Financing Infrastructure with Inattentive Investors: The Case of US Municipal Governments

Abstract

In the United States, building infrastructure (e.g., schools, roads, hospitals) is primarily the responsibility of state and local governments and financed by borrowing in the municipal bond market. Despite the governments' low historical default rate and statutory taxing power, prior empirical evidence suggests they are borrowing-constrained. This paper provides new evidence and theory that link the constraint to the dominance of retail investors in the market, who might not pay perfect attention to the financial needs of their municipal governments. It makes the capital available to more specialized investors, such as municipal mutual funds, a crucial determinant for the borrowing capacity of those governments. Supporting this hypothesis, I find that the mutual funds are among the first investors of municipal bond issues, and they gradually resell their bonds to other investors. Furthermore, in response to a 1% inflow to the mutual funds that are among the major investors of a county government, the government borrows more by 0.2% in the subsequent quarter, conditional on issuing new bonds, while the inflow reduces the interest rate by 0.002%. To rationalize these observations, I develop a model of the municipal bond market in which mutual funds act as the attentive intermediaries.'' By calibrating the model with the empirical estimates, I find that the elasticity of bond supply by the municipal governments is about 100; moreover, is at least one order of magnitude larger than the short-term elasticity of the bond demand. The results support market interventions by the federal government in times of crisis if they accompany massive outflows from municipal mutual funds.