The bloggers at bloggers at UMKC’s economics blog have been making the case that California’s IOUs are a currency. Randy Wray’s entry last Monday was particularly provocative because he suggests a movement to loosen national government power is supporting similar moves in other jurisdictions. Wray writes:
Some commentators have argued that the proposed California "warrants" are similar to local currencies (see, e.g., Mark Thoma). In this piece I discuss experiments with local currencies and continue my argument that if California were to accept its own "warrants" in payment to itself, it could turn these into a functioning currency free of the defects of local currencies.
Interest in local currencies has soared in recent years, with nearly 100 U.S. communities experimenting with them. While proponents offer a variety of arguments in favor of local currencies, they share three common themes. First, there is concern that the use of a national, monopoly, currency creates a variety of economic, social, and environmental problems. Second, local currencies are said to improve regional communities, again across several dimensions including economic, social, political and environmental spheres. Third, many proponents want to reduce the power of national government, recognizing a relation between the monopoly of currency issue and centralization. They believe that decentralized money would shift power back to the communities.
However, previous adventures in local currencies have failed miserably as Wray later attests:
As discussed, most local currencies have failed (of the 82 created between 1991 and 2004, only 17 remained by 2004). Those that succeeded shared some combination of the following characteristics: an exchange rate pegged to a strong national currency by a trusted institution; substantial supplies of unemployed or underemployed workers; businesses operating below capacity; and a strong community spirit, led by liberal, middle class residents. These characteristics are not always easy to replicate nor are they necessarily desirable. If the goal is to displace the national monopoly currency, linking the local currency to it appears inconsistent—especially if one fears national government policy is inflating away the value of the nation’s currency.
So I have another idea, which I got from a knowledgeable reader nicknamed aitrader. How about a Gold-backed IOU system. In response to a recent post I wrote on the similarities in the troubles in California and Ireland, he wrote:
Now here’s a curve ball for ya: what would happen if a state or even a private bank were to issue currency redeemable in gold or silver? What would the implications be for the US Federal Reserve? This was the situation for many years in the US. Private banks often issued their own paper currency redeemable in gold and silver. There is nothing illegal about this, though one would assume a new law would be crafted and passed to prevent this from occurring. On that note here is what happened recently to a private currency issuer, https://en.wikipedia.org/wiki/Liberty_Dollar#Fed….
Interesting times…
So, let me explore his idea using Ireland instead of California. I want to use Ireland as the example here because, in discussing my California-Ireland post, the Economist pointed out that Ireland is the place where true problems lie. The Economist says:
There is a problem with Mr Harrison’s thesis in the fiscal policy department, however. California has faced credit downgrades, but only because it is legally prevented from running deficits—it must default if it cannot make all its payments out of pocket. But California has a relatively small debt load, so far as nations go. If the state were allowed to run annual deficits, it seems highly unlikely that it would face pressure to balance its budget amid recession.
Ireland, on the other hand, is confronted by actual market pressures to prove that it can meet its obligations; it’s in trouble in an absolute sense. Ironically, both have fiscal difficulties that are not rooted in their federal status; Irish borrowing is limited by markets while California’s borrowing is constrained by the state constitution.
Point taken. So Let’s solve this problem.
Say Brian Lenihan is dispatched to consider how to prevent the government from sacking tens of thousands of workers in order to prevent the Irish from defaulting on its debt.
He suggests that California’s IOUs are a model for Ireland, but he goes one step further adding a redemption in 5 years at a 40% premium to the present spot price for gold, which represents a 7% annual return. Today, spot gold is trading at $950 an ounce. So, a 40% premium is about $1330 an ounce for gold. Lenihan would offer this deal to any and all creditors of the State in lieu of cash. The IOUs would be tradable in standardized amounts of 20, 50, 100, 1000, 10,000 and 1000,000 euros in order to facilitate a secondary market.
I got this idea from the high yield market where often bonds are issued with an embedded option to convert to equity at a premium or with PIK preferred shares thrown in as a kicker. The point of these options is to provide a sweetener to investors in order to get the deal done. These are the same kinds of deals that Warren Buffett did with General Electric and Goldman Sachs in 2008, and that he has previously done with USAir (now US Airways) and Salomon Brothers (now a part of Citigroup). If the embedded option increases in value significantly, the debtholder can make a lot of extra money. For Buffett’s options in Goldman, this has already occurred.
Here’s what the ‘investor’ gets in the case of the Irish IOUs:
- Bonds backed by the full faith and credit of the State paying a rate of interest that I suggest be a slight premium to the official 5-year bond.
- A 5-year out of the money European option to buy gold for the full face value of the bond at today’s price. Obviously,if you think gold is going up you would be willing to pay a lot for this option.
- An IOU that is not just backed by the full faith and credit of the sovereign like most currencies, but that has a tangible link to a real asset, gold.
What does the sovereign get?
- Ireland conserves cash without having to issue bonds. Ostensibly this would mean interest rates on Irish bonds could remain lower. That’s a huge deal, especially since these IOUs would not be considered legal tender.
- Ireland removes the restriction imposed by the Maastricht treaty as the IOUs are not cash and reduce the budget deficit. In effect, the government is free to add fiscal stimulus without those restrictions.
Obviously, the Irish government would have to hedge their gold commitment by buying Gold futures. But, the Irish could then legitimately claim that its IOUs were more than just a piece of paper. And, they would remove some of the constraints now imposed upon it by foregoing their own currency.