Debtor's Prison

Greetings fellow inmates:

Yesterday, 07.01.09, was a momentous day for US state finances. California, the country’s largest state economy and eight largest in the world, failed to reach an agreement on a plan to close a $24bln budget deficit. The wrangling has been going on for months, with both sides refusing to budge. Closing that budget deficit required either significant spending cuts or tax increases and Democrats and Republicans predictably split down the middle. The Governator also threatened many, many times to veto any bill that proposed tax increases in excess of what he had already proposed. Since states are not allowed to run budget deficits and borrowing to meet obligations is out of the question (in a way), California has ominously resorted to issuing I.O.Us starting today. This sets a precedent that is very important for our discussions about money, the USD and debt-backed currency in general. California is far from the only state with budget woes, and it will be quite interesting to see how other states respond to their own crises. If they follow California down the I.O.U. path, it could spell serious economic trouble.

To put it bluntly, California has flat out run out of money to pay its bills. Several other states are in a similar bind. As you can see from the graphic below, most states have run into deficits as the economy has significantly reduced the tax base. The total budget shortfall is $121bln for fiscal year 2009-2010, $166bln for 2010-2011 and $180bln for 2011-2012. In Pennsylvania, the governor is proposing a 16 percent income tax increase. In Illinois, a budget veto by the governor left the state with no spending plan at all. Indiana was a bit more lucky, barely avoiding a shutdown. A whopping total of 30 states have started their fiscal years without a budget. As you can see from the graph, there isn’t a single region that is performing better than the others.

Let’s explore what it actually means for these states to have run out of money. Pennsylvania will delay payment to vendors and businesses that have provided the state some services. Also, state workers will receive only partial pay on July 17^th and 24^th, and after that paychecks will be withheld entirely until the impasse is solved and then paid retroactively. In California, the budget woes will lead to a third monthly furlough day for more than 200,000 state employees, bringing their total pay cut to close to 14%. The state controller estimates that as much as $3bln of I.O.Us will be issued for the month of July, of which more than $1bln will be issued to the elderly, disabled, welfare recipients. Another $546mm will be sent to businesses that have state contracts and $159mm will be sent to students. California has one of the highest unemployment rates in the US and they are issuing I.O.Us to welfare recipients. These people most likely don’t have a rainy-day fund in case the state runs out of money and probably live check to check. If this doesn’t put a face on the problem I don’t know what will. Think about it, will people be able to go to the store and exchange these I.O.Us for food? Will the power company accept these warrants? It’s not difficult to see how this could be a powder-keg of social turmoil. To be quite frank, the American sheeple have proven numb to a plethora of sheer pillaging by the powers that be, but there is always a limit. What will happen when the basic necessities of a sector of the population are prohibitive because they are out of a job without any social safety net to speak of? We don’t know, but the possibility of this dragging on or spreading to other states certainly concerns us.

A more theoretical objection we raise to this issue is the notion of a state effectively issuing its own money. Perhaps objection is a strong word – what we feel is more like a very skeptical intellectual interest. These I.O.Us are effectively debt, both practically and philosophically. The state basically tells its workers “give us this month of labor and we will pay you back next month, we promise”. They also have an interest rate, yet to be determined, associated with them. The line between debt and money becomes even more blurred than usual due to the convertibility problem: one can’t go into a store and pay for stuff with them. Some banks however have announced that they will accept the I.O.Us, basically treating them like checks. The banks will then sit on them and earn the interest. It is unclear at the moment however, how much this will absorb some of the shock to the larger economy if people and businesses go cash them in. Ultimately, from a monetary point of view, these instruments are a form of fungible currency that is directly backed by California GDP. This effectively circumvents the USD in the Petri-dish that is this experiment. While we are not surprised by the fact that things came to this (they have been building up for months after all), we would have expected more of a response at a federal level to these extreme actions.

Ultimately, the question is where will the money come from to pay for the I.O.Us if they are out of it now? Tax revenues will remain depressed for the foreseeable future. Even if draconian spending cuts are set in place, the state would still be very vulnerable to a further decline in tax revenues if the recession worsens or drags on. It seems likely the federal government will have to bail-out California, and other states, eventually. What form this bailout will take is subject of speculation at this point. While it might seem unlikely, we would not be surprised if Uncle Benny gets in on the action and uses his FedBS to provide states with funds perhaps by buying up some of their newly-issued debt. Even if the funds come instead from the Treasury, Uncle Benny is partly supporting the gargantuan issuance of new Treasury debt by buying it up through quant easing. If more debt needs to be issued at the federal level in order to bail out states – the federal government is out of money as well, it just has the capacity to run deficits – then it would further pressure Uncle Benny to ramp up QE, as we expect he will. It will certainly be an interesting next few weeks seeing how this will pan out.

May your capital be safe and your investments prosperous,

MAAA