Local and State Governments
Municipalities can finance themselves through taxing its citizens - this can be done a few ways. There are income taxes on salaries and wages, property taxes on physical property, and sales taxes on all sorts of products.
- General Obligation Bonds: A municipality issuing general obligation bonds repay those bonds through its tax revenues. These bonds can be used to finance general operations and expenses that don’t usually generate a monetary return like public schools and parks.
- Revenue Bonds: Certain facilities run by the municipal government receive revenue to fund themselves and the bonds used to finance them. For example, tolls on highways can go towards repayment of bonds issued for building the highway. Metro fares help pay for bonds issued to build metro systems.
Spend on Infrastructure, Social Programs, Education
It may seem like government takes in a lot of money, but this is necessary for a smoothly functioning society. It invests these funds in projects for the public good: schools for education, bridges and highways for infrastructure.
At the federal level, financing is similar to that at the state and local level. The main revenue source from taxation is the federal income tax.
Debt can be issued by the Treasury in a few ways, but a common method done for large sums is a treasury auction where bidders submit their bid prices. The highest bids are fulfilled until the issuing amount is reached. Bidders can be individuals, institutions, and foreign governments.
Spend on Infrastructure, Social Programs, Defense, Education
The federal government spends on public projects such as interstate highways, student loans and research grants, and defense contracts for military equipment.
Relationship to Banks
Banks play an important part in helping both the federal government and municipalities issue their bonds. Similar to underwriting bonds and equity issuances for corporations, banks underwrite bonds for municipal governments. When a bank does this for municipalities, it considers factors like:
- Is this a general obligation or revenue bond?
- Does the municipality or the facility seem to be able to pay for the bond?
- What interest rate should it be set at?
- What are potential investors that might be interested in this bond?
For treasury debt issuances, banks and independent broker-dealers (brokerage firms that buy and sell as principal) underwrite government debt, but only the ones large and liquid enough are allowed to do this. These banks are called primary dealers , are major participants in treasury auctions, and include commonly known ones like Goldman Sachs, J.P. Morgan, and Citigroup. Note that we named three banks but only one of them is a pure investment bank - Goldman Sachs. For the two bank holding companies, it is their investment bank branch that actually does the underwriting. On the flip side, the Federal Reserve is responsible for issuing and selling the Treasury’s debt to underwriting banks.
The Federal Reserve
The Federal Reserve is the central banking system created by Congress through the Federal Reserve Act of 1913. Its influence is felt throughout the economy, but it deals primarily the with the banking sector and with government.
With banks, the Fed sets reserve requirements to determine the amount of money being lent around in the banking system. Lower reserve ratios give more flexibility to banks to lend out more money.
In earlier lessons, we discussed how banks can lend out money to earn interest, and the amount left is the reserves it holds on balance sheet. However, what if banks can earn interest on that too? This is where the Federal Reserve steps in. The Federal Reserve is actually a banking system with several branches across the country to act as a “banker’s bank”, for depository institutions to park their cash. If a commercial bank has $1000 in deposits and is allowed to lend out $800, it has to keep $200 in reserves, but it doesn’t want to earn nothing on that $200. It can then deposit that $200 with the Federal Reserve and earn a low interest return. Might not sound like much, but for large banks that have tens, hundreds of billions in deposits, even 0.01% is a huge amount.
The reserves that banks have on a day to day basis might fluctuate. Some days banks need to borrow to maintain the reserve requirement, some days banks have more than they need. To solve this, banks can lend and borrow from each other, usually overnight, to maintain their reserve requirements and to generate interest from excess reserves. The interest they charge each other is the fed funds rate.
The Fed uses this fed funds rate to set monetary policy, which is discussed in more detail in the prerequisite course The Federal Reserve under Investing.
After the Great Depression and the more recent Financial Crisis, the Fed played an increasingly important role in regulating banks. One recent example is the Fed setting capital requirements for banks - a concept similar to reserve requirement in the sense that it prevents excess leverage.
Interactions with the Treasury
In addition to interacting with banks, the Fed interacts in important ways with the Treasury Department. Both agencies act to maintain the health of the country’s economy, and the Treasury Department, which manages the nation’s finances plays a central role. For example, during the Financial Crisis, the Treasury and the Fed worked hand in hand to keep the boat afloat.
While the public sector doesn’t play as flashy of a role in the economy as idea-generating businesses and money-compounding investments, it is the overseeing umbrella that makes all things possible. By creating a safe environment for its businesses and citizens, it lets its talented constituents put their skills to the test, fostering healthy competition. Sometimes the decision by lawmakers to intervene and guide the economy in times of distress seems like the only viable solution, but how exactly to go about doing it is not always obvious to the most qualified economists. In any case, with care and ingenuity, humans have always been able to recover from crises. Let’s hope with the knowledge we have gained in Finance Fundamentals, we can improve both our own lives and those of others. For further studies, be sure to check out the the lessons under The Industry and Investing. If you have enjoyed the material so far and found it useful, subscribe to our Pro membership to learn about recruiting, finance jobs, and how to invest!