Friday, June 26, 2009

Can California Create Its Own Money?

An article in yesterday's New York Times, "California May Be Forced to Issue I.O.U.'s," reports that the government of the state of California might -- for only the second time since the Great Depression -- give its creditors "registered warrants" in lieu of actual payment in cash, check, or electronic transfer. What is a registered warrant, you ask? It's either money or not money, a contract or not a contract, and meaningful or meaningless. Allow me to be a bit more specific.

The basic idea is that these warrants are a way for California to "pay" their bills when due by promising to pay their bills later. Why issue an I.O.U. to someone who is already presumably holding a valid legal claim against you? Good question, one that goes to the very core of the "money from thin air" question that I have discussed in a series of posts this Spring and Summer (here, here, here, and here). But first, a bit more about the registered warrants and the reasons that the state might issue them.

According to the state Controller's Office: "A registered warrant is a 'promise to pay,' with interest, that is issued by the State when there is not enough cash to meet all of the State’s payment obligations. If there is sufficient cash available, registered warrants, or IOUs, will be paid by the State Treasurer on October 1, 2009." (There are actually two types of warrants, but I'll use the word warrant here to refer only to these registered warrants.) California's plan is thus to issue the warrants as a way of saying, "Your money's coming, really!" Thus, rather than simply failing to pay up on the date that payments are due, at least the state will acknowledge its obligations and tell its creditors that it won't be too much longer before the money arrives.

Of course, everyone knows that the money might not arrive on October 1, for exactly the reason that the money isn't there right now: political gridlock. The state government operates under rules that make tax increases nearly impossible to pass, and the state's budget deficit is so large that the spending cuts necessary to close the gap are too large to be politically palatable. (That states operate under budget rules that perversely require tax increases or budget cuts in response to a recession -- a sure recipe for a downward spiral -- is the subject for a different discussion.) The recipients of the warrants can thus reasonably worry that the warrants due in October will be paid with another round of warrants.

Ultimately, of course, this cannot continue. Even if the state were to succeed in permanently stiffing the holders of billions of dollars of the state's current obligations, no one will be willing to do business with the state in the future, once it becomes clear that the Golden State has become a deadbeat. The process of getting out of this crisis will surely be messy, but it is simply not possible for the fifth-largest economy in the world to operate for long without a government that pays its bills.

As important and interesting as the underlying fiscal crisis and political stalemate in California are, however, I want to focus instead on the warrants themselves as an exercise in thinking about the nature of money. The state Controller goes on to say: "Registered warrants, or IOUs, are legal negotiable instruments that are paid with interest." Sounds good so far. If they are legally negotiable, how can a person use them? The Controller's new frequently asked questions page includes the following intriguing information:
6. Will my financial institution honor a registered warrant?

Recipients of registered warrants should contact their financial institution to determine whether they will honor the registered warrant before the redemption date.

7. What happens if my financial institution will not accept the registered warrant?

You may decide to open an account at another financial institution that will accept registered warrants, or you will have to hold the warrant until it matures on October 1, 2009.

17. Will the State pay for any overdraft or late payment that occurs because I was issued a registered warrant and unable to redeem it for a period of time?


In other words, if there are banks that are willing to accept warrants as deposits, you can turn the warrants into cash. If not, too bad for you.

If you can find such a bank, however, you might not bother to deposit your warrant at all. After all, if you are holding something that can be turned into cash, you might not bother depositing it in a bank (since the warrant is already paying interest) or turning it into cash (if you have no current need for cash -- and you think the bank's offer to honor warrants will continue). You might thus hold the warrant, and if you later decide to buy something that is worth the amount of the warrant, you might simply exchange the warrant for the thing you want. The other party will accept the warrant as payment if she believes that the warrant will in turn be accepted by someone else!

California might, therefore, be creating money from thin air. In fact, you or I could conceivably create money out of thin air in the same way. Anyone who can create something (even something without intrinsic value) that other people will be willing to use in transactions has in a meaningful way created money. Similarly, if people do not accept California's warrants as cash equivalents, that means that California's attempt to create money has failed. It will have to get "real money" from somewhere else.

Which brings us to the ultimate question: What is real about real money? We accept greenbacks because we know other people will accept them. If others stopped doing so, dollar bills would not be money anymore. Similarly, many people think of gold as real money, but the only difference lies in whether more people will accept gold in payment than dollars. The dollar-denominated value of gold fluctuates in an open market, suggesting that gold is also an uncertain store of value.

The California warrants thus help to clarify the essential point about money. Anything can be money if people accept it as such. The key for a monetary authority is to make sure that people never stop treating a country's money as money. Even with the remarkable changes in the U.S. and global economies over the past year or so, the possibility of people no longer viewing U.S. money as money is simply not credible. Any monetary system can collapse as a result of gross mismanagement, but we are fortunate to have a system that continues to be run more than well enough to prevent this from being a serious threat.

[Aside: My colleague Sarah Lawsky, who brought the Times article to my attention and asked me to clarify the "Is this money?" question, raised a further point. Does California's issuance of warrants violate Art. 1 Sec. 10 of the U.S. Constitution: "No State shall . . . coin Money"? I suspect that the answer is pretty clearly no, but given that the name on this blog belongs to a constitutional law scholar, I'll leave it to him to answer that question either on the comments board or in a separate post.]

-- Posted by Neil H. Buchanan


Anonymous said...

I love this, but I must say, I figured out the nature of money back in the 1960's, when the subway fare was 15 cents, and I discovered that virtually any New Yorker would accept tokens as part of change of a dollar. "Gee," I thought, "the next step is for merchants to accept tokens, and presto! the Transit Authority has created money! And if I were well known, I could issue IOU's, and everybody would accept them, and I could create money!

It does seem that paying interest legally differentiates California's IOUs from money.

Michael C. Dorf said...

The prohibition on states coining money is not violated by people voluntarily choosing to treat the state's debts as negotiable. (This is why, e.g., states and municipalities can issue bonds--another form of debt that pays interest--that then trade in a market.). By contrast, as the greenbacks themselves say, they're legal tender for all debts.

Neil H. Buchanan said...

I take Mike's answer to mean that this is purely a matter of form, which confirms my suspicions. Surely a state could issue non-interest-bearing warrants, and people could trade them freely and treat them like money. Even if the state does so fully knowing that it is creating a type of money, it still will not violate the Constitution because it does not purport to issue a piece of paper that is legal tender. As a substance-over-form guy, I am surprised that I find this answer satisfactory. Yet I do.

PeonInChief said...

California has done this several times before--during the Depression and the various fiscal crises of recent years. Many state employees maintain their bank accounts at a local credit union because the credit union honors the warrants.

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