Should States Be Allowed to Create Currency?

Marshall Auerback says California is challenging the federal monopoly on money creation:

Schwarznegger to Obama: Watch and Learn, by Marshall Auerback: According to the San Diego Union-Tribune, Republicans and Democrats alike embraced legislation last Friday that would make California IOUs legal tender for all taxes, fees and other payments owed to the state.

Effectively, California is using its IOUs to create a currency. If this bill passes it would allow California to deficit spend just like the Federal Government and with the IOU's acceptable as payment of state taxes, it instantly imparts value to them. In effect, what you have is a state of the union creating a sovereign currency right under the noses of Treasury, Fed. They are stumbling their way into it...

It will be viewed as a stop gap measure at first, and then could very well become entrenched as states realize they have a way to escape balanced budget requirements..

The ... Federal government retains this monopoly under our existing monetary arrangements. If California is successful here in allowing its IOUs to pay tax, it has profound constitutional ramifications..

It will be interesting to see what the exchange rate is between California IOU and US currency - the IOUs do offer a yield, so should be less than par by design. I wonder if NY is next.

It will be interesting to see how this plays out. As California goes, will the nation follow?..

Setting aside the particulars of the California case and whether or not the IOUs are actually functioning as money -- that's debatable - very, very generally, the federal government has a budget constraint just like everyone else, well sort of like everyone else anyway -- most of us can't levy taxes or print money. Federal government finances must satisfy

G - T = ΔM + ΔB,

where Δ means "change in," G is government spending, T is taxes, M is the money supply, and B is bonds. The left-hand side is the deficit, and the right-hand is how it is financed. Thus, when G is greater than T so that there is a deficit in a given budget period, it must be financed by printing new money (ΔM) or issuing new bonds (ΔB). (If it helps, think of G as being 100 and T being 70 so that the deficit is 30. The deficit can be financed by printing 30 new dollars, by borrowing 30 dollars from the public, or some combination of the two.)

Now, for states, ΔM is zero since that would be money creation, and they are not allowed to do that. Thus, a state's budget constraint is:

G - T = ΔB

This must be satisfied each budget period. Because this constraint must hold each budget period, notice what happens if there is a legal or political debt limit -- in some states it is effectively B=0 -- and B is already at the limit (which means ΔB cannot be positive since that would add to the debt). If the state's budget deficit rises in a recession due to decreased tax revenue and increased spending on social services, then G must fall to eliminate the deficit, or new taxes must be levied, and the cutback in spending and/or increase in taxes makes the recession worse.

But what if a state was suddenly granted the power to print money? Then it could pay for that year's deficit without increasing bonds (i.e. debt) any further, i.e. G - T could be financed solely by ΔM if it so chooses. That is, the state now has the constraint

G - T = ΔM + ΔB

If B is maxed out politically or legally so that ΔB must equal zero (or be negative), then a deficit, G - T, could still be financed with ΔM.

Having fifty different currencies isn't necessarily bad, there are pros and cons to having a single currency across all fifty states, i.e. to forming currency union. With a currency union, individual members lose the ability to conduct independent monetary policy - there is one money and one policy so everyone in the group gets the same treatment - but that is less costly when the economic differences among the members of the union are small and the same policy is generally applicable.

There are many advantages to having a single currency (no exchange rate uncertainty and lower transactions costs to name just two), and for countries considering forming a currency union, there is a list of factors that are cited as working for or against unification. Many of these factors involve social, political, economic, and geographic factors, and generally, though not always, the more similar the countries are, the more likely it is that a currency union will be beneficial (e.g. similar levels of development, a similar mix of products, similar legal institutions, same language). In the case of the fifty states within the U.S., I believe the advantages of a single currency far outweigh the disadvantages, and states should not be allowed to create their own currencies.

Comments

[Roger Knights:]

During the Great Depression states and cities issued IOUs. How was that handled?

Jul 13 08:12 AM

[a. palmer jr.:]

This is beginning to get messy....what about counties? If our county runs a deficit, how about our county buying a printing press. I guess the local newspaper company could print IOUs instead of the daily paper. I don't like the idea of anybody constantly running a deficit...I think anybody with a brain can figure out that we need to start cutting expenses. Yes, some of it will hurt, but some expenses should never have been allowed to start in the first place. Like I stated earlier, almost anybody can figure out where their local expenditures can be lessened, so we should vigorously attack it from that end. If it means your local school has to stop plans for a new swimming pool or football field, so be it. Anything that costs money, locally or federal, if it is not absolutely necessary, should be cut out until we get this mess resolved.

Jul 13 10:07 AM

[Ferdinand E...:]

After reading this I know why I stopped teaching macroeconomics, even though I was a brilliant macro teacher. Not that I contest the author's economics - in some sense this is a very interesting paper - but although I haven't put a (strictly) macro equation on a blackboard in a couple of centuries, I know that the one in this article is for the birds.

Jul 13 11:08 AM

[derryl:]

Go Arnie!

Jul 13 11:35 PM