If the Federal Government Won’t Fund the States’ Emergency Needs, There is Another Solution

Photograph Source: Henry Ngo – CC BY 2.0

Many states are now experiencing severe budget deficits as they cope with the combined collapse of tax revenues and corresponding expansion of spending brought about by the coronavirus. Although the most recent $3 trillion fiscal package of the House Democrats proposes significant funding for the state and local governments, the GOP and the president have already said it’s “DOA.” That’s despite the fact that California Governor Gavin Newsom has already announced that the federal government has “an ethical obligation” to send money to the states in order to fund many of the frontline workers working to contain the coronavirus. New York Governor Andrew Cuomo also has called for hundreds of billions more in federal funding for the states not only to get through this phase of the crisis but also to protect their citizens moving forward in the event of a feared second wave. Absent this assistance from the federal government, many of the country’s states might have to introduce cuts amid a crisis at a time when the economy has already collapsed into a depression. That would be the worst thing to do at this juncture.

Today’s dire situation evokes what many states experienced in the wake of the 2008 financial crisis (if not worse). At that time, many of the same arguments marshaled against revenue sharing for the states were being made (especially by Republicans)—namely, that this kind of a measure represented a bailout for fiscally irresponsible governments that were failing to adequately reform their bloated pension schemes or undertake “meaningful reforms” (which in many cases was code for weakening public-sector unions that espoused political views contrary to the prevailing orthodoxy). Former Wisconsin Governor Scott Walker (a noted union-buster when he ran his state) is making exactly this case today.

But the truth is that today we are in the midst of a pandemic. Unlike 2008, it is a federal government-mandated shutdown that is the key precipitating factor behind the states’ respective fiscal crises, not runaway pension funds or uncontrolled government spending.

Washington should therefore supply the funds required to help the states close their budget gaps and to maintain public services at baseline levels, for the duration of the crisis. That’s the norm. Anytime a state is hit with a national emergency, the federal government does not first demand that the state government get its fiscal house in order. It mobilizes national funding immediately to deal with the crisis at hand, whatever the cause.

If the federal government persists in ignoring the fiscal needs of the states, a more radical approach might be required. California’s own history provides a potential path forward.

Back in 2009, when faced with a similar fiscal crisis, California’s state controller, John Chiang, began printing IOUs in lieu of cash to pay taxpayers, vendors, and local governments. In the context of a $26 billion fiscal deficit, the amount of IOUs created was actually quite small: 28,750 IOUs worth $53.3 million issued initially. But these IOUs came with a potentially radical provision, namely allowing them to be used for personal income tax refunds—an action that effectively would have meant that California was de facto entering the currency issuing business.

The tax payment provisions of the IOU program were headed off before they came into use. There were indications that Treasury Secretary Timothy Geithner pressured the banks not to accept the IOUs as payment for taxes. In any case, the Obama administration ultimately passed a sufficiently large-scale fiscal relief package (the 2009 American Recovery and Reinvestment Act) that alleviated the need for the more extreme measures contemplated by the California state government at that time.

That said, the economics behind the 2009 California project were solid, even though the experiment was never seen through to its full conclusion. In the words of the American economist Abba Lerner, from his essay in the 1947 edition of the American Economic Review:

“The modern state can make anything it chooses generally acceptable as money… It is true that a simple declaration that such and such is money will not do, even if backed by the most convincing constitutional evidence of the state’s absolute sovereignty. But if the state is willing to accept the proposed money in the payment of taxes and other obligations to itself the trick is done.” [emphasis added]

The key insight from Lerner here is that in a world of fiat currencies (i.e., money established via government fiat), both the use of currency and the value of said currency are based on the power of the issuing authority, as opposed to some underlying intrinsic value (as would be the case, say, if a currency was backed by gold). As I have written before, “The tax (and the corresponding ability to enforce payment) is what gives an otherwise worthless piece of paper with pictures of dead presidents on it its value. Even though this paper is not ‘backed’ by anything, taxes function to create the notional demand for said paper dollars.” The tax provision itself imparts the value or, as the economist A. Mitchell Innes termed it, “A dollar of money is a dollar, not because of the material of which it is made, but because of the dollar of tax which is imposed to redeem it.”

There’s no question that if the California government were to pursue this course today, they would be moving in a radically new direction because money creation has long been a monopoly function of the federal government, as the issuer of the dollar. States and municipalities are currency users and, as such, are limited in their ability to spend by taxation and bond revenues raised in the capital markets. They do not have access to a currency-creating printing press.

But if California did move in this direction, it would not be historically unique. Economist Rob Parenteau and I have documented five instances of paper currency being used simultaneously and interchangeably in the U.S. in the 1920s:

1) Gold Certificates (redeemable in gold coin until FDR’s prohibition on private citizens holding gold)

2) Silver Certificates (redeemable for coin or bullion)

3) National Bank Notes (issued by U.S. government-chartered banks with equivalent face value of bonds deposited by bank at Treasury)

4) United States Notes (issued directly by Treasury and called Legal Tender Notes, but with no “backing”)

5) Federal Reserve Notes (redeemable in gold on demand at Treasury or in gold or “lawful money” at any Federal Reserve Bank, until FDR’s prohibition, when it was just declared legal tender redeemable in lawful money at the Fed or Treasury).

Similarly, in this instance, the proposed IOU would not replace the dollar, but could operate in parallel to extinguish state liabilities. By no means would this fully resolve California’s fiscal crisis (or any other state that adopts the proposal for that matter). But imparting a value to these IOUs (i.e., letting them be used to settle state tax) would ensure a demand for them and mitigate the immediate budgetary crisis faced by the states.

To be clear, this is not an ideal way to proceed. Far better would be immediate per capita distributions to all states to allow them to sustain relief efforts and public health policies designed to mitigate the spread of the coronavirus, similar in model to the range of block grants that the federal government has in the past allocated nationally.

There is nothing inherently radical or “un-American” about this proposal. Indeed, it was a Republican president, Richard Nixon, who first introduced the concept. As I described in an earlier piece:

“Nixon viewed the federal bureaucracy as a poor revenue manager and argued that much counter-cyclical spending should go to the states, as they are closer to people’s needs and more directly hurt by falling revenues. But instead of simply cutting taxes, as later conservatives would, he proposed a new system called revenue sharing, which redirected funds to states and municipalities… Passed after contentious debate, the State and Local Assistance Act of 1972 initially delivered $4 billion per year in matching funds to states and municipalities. The program, which distributed some $83 billion before it was killed by Ronald Reagan in 1986, proved enormously popular.”

And the mechanics today would likewise be very easy: the Treasury would appropriate the funds and the Federal Reserve would credit the states’ existing bank accounts. The states in turn could then spend those dollars to sustain vital services. This is another instance where the GOP’s obliviousness to the ramifications of the states’ respective fiscal crises is likely to make things far worse. At a minimum, Governor Newsom should force the issue before resorting to the drastic expedient of cutting essential workers.

The U.S. already operates a fiscal transfer union, so the chaotic issues of distribution and implementation that have characterized many of the newer federal relief programs would be non-factors here. There would be no bureaucratic obstacles to overcome, as has characterized other programs, such as the government’s Paycheck Protection Program (PPP) nightmare.

Done on a per capita basis, it would be effective at dealing with fiscal crises in a manner less prone to the kind of fascistic crony capitalism that continues to erode the political legitimacy of our existing institutions. But if per capita revenue distributions fail to pass muster in Washington, then California, as it has done so many times in the past, should be prepared to adopt a more radical policy stance in order to help lead the nation as a whole out of a self-inflicted fiscal crisis.

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Marshall Auerback is a market analyst and a research associate at the Levy Institute for Economics at Bard College (www.levy.org).  His Twitter hashtag is @Mauerback

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