Guest Post: California’s IOUs Offer a Way Out of Its Fiscal Crisis

Submitted by Marshall Auerback, an investment manager who also writes at New Deal 2.0:

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.

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  1. Mondo

    Well, doesn't it amount to a full scale moratorium on USD debt if California only recycles IOUs, generating no USD to pay interest on the old-style bonds in the process ? How long before California bondholders panic and send rates even higher ?

  2. Anonymous

    And he's an Austrian, literally….

    There is a positive carry on them too, I beleive the rate was in the neighborhood of 3%.

    This is way better than dollars.

    I can't wait to see the steam coming off the head of the right when they realize that California is doing what they always wanted to do, get rid of the FED.

    Another note on the Golden State and its new found policy "pump-you-up's-

  3. Anonymous

    Obama's obliviousness? He tried to give much more stimulus money to the states, but the "moderates" in the Senate insisted on cutting back that particular item.

  4. Anonymous

    Just because the FED and the US treasury do not have a sustainable program does not mean that California pursuing the same policy is in the interest of the citizens.

  5. joebek

    It will be interesting to see how long before these CAIOs start trading on currency markets. It will also be interesting to see if they cannot eventually drive out the frn as would be suggested by Gresham's law. This suggests an interesting take on the notion of liquidity preference. And finally, will the CA congressional delegation push for the Federal govt to accept CAIOs in payment of Federal taxes? You would think they would. It's all over now baby blue.

  6. Pat Shuff

    Don't be a girly-man, print the whole state deficit! I'll be Bach!
    We are so fugued. Resistance is
    fugal. Er, feudal.

  7. Anonymous

    This can cut both ways– a gummit can use its taxing power to force people to work for whatever it defines as money, whether they want to or not.

    In 19th century South Africa, many natives were reluctant to take wage-paying jobs, being content with their own "natural" economy, based on barter. Who can blame them? Traditional Herding and farming are a lot more pleasant than working down in some mine.

    This produced a labor-shortage. So the colonial gummit instituted a head tax. The purpose of the tax was not revenue, but to force the natives to work at money-payng jobs.

  8. Anonymous

    If the federal government doesn't step in and stop this an extremely dangerous precedent will have been set.

    With California defacto issuing a parallel currency, and its acceptance as payment for some or all goods and services, whether intentionally or not, they are putting in place nation state-level institutions that will be very hard to take away once they've had a taste. It's especially bad given that CA, as a populous, geographically isolated and wealthy place is certainly a more viable nation than, say, Kosovo or any of the other statelets from the Balkans or the former USSR.

  9. Peter T

    If California pays vendors with IOUs, it is only fair that those vendors can pay their taxes with their IOUs. But can also other people use those IOUs for their taxes? California once demanded that every exchange of IOU need to be notarized to be accepted by California – is that true also for tax payments with IOUs? If not, California would indeed establish a parallel currency. The Fed, however, will not accept California's IOUs for federal tax payments, so IOUs will trade for less than US dollars.

  10. Anonymous

    There is a flaw in this argument. People may accept the IOUs to meet their CA tax obligations, but they will not want any more IOUs than that. At that point the state will not receive any FRNs at all in taxes, and must pay all state employees 100% in IOUs. But those IOUs won't work to buy goods from out of state, or to pay federal taxes on state employee income.

  11. Bill

    The next step is to pay a % of the California worker's pay in these IOU's. I imagine this "currency" will have a very high velocity as people will treat them like hot potatoes and try to get rid of them as quickly as possible. This is a fascinating experiment.

  12. Ricochet Smith

    So now I can pay my DMV fees and the like with my CA income tax IOU? It must work both directions or it's not really money.

  13. Anonymous

    these iou's are similar to the Civil War era greenbacks, which ultimately collapsed and threw the country into a depression. After a while, California will have issued more than can be used for tax obligations, and the value will plummet.

  14. Anonymous

    Bill, they pay interest unlike greenbacks. Bad money flushes out good money so don't ever expect to see CAIO's.

  15. Anonymous

    Very naive. The tax argument was well-understood in the eighteenth century and a staple of monetary writings of the 19th century.

    The problem is that we are now in the 21st century. Most money is no longer currency. There won't be much float on the warrants unless CA pays interest. And if they pay interest, what's the value to issuing a currency?

  16. Fred

    What a ridiculous argument? The author probably plays Monopoly in his bedroom while playing with himself! CA IOUs are no better than Monopoly money: its the same BS thats been done to Social security except these are fungible. Next stop every state issues its own IOUs as currency. Then we can have Forex right inside the US.

    Author should should stick to fantasy Monopoly.

  17. Anonymous

    There is a good reason why Article 14 of the US Constitution prohibits the States from issuing thier own currency – which the CA IOUs clearly are – as defined in the Constitution. The power to print money, end effectively indebt the economy is something that only the Federal Government should be able to do. CA is impacting the other states, and since this currency is effectively local to CA, this will limit overall curency velocity, by carving a piece out of the overal total US economy and forcing it to trade within a single states border. This will discourage interstate commerce, and encourages intrastate commerce. Good for CA, bad for the rest of the country. This IS NOT A GOOD THING.

  18. carol765

    Marshall writes: "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."

    Not so fast: look at the table presented by Felix Salmon in his blog, when the IOU's were issued:

    A lot of people getting IOU's probably do not have to pay taxes to CA.

  19. Anonymous

    the US Constitution prohibits the States from issuing thier own currency – which the CA IOUs clearly are – as defined in the Constitution.

    This is precisely right. The California proposal described above is the functional definition of "legal tender". Less well known is the fact that citizens are not required to settle private debts in Federal Reserve notes, provided they agree to an alternate tender ahead of time.

    I cannot conceive Bernanke and the FRB will allow this to stand. But if they are that weak-minded or willed, then fasten your seatbelts. Momentous political events lie directly ahead.

    Let's assume this does come into effect. I see no reason these IOUs would remain confined inside California's borders. Example. Others outside CA could accept these "bills of credit" as payment at a 10% discount from face, knowing they could resell them at a 5% discount to anyone owing CA taxes. This kind of discounting is done every day with accounts receivable.

  20. King of the Paupers

    Jct: There’s nothing wrong with small denomination municipal or California State IOUs if anyone can pay their taxes with them. When Argentina’s government workers were faced with cuts, their unions talked 6 state governments into paying them with small-denomination state bonds which could be used to pay for state services and taxes by everyone.
    When the local currency is pegged to the Time Standard of Money (how many dollars per unskilled hour child labor) Hours earned locally can be intertraded with other timebanks globally! In 1999, I paid for 39/40 nights in Europe with an IOU for a night back in Canada worth 5 Hours. U.N. Millennium Declaration UNILETS Resolution C6 to governments is for a time-based currency to restructure the global financial architecture.
    Too bad California IOUs won’t be accepted in payment for state taxes and services like state bonds were in Argentina. Too bad California IOUs will be denominated too big to use as local currency. Too bad Argentina people were smart enough to avoid the tent-cities catastrophe and California people are too stupid to follow their example.
    If they make IOUs legal tender, I'll take back every joke I ever made about Girlieman Governor Musclehead if he engineers the California state currency lifeboat.
    But Philadelphia has an Equal Dollars system that could save them so they might be even stupider.

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