California will gladly pay you Tuesday ...

John W. Schoen Senior producer • Profile • E-mail

If California is going to issue IOUs instead of paychecks for employees, can the employees use the IOUs to offset their tax liabilities?
— Ruth D., Ohio

It would be a fitting use for this quasi-cash to send it right back to the government. But for most state workers, it likely won’t get that far.

For starters, the law bars paying state workers with anything other than real money. But plenty of other people owed money will have to figure out how to get by for a bit without it.

To save cash, California will print up $3.6 billion in funny money this month to pay some of its other bills — mostly to vendors who sell goods and services to the state. These include both major corporations and mom-and-pop operations that can ill-afford the disruption in their cash flow. Some of these businesses may have to fold, generating more layoffs in a state where the official unemployment rate already stood at 11.5 percent in May.

In the short run, businesses or individuals could send the bogus bucks right back to Sacramento to pay taxes. But these IOUs will likely mature in 90 days, which means the state will convert them back into cash — with interest — before most people have to pay their taxes in April. In the meantime, the IRS will continue to require that employers withhold taxes from most workers’ paychecks. So the IOUs can’t be used to offset that federal tax liability.

It’s also not clear whether banks will accept this funny money once it’s issued. Most did so the last time this happened in 1992, but the financial problems of both the state and the banks are much worse than they were 17 years ago. If banks do accept IOUs, they’ll probably pocket the interest paid when the IOUs convert back to cash. Or they may charge a fee to cover the risk that these faux dollars turn out to be worthless.

Given the sorry state of the state’s financial and political affairs, that’s not an unreasonable fear. State officials in Sacramento have been flailing for years as this budget nightmare has escalated. But they didn’t create this mess by themselves. The people of California, having led the nation in a “property tax revolt,” have now shot themselves in the foot with a government that spends $26.3 billion more on services than it takes in on taxes.

This is roughly equivalent to cash-strapped family members who can’t agree on where to stop spending — so they just keep running up their credit cards and then ignore the bill. It worked for a few years. Now, after raiding the piggy bank and selling everything they can think of on eBay, there’s no more cash. Friends and family have cut them off. But instead of cutting spending or looking for a second job, these folks go right on spending.

State officials insist they won’t default on their bonds, a prospect that could have a catastrophic impact on the financial markets. Issuing IOUs may yet bring a round of defaults by local governments and state agencies that rely on the Sacramento to honor its financial commitments with real cash. By using IOUs, state officials are passing along the financial mess they created to local officials. If those local governments run out of cash, they may have to default payments to investors who bought their municipal bonds.

California may have started this trend of living beyond its means, but other states have picked up the same bad habit of winning favor with voters by offering popular services — without having the courage to explain to those voters how much it all costs. Now, with the collapse in property values and the slowdown in retail sales, tax revenues have plunged and budget gaps have widened. But in most statehouses, elected officials are still stuck at the finger-pointing stage.

Despite all the political theatrics, the solution is pretty simple. Taxpayers have to pay more to cover the cost of the services they don’t want to give up. Or they have to expect a lot less from state government — including big cuts in basic services like education and road repair.

Just like the family that spent more than it could afford during the bubble, the party is over for state governments. We may be only beginning to feel the hangover.

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