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Are California IOUs Constitutional?

Yesterday, California started to issue IOUs (technically, registered warrants) to creditors since it is ensnared in a major budget impasse.  California has taken this step before, most notably in 1992, but they also issued IOUs during the Great Depression.

fires Are California IOUs Constitutional?
California’s Budget Fire… from Alex Miroshnichenko

Since the warrants are unavoidable at this point, I’ll shift my focus to another issue- constitutionality.  Is what California is doing legal under the terms of our Constitution?  And what is a ‘bill of credit‘?

What Does the Constitution Say

The entirety of this discussion will be framed around this section of the constitution, Section I Article 10:

No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.

Setting aside the issue of paying back debts with notes backed in gold and silver (read more here), the statement we are interested in is ‘emit Bills of Credit’. What exactly is a ‘Bill of Credit’?  Take a look at this definition from the Annotated Constitution at Cornell.  It seems to my untrained eye that we could be running into “[States are not forbidden] to execute instruments binding themselves to pay money at a future day for services rendered or money borrowed.“, and “Within the sense of the Constitution, bills of credit signify a paper medium of exchange, intended to circulate between individuals, and between the Government and individuals, for the ordinary purposes of society.”

States are not forbidden to issue bonds which will be paid off in the future for services or debt.  What does this mean?  I read it as debt that hasn’t yet been issued or services that haven’t yet been rendered.  For example, take a look at municipal bonds.  Municipal bonds are issued to allow a state to borrow money that hasn’t been borrowed yet.  Regardless of whether that money gets spent on projects that have already started, the point is investors invest in the bonds knowing that there will be a debt in the future.  In the case of California’s IOUs, the contracts have already been signed, and the creditors expect payment in currency.  Contractors expected California to pay them back in dollars, and are instead receiving these warrants.  In my opinion, this means that this clause doesn’t specifically make what California is doing legal.  However, IANAL (I Am Not A Lawyer), so please correct my thoughts in the comments section if you disagree.

Now, how about the second statement?  It is obvious that these IOUs are intended to circulate between the

constitution Are California IOUs Constitutional?
Remember This? From Jonathan Thorne

California Treasury and individuals.  The fact that they come from the State Controller means they are circulating from the government to individuals, and back again when they are redeemed.  However, are these IOUs intended to circulate between individuals?  This is where everything gets hazy.  I present two points in the yes column:

  1. Banks are willing to accept the credits.
  2. California law relating to Registered Warrants says, “Any interest paid on any registered warrant shall accrue to the person holding the warrant on the date of redemption.“  Does this mean that the warrants can be traded?  Yes; the holder of the bond on the maturity date is the payee.  Interesting.

We Won’t Get Fooled Again…

California IOUs are technically ‘Registered Warrants’, as described at the FAQ site of the State Controller.  The link in the previous article is the text of California law relating to the handling of these warrants.  These particular warrants are redeemable in October, and pay 3.75% interest.  Again, this is not the first time that California has issued Registered Warrants in order to pay its debts during a budget crisis.

In 1992, California’s budget presented the state with a similar issue.  With a $10.7 billion budget shortfall, on July 2, 1992, California sent out 12,000 IOUs.  At that time, banks freely accepted these IOUs and they were paying a 5.0% interest rate to their bearers.  Unfortunately for California, aspects of the 1992 program were eventually deemed illegal.  Notably, California cannot issue IOUs to state workers.  This means that state programs and contractors get the shaft initially.

More Questions than Answers

California has taken this drastic step before in order to rectify a budget situation, and who’s to say they won’t do it again.  People who signed contracts with the state of California expected to be paid in dollars, not pieces of paper printed by California.  However, this program hasn’t yet been challenged on broad grounds constitutionally, so it will continue.  In my opinion, I don’t think this program meshes well with the intent or the language of the Constitution.  Until a court rules, the practice will continue.  Of course, I’m not a lawyer.  I want to hear your opinion!  What is your reading of the Constitution, narrow or broad?  Sound off in the comments section.

Disclaimer: I hold a diversified portfolio of nationwide municipal bonds.  I’m also definitely not a lawyer.

Los Angeles thumbnail sourced from www.flickr.com/photos/15965815@N00/416554605, shot by Marshall Astor.
Posted by PK on July - 3 - 2009
      

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  • http://www.smallbusinessgrantsmoney.com KingofthePaupers

    Jct: There’s nothing wrong with small denomination California State IOUs if I or anyone else can pay their taxes with them. When Argentina’s government workers were faced with cuts, their unions talked 6 state governments into paying them with small-denomination state bonds which could be used to pay for state services and taxes and which everyone accepted as useful currency. Best of all, when the local currency is pegged to the Time Standard of Money (how many dollars per unskilled hour child labor) Hours earned locally can be intertraded with other timebanks globally! In 1999, I paid for 39/40 nights in Europe with an IOU for a night back in Canada worth 5 Hours.
    U.N. Millennium Declaration UNILETS Resolution C6 to governments is for a time-based currency to restructure the global financial architecture. See my banking systems engineering analysis at http://youtube.com/kingofthepaupers
    Too bad California State IOUs won’t be accepted in payment for state taxes and services like state bonds were in Argentina. Too bad California State IOUs will be denominated too big to use as local currency. Too bad Argentina people were smart enough to avoid the tent-cities catastrophe and California people are too stupid to follow their example.
    Sorry… forgot to say great post – can’t wait to read your next one!

  • http://dqydj.net PKamp3

    KingofthePaupers,

    This article suggests that at least one group, retailers, won’t have the ability to use these IOUs for taxes:

    http://www.sfgate.com/cgi-bin/blogs/pender/detail?&entry_id=42871

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  • http://cashforclunkersprograms.org/ Joe

    Regardless, the state of California is in a deep financial mess. Sadly, the Democrats and Republicans in the region can’t seem to agree on anything and this whole mess is getting worse with prolonged hardball politicking.

  • http://dqydj.net PKamp3

    Joe, it’s true, but you can’t leave the population out of the blame. The California Ballot Proposition system (see http://en.wikipedia.org/wiki/California_ballot_proposition) allows the people to vote for things without voting for a method to fund it. I’ve railed against populism before, but California takes the cake with this system to vote by poll.

  • Steve

    In HOUSTON & TEXAS CENTRAL R. CO. V. TEXAS, 177 U. S. 66 (1900) the issue was settled that the Warrants are not unconstitutional. The test is whether or not the paper is used in daily commerce. In this case the Warrants evaporate when exchanged for real money, whereas real money wouldn’t evaporate.
    http://supreme.justia.com/us/177/66/case.html

    It must not only be that they are capable of sometimes being used instead of money, but they must have a fitness for general circulation in the community as a representative and substitute for money in the common transactions of business. This is what is meant by the expression “intended to circulate as money.” These warrants were payable to the individual to whom the state was indebted or to bearer, and were issued to a creditor of the state. That the legislature may have desired to facilitate the use of the warrants by these provisions is perhaps true. But the members of the legislature knew that to issue the warrants to circulate as money would be to condemn them from the start. That the promise should be made to receive them in payment of debts due the state would add to their usefulness and to the willingness of people to take them in payment of debts due them from the state, and that, while in their hands, others might receive them in payment of debts was a possibility or probability depending upon whether the person taking them had opportunity to use them to pay some of his own debts to the state. That he might on some occasion be able to so use the warrant as to enable him to thereby discharge an obligation from himself to a third person who was willing to accept it does not bring the warrant so used within
    the ordinary meaning of the term “money.” It is not money in that sense.
    The provision in the state is substantially the same as that in the federal Constitution, in that the legislature is prohibited from issuing treasury warrants, treasury notes, or paper of any description intended to circulate as money, while in the federal Constitution the prohibition is against a state’s emitting bills of credit, and the necessity exists in both that the paper shall be issued to circulate as money in order to be in violation of either instrument. It has been held that the bills of credit prohibited by the federal Constitution are those which were intended to circulate as money, and hence the authorities as to the meaning of that expression, when so used, are applicable here.

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