approved a $500 million issuance of general obligation bonds for R&D investment, which is awarded on a merit basis by a pre-existing economic development investment program, the Ohio Third Frontier program. The program invests in advanced energy, advanced materials, biomedical, instruments, controls and electronics, and power and propulsion research and technology commercialization. (11) The investments made through the Ohio Third Frontier program has largely been heralded as a success. An independent study found that the $681 million invested generated $6.6 billion in economic activity, 41,300 jobs, and $2.4 billion in employee wages and benefits, or a $10 return on every dollar invested in Ohio. (12) On May 4, 2010, Ohio voters approved an issuance of an additional $700 million in general obligation bonds to be awarded through the Ohio Third Frontier program. (13)
American Energy Bonds (AEBs) / The Energy Development Credit System
A new category of American Energy Bonds (AEBs) could complement or replace several existing tax credit bonds created in recent years by Congress. The American Recovery and Reinvestment Act of 2009 (ARRA) expanded the existing tax credit bond programs for renewable energy, new Clean Renewable Energy Bonds (CREBs) and Qualified Energy Conservation Bonds (QECBs).CREBs pay a 70 percent subsidy on the interest from investments in qualified renewable energy production projects. (14) First authorized in 2005 with a volume cap of $500 million, ARRA raised the authorization limit for CREBs to $2.4 billion, to be allocated equally among public power providers, governmental bodies, and electricity cooperatives. QECBs pay a 70 percent taxable interest subsidy for public energy conservation projects, including reducing energy consumption in public buildings and mass transit, implementing green community programs, and developing clean energy research facilities. (15) ARRA raised the volume limit for QECBs, which was first set at $800 million in 2008, to $3.2 billion, allocated among the states in proportion to their populations.
Skill Development Bonds (SDBs) / The Skill Development Credit System
Yet another category of new tax credit bonds would be Skill Development Bonds (SDBs). State and local governments could issue these federally-subsidized tax credit bonds in order to fund grants or tax credits used by businesses in training new hires and retraining midcareer employees. State and local governments could also use the revenue from SDBs to fund vocational training programs and apprenticeship programs at community colleges, state and private universities, public high schools and other educational institutions.
Two of the proposed bonds—American Innovation Bonds to fund R&D and Skill Development Bonds to fund employee training—represent an advance in thinking about the proper use of debt finance. Long-term borrowing is justified when the funds are used for investments that make the economy more productive over the long term, thereby raising tax revenues and making it easier to pay down debt. This principle has usually been accepted in the case of physical assets like roads, schools and power plants. Basic science and human capital are long-term investments that pay off in enhanced productivity, and for this reason it makes sense to use bond finance to channel private capital to R&D and worker skill development.
In the tradition of federal GSEs, each new funding corporation might be given its own nickname:
Mannie Mac. The Federal Manufacturing Loan Marketing Association, which would act on behalf of the regional banks of the Manufacturing Credit System.
Ida Mae. The Federal Infrastructure Development Loan Marketing Association, which would act on behalf of the regional banks of an Infrastructure Development Credit System.
Rudi Mac. The Federal Research and Development Loan Marketing Association, which would act on behalf of the regional banks of the R&D Credit System.
Eddy Mac. The Federal Energy Development Credit System Loan Marketing Association, which would act on behalf of the regional banks of the Energy Development Credit System.
Sadie Mae. The Federal Skill Development Loan Marketing Association, which would act on behalf of the Skill Development Credit System.
Private Capital and Public Purpose Finance
Private capital is readily available to help capitalize on an ongoing basis the public purpose finance system outlined here. Adding a new layer or class of government bonds would add stability to our financial system that is now short of safe assets for investors, both domestic and foreign. And it would fill a huge hole in the range of fixed income investments left by the problems in mortgage backed securities and related government agency debt market.
Large investors of all kinds—whether they be foreign sovereign wealth funds, European and U.S. pensions funds, or large mutual funds—want and need relatively safe investments that offer returns slightly higher than the standard yields on U.S. Treasuries. Despite its large size, the U.S. Treasury market and other safe sovereign debt markets are simply too small to satisfy the demand for relatively safe fixed income investment. And there is reason to believe demand will increase in the years ahead as the large baby boom generation begins to move more money out of the housing and equity market into fixed income in the interest of greater retirement security. As it is now, the American public is underinvested in fixed income, and a new class or sector of relatively safe bonds tied to public purpose finance would offer American investors exactly what they now need and want.
Public Purpose Finance and the Economic Development System as a Whole
The economic development banks of the new public purpose finance system that we propose would play a vital role in a larger national economic development system. In addition to the development banks, the innovation ecosystem should include federal agencies, research universities and Agricultural and Mechanical (A&Ms), extension agencies, and community colleges.
Federal Agencies. Each development bank would be associated with a federal agency in the way that the Home Loan Bank System works with the Department of Housing and Urban Development (HUD) and the Farm Credit System works with the Department of Agriculture (USDA). Newly-created development banks, existing agencies or divisions of agencies could work with an existing federal or state agency or agencies. For example, the proposed Federal R&D Bank could work with the National Institute of Standards and Technology and the National Science Foundation, while the Federal Energy Development Bank would work with the Department of Energy. In the case of the Federal Manufacturing Credit System, a case can be made for removing manufacturing-related programs from the Department of Commerce and assigning them to a new Cabinet-level Department of Manufacturing.
Research Universities and A&Ms. In all of the areas of the economy to be helped by the public purpose finance system, there is a need for continuous interaction between basic science, applied science and the needs of manufacturing or construction. This is true even in the case of housing, which is seldom thought of as a high-tech, cutting-edge industry but which could benefit from both basic and process R&D.
America’s institutions of higher education could take their part in a new division of labor. Research universities should focus on basic R&D, while polytechnics like state A&Ms should act as the intermediaries between researchers and producers.
Germany’s highly successful Frauenhofer Institutes could be the model for a reorganized A&M system. All except the largest companies lack the ability to conduct significant internal R&D. Small and medium enterprises (SMEs) might come to A&Ms with their technical problems, which A&M researchers would address using the latest in basic science and technology research. The results would be shared by the A&M with all of the producers in the industry by means of extension services, modeled on agricultural extension services.
Community Colleges. Community colleges would also play a vital role in the national economic development system. Only a minority of jobs in the future will require expensive four-year college educations. But economic growth driven by investments in infrastructure, manufacturing and energy development will create many jobs for Americans with post-high school vocational training.
The traditional approach to funding higher education in the U.S. is economically inefficient, because it forces young Americans to guess what skills they will need for the rest of their lives, even though industry needs change and entire industries disappear. A far better approach would be to subsidize employers with loans or grants from the proposed Federal Skill Development Bank, to enable them to train entry-level workers or retrain mid-career workers. Community colleges could partner with individual firms to train workers. At the same time, community colleges could serve entire industries by creating apprenticeship programs funded in part by contributions from the industries that benefit from them.
Public Purpose Finance: Recovery and Reform
During the Great Depression, President Franklin Roosevelt described the three goals of government action: relief, recovery and reform. In today’s Great Recession, recovery and reform can both be promoted by creating the proposed system of economic development banks. The development banks can strengthen recovery by helping to channel the flow of private capital toward small and medium enterprises that are desperate for credit in the aftermath of the credit crisis. And the development banks should be central to any program of structural reform of the U.S. economy intended to increase innovation and steady growth in the decades and generations ahead.
Building on successful domestic precedents, and informed by the best practices of other countries, a new public purpose finance system as the centerpiece of a new national economic development system can serve as a powerful catalyst for a dynamic American economy.
5 “H.R. 1698 – To establish the Green Bank to assist in the financing of qualified clean energy projects and qualified energy efficiency projects.” Available at: <http://www.opencongress.org/bill/111-h1698/show>
14 Government Finance Officers Association. Issue Brief: Taxable Tax Credit Bond Programs. Updated February 2009.