A Sad State of Affairs
The State of California is one of the most prosperous and desirous places to live anywhere on earth. It is the eighth largest economy in the world. Its cultural impact on the world is profound. Yet, the state is on the verge of issuing IOUs to pay its bills. Talk of federal “bail-outs” permeates the ether. Experts claim a perfect storm of economic down-turn, overly progressive tax system and collapsing credit market have led to the state’s cash crunch.
California’s cash crunch has made the issuing of IOUs to pay the state’s obligations a real possibility. Without cash in the bank, checks will bounce. California’s constitution, federal law and case law mandate that the state must meet certain obligations, such as debt service on its external loans. The state must have enough cash on hand for payments. Therefore, to ensure the state can meet its obligations to schools and repay external loans, IOUs may have to be issued in lieu of salaries and per diem payments to 1,700 legislators, state elected officers, judges and their appointed staff, as well as tax refunds owed to individuals and businesses. California State Controller John Chiang has indicated that his office may be forced to issue “IOUs” as early as February 1, 2009 depending on the “cash on hand” situation at the time.
What is an IOU?
IOUs are “Registered Warrants.” A registered warrant is a piece of paper issued by the State of California, with a promise to pay the bearer the amount imprinted thereon within one year of the date of issuance. Interest accumulates at the rate determined by the Pooled Money Investment Account. Simply put, the term “IOU” is more easily understood in the common vernacular than is “registered warrant.”
When an IOU is issued, it is not cash but a promise to pay at some point in the future. In the past, financial institutions have honored IOUs as cash, holding them until the situation is resolved and then redeeming them for their cash value plus interest. However, even if a financial institution agrees to accept and honor state IOUs, they cannot be issued electronically like normal state payments such as “direct deposit” of payrolls. Furthermore, advancements in the technology of check processing and fraud abatement programs make registered warrants more difficult and expensive to process. After all, they are not checks.
“All of this has happened before and all of it will happen again”
California has not resorted to IOUs since the 1992 budget crisis when the state operated without a budget for more than two months. During that time, the state issued registered warrants due to a lack of spending authority. In September 1992, the impasse ended when Governor Wilson signed a $57.4 billion Budget Act. In the ensuing years, a federal judge declared 1992 IOUs to be a violation of the federal Fair Labor Standards Act when the state issued IOUs to cover the payroll for 93,000 state workers.
This time, the conditions are somewhat different. In fact, the situation is unprecedented. In 1992, IOUs were issued because, without a budget in place, the Controller lacked the legal authority to make payments. During the impasse, money was accumulating in the State Treasury and bankers had confidence that a budget would be enacted in a relatively short time. They knew IOUs would be honored once a budget was passed and signed. The state’s credit rating was stronger as were the credit markets. The situation is quite different this time around. Should the state start issuing registered warrants, its credit rating would tank. Credit markets are strained and cash accumulating in the State Treasury is obligated, already.
Deferring the Problem
As of now, the Controller’s Office is not certain that IOUs will be issued at all. The Controller has stated that IOUs will be the option of last resort. Rather than issuing IOUs, the Controller’s Office is hopeful that other options, such as payment deferrals, which he has begun to implement, will keep the state afloat through the end of the fiscal year. In the short run, deferrals are preferable to IOUs because once the state starts issuing IOUs, California’s credit rating will collapse entirely. Deferral of payments to vendors and others, including those for state income tax refunds and many health and welfare programs, for 15 to 60 days will be taken first. Interest would have to be paid to vendors and to recipients of tax refunds, but the same would be true of IOUs. Such an option is dependent upon the daily cash receipt reports to the state. Already, the Controller has announced that he intends to delay $3.7 billion in state payments due in February, including estimated $1.9 billion in income tax refunds due to state taxpayers.
In the long run, deferring payments simply pushes the cash-flow crisis off by a couple of months, which could have the effect of compounding the already tenuous fiscal situation. The state would be responsible for covering its financial obligations that come due at the end of the fiscal year in addition to those it deferred in February and March. Furthermore, deferral of payments to vendors for goods and services can have a ripple effect through the economy that could worsen the state’s financial picture. Individuals who count on their tax refunds will be hit hard. Small businesses that do not get paid may have to seek short term financing to cover their costs or else lay off more workers. Although such actions may provide the state with additional breathing room, withholding money from Californians will prolong their pain and delays economic recovery.
Paying the Piper
Payroll issues are more complicated. The courts have ruled that the state cannot use registered warrants to pay employees. The state has obligations under the federal Fair Labor Standards Act to pay its employees for services rendered. Therefore, if IOUs are to be used to cover payroll, the Governor has proposed that employees would be paid minimum wage in cash with the remainder of what they are owed in the form of an IOU. This would be a technical and logistical challenge to accomplish but, also, it is not clear from the 1992 court decision whether such a method would be consistent with the court’s decision. However, it is clear that political appointees, judges, legislators, legislative staff, and exempt employees could be paid with registered warrants.
It should be noted that the recent plan announced by the Governor to furlough state employees is a separate issue from the deferral and IOU plan. It is complementary in the sense that the estimated $1.2 billion in savings will help relieve fiscal pressure. The Governor issued an executive order in December 2008 that will require employees to take off two unpaid days per month through June 30, 2010. Rather than laying-off countless state workers and putting them in the unemployment line, the furlough order could save jobs while offering monetary relief on the state’s treasury. Yet, nearly all the state’s constitutional officers, other than the Insurance Commissioner, are attempting to undermine the furlough plan by insisting they will not comply. Labor unions have filed suit against the state in an attempt to block the Governor's furlough plan. The Controller, siding with the unions in court filings, says he will not implement the pay reductions that would accompany the furloughs. Essentially, this renders them moot.
Financial institutions are uncertain about what they plan to do. If they have confidence that it will be a short term problem (30 days, or so) then it is likely that they will honor IOUs. However, paying vendors in IOUs complicates matters significantly because then the banks become, in essence, the state’s treasury and end up financing state operations. This is not something that they can sustain for very long as they have to go out into the credit market seeking loans to cover the state’s expenses. At five percent interest, it is likely that they can manage this for a while (even profit) but, in a tight credit market, will they be able to gather enough cash to keep everything going?
“The hall is rented, the orchestra engaged. It's now time to see if you can dance.”
California’s financial future is teetering on the edge of an abyss. Whether IOUs are issued or not, or payments deferred, the actions that the Governor, Controller, Treasurer and Legislature take over the several months will be historic in their proportions. Around the world, financial markets and political scientists will be watching to see how California climbs out of this mess. Lives and property will be affected. It is proving to be a tricky dance on a crowded floor.
For more information on this report or other Governmental Organization issues, contact Richard Paul, Senate Republican Office of Policy.