California’s I.O.U’s

The State of California’s tax revenues fall far short of its spending and the legislature and governor are unable to close the gap, due in part to the large number of constitutionally-imposed constraints and in part to all the usual hurdles to forging agreement among a diverse group of human being (hereis the NY Times article). So the State is planning to start issuing i.o.u.’s to pay its creditors. Further, these i.o.u.’s may pay interest (they did in 1992).  How should we think of and value these new assets?

To understand what this means, we can think of California as simply issuing its own interest-bearing money, call it Calicurrency. This new currency is pegged to the dollar, meaning that the State of California is promising to exchange a $20 i.o.u. for $20 of U.S. currency plus interest at some point in the future.  Thus we can use the tools of valuation that we use in the study of money and fixed exchange rates.

For example, these might trade at par – meaning one dollar of i.o.u. will trade for $1— if people believe with certainty that the State will indeed make this exchange and the interest rate is the market rate (say the maturity-matched interest rate on Treasury debt).  But this ignores liquidity.  I would prefer the dollars.  For one thing I live in Illinois, and I doubt anyone around here would accept Calicurrency. But in general, maybe banks will accept Calicurrency, but will the local restaurant?  In 1992, banks were willing to accept Calicurrency and credit the account the face value of the Calicurrency in dollars.  The banks earned interest on the Calicurrency while the depositors earned the lower interest on their checking accounts, but of course had the convenience of U.S. dollars.

Another issue is whether this policy constitutes expansionary monetary policy in California.  Certainly, if the Calicurrency is used in some transactions that would have otherwise used dollars, then those dollars can be used elsewhere and the demand for the U.S. dollar declines.  Put differently, if Calicurrency competes at all with dollars (and so is more liquid than other California debt instruments), then Calicurrency can meet some liquidity needs, and so this policy is indeed akin to expansionary monetary policy. While this does not affect the value of Calicurrency directly, it is an interesting consequence of the policy.

But, most relevant to the value of Calicurrency is whether the State will actually pay off the promised amount of dollars.  This question is closely related to my initial thought: how is this not just like issuing debt? One answer I think is that the State constitutionally cannot issue debt.  (Could a ‘concerned citizen’ point out the similarities via lawsuit and stop the use of i.o.u.’s.?)  But the key economic answer is that California has to make good on its official bonds, while it can more easily default on Calicurrency (or at least pay less than $1 for each dollar of Calicurrency).

And unfortunately, the history of fixed exchange rates in practice includes lots and lots of these effective defaults.  Governments that can issue these i.o.u.’s and have trouble balancing budgets tend to issue a greater value of their currencies than they have the will or ability to maintain.  And default follows.

I would rather see California issue actual official debt. And I am not accepting any Calicurrency as payment unless at a steep discount.