More On Those California IOU's

As mentioned last Thursday, the State of California has started issuing IOU’s in place of cash as a result of a political impasse in Sacramento. One commenter here chastised us that this has been done many times before and it is much ado about nothing. I beg to differ.

These IOU’s are useful to the state of California and the recipients only as long as banks are willing and able to exchange them for cash. It appears now that the banks are sending signals that they don’t want to accumulate this quasi currency for much longer:

A group of the biggest U.S. banks said they would stop accepting California’s IOUs on Friday, adding pressure on the state to close its $26.3 billion annual budget gap….The banks had previously committed to accepting state IOUs as payment. California plans to issue more than $3 billion of IOUs in July.

The California IOU example may wreak havoc with President Obama’s monetary and fiscal policy goals as it exposes the risk of issuing fiat currency. Kevin Hassett made this point quite clearly yesterday:

The California morass has Democrats in Washington trembling. The reason is simple. If Obama’s health-care plan passes, then we may well end up paying for it with federal slips of paper worth less than California’s. Obama has bet everything on passing health care this year. The publicity surrounding the California debt fiasco almost assures his resounding defeat.

It takes years and years to make a mess as terrible as the California debacle, but the recipe is simple. All that you need is two political parties that are always willing to offer easy government solutions for every need of the voters, but never willing to make the tough decisions necessary to finance the government largess that results. Voters will occasionally change their allegiance from one party to the other, but the bacchanal will continue regardless of the names on the office doors.

California has engaged in an orgy of spending, but, compared with our federal government, its legislators should feel chaste. The California deficit this year is now north of $26 billion. The U.S. federal deficit will be, according to the latest numbers, almost 70 times larger.

This type of scheme only works as long as the money and financing flows and therein is the flaw of the “business as usual” argument. If the banks refuse to accept the California IOU’s it is game over. If the banks continue to eat the scrip issued by the state it is a de facto bailout of California’s fiscal insanity by the U S taxpayer.

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