California has over $17 billion on deposit in banks that have refused to honor its IOUs, forcing legislators to accept crippling budget cuts. These austerity measures are unnecessary. If the state were to deposit its money in its own state-owned bank, it could have enough credit to solve its budget crisis with funds to spare.
"We make money the old-fashioned way," said Art Rolnick, chief economist of the Minneapolis Federal Reserve. "We print it." That works for the federal government's central bank, but states are forbidden by the Constitution to issue "bills of credit," a term that has been interpreted to mean the state's own paper money. "Sacramento is not Washington," said California Governor Arnold Schwarzenegger in May. "We cannot print our own money." When legislators could not agree on how to solve the state's $26.3 billion budget deficit, the Governor therefore did the next best thing: he began paying the bills with IOUs ("I Owe You's," or promises to pay bearing interest).
The problem was that most banks declined to honor the IOUs, at least after July 24. "They said something about not wanting to enable the dysfunctional state legislature," observed a San Diego Union-Tribune staff writer, "which is kind of funny as the federal government has been enabling the dysfunctional financial sector for almost a year."
On July 21, California legislators were strong-armed into a tentative agreement on budget cuts, a forced move that was called "painful" by the Speaker of the Assembly and "devastating" by the executive director of the California State Association of Counties. The cuts involve more job losses, more bleeding of school funds, more closing of facilities. Worse, they will not solve the budget crisis long-term. The state's economy is expected to continue to deteriorate along with its revenues. But without banks to honor the state's IOUs, California has no time to negotiate or explore alternatives. There is no "quick fix," says UCLA Professor Daniel Mitchell.
Or is there?More Than One Way to Solve a Budget Crisis
Among the banks rejecting California's IOUs are six of particular interest: Citibank, Union Bank, Bank of America, Wells Fargo, U.S. Bank, and Westamerica Bank. These banks are interesting because they are six of the seven depository banks in which the state of California currently deposits its money. (The seventh is Bank of the West, which loyally said it would accept the IOUs indefinitely.)
Banks operate under federal or state charters that grant them special rights and privileges. Chartered banks are endowed with a gift that keeps on giving: they can "leverage" the value of their deposits into anywhere from ten to thirty times that sum in interest-bearing loans. This "multiplier effect" is attested to by many authorities, including President Obama himself. He said in a speech at Georgetown University on April 14:
"[A]lthough there are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks 'where's our bailout?,' they ask the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth."
The website of the Federal Reserve Bank of Dallas explains: