California's IOUs Offer a Way Out of Its Fiscal Crisis

[girl gone mad]

(Edited because of redundancy.)

This is good news for California. It will be interesting to see how the federal government reacts, especially when more states decide to adopt a similar strategy to deal with debt and declining tax revenues.

California's IOUs Offer a Way Out of Its Fiscal Crisis
by Marshall Auerback
http://www.nakedcapitalism.com/2009/07/guest-post-californias-ious-offer-way.html">Naked Capitalism

Republicans and Democrats alike embraced legislation last week that would make California IOUs acceptable payment for all taxes, fees and other payments owed to the state - an action that effectively would mean that California is entering the currency business. Some commentators, notably Lex of the FT, have suggested that the proposed California “IOUs” “would create a vicious circle for the cash-strapped state, forcing issuance of even more IOUs.”

Quite the contrary: In fact, California's innovative IOU proposal represents a way of alleviating the state's fiscal crisis, not exacerbating it.
While it might appear that the new law seems merely to allow California to deficit spend just like the Federal Government - in actuality, the effect is far more profound than that. Allowing the IOUs to become an acceptable payment method for state taxes, instantly imparts value to them - in effect, what you have is a state of the union creating a parallel currency right under the noses of the Treasury, alleviating its fiscal straitjacket in the process.

So why are so objections being raised? The confusion seems to arise because of a mistaken understanding of the nature of modern money. Modern money has no intrinsic value in the absence of state sanction. In the words of economist Abba Lerner:

The modern state can make anything it chooses generally acceptable as money…It is true that a simple declaration that such and such is money will not do, even if backed by the most convincing constitutional evidence of the state’s absolute sovereignty. But if the state is willing to accept the proposed money in payment of taxes and other obligations to itself the trick is done.

The modern state, then, imposes and enforces a tax liability on its citizens and chooses that which is necessary to pay taxes. The unit of account has no real value if not ultimately sanctioned by use from the State. By extension, the state is never revenue constrained because it alone determines what is money. The tax is what gives the currency its value insofar as it functions to create the notional demand for federal expenditures of fiat money, not to raise revenue per se. Value has been given to the money by requiring it to be used to fulfill a tax obligation, but the money is already in existence, not “created” by the revenue.

It is in this context that one has to look at the California IOU proposal. It is important to note that the IOU would not replace the dollar, but operate in parallel to extinguish state liabilities. And if the IOU becomes functionally like a currency, then California’s bankruptcy problems are over. By imparting a value to these IOUs (i.e. letting them be used to settle state tax) this will ensure a demand for the state’s IOUs. Each individual vendor, contractor, or even state employee will accept the state’s new warrants up to the individual’s expected tax liability. Eventually the warrants will also be accepted by retail establishments and others, including banks, which also have liabilities to the state of California—meaning that the state could (eventually) issue a number of warrants equal to the total of all such obligations owed to the state, on an annual basis.

There are other historic examples of local currencies operating in parallel with national ones. As economist L. Randall Wray has noted, in Argentina as the financial crisis deepened after 2000, local governments began to issue “Patacones” (bonds with interest) as local currencies, paying workers and suppliers, and accepting them in tax payment. Utility companies began to accept them—knowing they could pay part of their taxes with them--and acceptance spread even to international corporations such as McDonald’s.

It is true that this legislation represents a profound break from all federal laws. But this is another instance where Obama’s obliviousness to the ramifications of the states’ respective fiscal crises has come back to haunt him. He and his advisors keep thinking that if they provide “liquidity” to banks, the banks will go out and lend. They don’t seem to understand that credit is not a “flow” but a two-way contract between lender and borrower: Incomes have to improve first before credit conditions can improve. Rising incomes create improved credit worthiness and ultimately improving asset values, thereby enhancing lending activity.

Of course, if the Federal government truly finds California’s proposals far too radical, then there is a simpler solution at hand: a payroll tax holiday and revenue sharing with the states will go a long way toward alleviating the states’ respective fiscal crises and almost instantaneously improve private sector incomes and aggregate demand.

[drm604]

1. Local Currencies

This has been done before. Here's an interesting Wikipedia article on local currencies: http://en.wikipedia.org/wiki/Local_currencies

[Newshues]

2. Art. ! Sec 10 of the US Constitution

Section 10. No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit, make any Thing but gold and silver Coin a Tender to Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts...



Ignore the prohibition on coining money, that isn't what California is doing. Pay attention to the prohibition on "Bills of Credit" because that is what California is doing. California is perfectly within it's rights to issue a bill of credit for an obligation that it owes to an individual. Where California would cross a line is in allowing those bills of credit to be used as "legal tender" between private entities for any transaction other than the buying/selling of the bill of credit.

A local currency, as the other responder highlights, is substantially different from what California is doing in that there is no government entity involved, usually, in a local currency. Private citizens are free to set up their own currency if they so desire but the states are not.

A more simplistic and Constitutionally defensible way for California and other states to take the pressure off their budgets is to charter their own banks and do all state and local borrowing through that bank. Not only would that take tremendous pressure off of the state that does so it would also help the cities and towns within that state with the bonus of not feeding the Wall Street sharks who helped create this mess.

I'd much rather my city pay the state interest and issuance fees for the bonds needed to separate our storm water from our sewerage then to pay Wall Street sharks the issuance fees and the bond hedge fund managers the bulk of the interest.

Done right it's a win for everyone but Wall Street.

[cobber2005]

3. Are county/municipal governments prohibited from issuing bills of credit?

Newshues, thanks for your very informative posting. It made me wonder: Instead of states, could counties or municipalities constitutionally issue bills of credit?

I realize that 'counties' and 'municipalities' are not explicitly barred from doing this in the language of Article 1 Section 10, but do you think a judge would say that it's the same type of thing?

[tama]

4. "No state"

obviously implies also the union of all states - federal bills of credit.

Dead letter.

[notesdev]

5. Oh, it's totally unlawful what they are doing

But who follows the law nowadays, anyway, except the little guy?

No one will hold them to account so it is de facto a done deal, no matter how lawless the act is.

It doesn't matter that the state accepts IOUs for taxes (by the way, they didn't the last time they pulled this trick), because the Federal government does not!