California’s Golden IOUs

Posted: Jul 16, 2009 4:31 PM

In the mid 1800s, California was the destination for those seeking untold wealth buried beneath the earth. The Gold Rush lured thousands of settlers to the West Coast with the promise of immense riches, earning California the title of the Golden State. Today, California has become the not-so-golden state. In fact, with every day that passes, California sinks further in debt. And instead of luring modern-day prospectors (entrepreneurs), productive businesses—the engine of the state’s economy—are fleeing the state.

Governor Arnold Schwarzenegger and legislative leaders continue to meet behind closed doors, hammering out details of a budget agreement that will close the massive $26 billion state deficit. In an address to the legislature last month, Schwarzenegger lamented that unlike Washington, D.C., which faces its own swelling deficit, California cannot print its way out of its fiscal crisis. “We are not Washington,” he said. “We cannot print money. We cannot run up trillion-dollar deficits. We can only spend what we have.”

Earlier this month, State Controller John Chiang began issuing registered warrants, or IOUs, because the state has no money to pay its mounting bills. In July alone, it’s estimated the state will issue over $3 billion worth of IOUs. California law mandates those issued IOUs to accept the document as full payment for a debt. It also requires IOU recipients to pay taxes on the IOU as though it is actual payment from the state.

Businesses and taxpayers are essentially carrying the state government’s deficit by receiving these IOUs as payments. But unlike the government, businesses and taxpayers cannot in turn issue their own IOUs to their creditors without risking their own fiscal collapse. In the real world, only trustworthy currency will settle a debt.

Recognizing the hypocrisy of this situation, and coming to the rescue of taxpayers, was Assemblyman Joel Anderson (R-San Diego). Anderson introduced AB 1506, legislation that will require the state to accept its own IOUs as payment from businesses and citizens. Business and taxpayers could then use the IOUs to pay off their taxes, DMV fees, even school tuition.

Thus far, the bill appears to have bipartisan support in a legislature deeply divided over how to resolve the budget deficit. Even State Controller Chiang has expressed his support for AB 1506. If approved by the legislature and the governor, AB 1506 would strengthen confidence in the market as IOU recipients will in fact be able to use their registered warrants to make payments. Passage of AB 1506 also shows that the state government recognizes it is not above the law, and must abide by the same rules it imposes on citizens.

AB 1506 needs to pass the legislature quickly not just for market confidence, but because as of last Friday, banks are no longer cashing California’s IOUs. Major banks such as Bank of America, Citigroup, Wells Fargo and J.P. Morgan Chase, refuse to honor the IOUs. Unable to cash their IOUs, taxpayers and businesses can’t pay their own bills. If the state accepts its IOUs as payment for taxes and other government fees, it will bring some relief to IOU holders who cannot afford to float their government a loan.

Although issuing IOUs may be unfortunate for California, there is a silver lining for investors. In a sign that the free market still has some pulse, last week the Wall Street Journal reported that investors are already interested in the burgeoning California IOU market. The SEC’s ruling that the registered warrants are municipal securities means trading opportunities. The IOUs mature on October 2nd with a 3.75% interest rate. For those betting on the state’s ability to pull itself out of its hole, the payoff could be quite handsome.

It looks like California may in fact be issuing its own currency, turning fiat into gold—at least for some.

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