California State IOUs: who gets the shaft?

July 2, 10:31 AMPage One ExaminerTim Worstall

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The State of California has run out of money to pay its bills: it is therefore printing its own version of money, so called "registered warrants" or IOUs, to make those payments. But who is going to get the shaft here? Anyone who knows anything about politics should be able to answer that question (it ain't going to be the politicians now, is it?) but here is the answer in detail.

The first necessity is to realise that someone, somewhere, really is going to get the shaft. If an IOU is issued today, when is the State going to pay it back? The current rumor is perhaps in October. So does that mean that everyone who receives one is going to have to wait until October for their money? No, for two reasons. The first is that some banks, like Bank of America, have said they will accept them from their customers. The second is that there undoubtedly will be (as there were when this was tried before) investors and speculators who will purchase the IOUs from those who have received them.

So does that mean that everything will be just fine then, and no one is disadvantaged? No, not quite, for whoever buys an IOU today will have to wait at least until October to get their money. If they didn't buy the IOU then they could put their money elsewhere and get interest or make a profit. So, if they do buy the IOU then they'll want at least that same profit they could have made elsewhere (plus, perhaps, a risk premium for the fact that the State might not pay them back in October. After all, the great State of California is already breaking its word by issuing the IOUs, isn't it?). This procedure is nothing new, it's been commonplace for centuries. Indeed, it's pretty much the origin of banking in one sense and is known as the discounting of bills.

The discount applied to the bills or IOUs is of course the amount by which those about to receive them will get shafted. It might be quite low, a few percent over the next few months, it might be higher than that, it could be nothing, it depends upon what the banks and speculators decide to do. (More formally, it depends upon supply and demand, how many people want to sell the notes for cash now against how many people with how much money want to buy the bills now and wait for their money.)

So there is definitely at minimum a possibility of some people losing money over this, of their getting shafted. So who is it likely to be? Clearly, it will be those who are getting the IOUs from the State as opposed to those who will still be getting cash. But who are those two groups?

A little diversion here, to talk about an idea in economics called "public choice economics". At its heart this is just the simple observation that politicians and bureaucrats are not morally different from the rest of us. They do not work selflessly for the sheer joy of improving the public good: they are motivated by all the same things the rest of us are. Yes, they like the cash they take home at the end of the month just as we do, they don't like losing their jobs any more than we do and so on.

While public choice is a simply enough concept, it's not all that often that we can actually observe it in action out in the open. It's more normally hidden from view, in the back rooms of the political system. However, if we analyze who is getting the IOUs (and thus potentially the shaft) and who is still getting cash payments, well, can we see the politicians and the bureaucrats making sure that they get better treatment than some other groups?

As Felix Salmon points out, yes we can indeed see that. Here are the two main documents. Those who get IOUs and those who get cash payment.

That certainly looks like the most vulnerable in society are the ones at risk of getting that shaft and that the politicians and bureaucrats have been able to shield themselves from the consequences of their own actions, doesn't it?

Consider the public choice theory of economics proven.