California Faces Issuing IOUs Again

California, and its largest city, Los Angeles, continue to be embroiled in a political deadlock. Yesterday, Governor Arnold Schwarzenegger released a new executive order requiring state workers to take 3 unpaid days off per month starting in August.  State workers were furloughed a total of 46 days when Schwarzenegger issued a similar order in February 2009, which translated to a pay cut of about 14%.

California faces a $19 billion deficit for the fiscal year that began July 1, and Schwarzenegger is demanding pension, tax and spending reforms in the new budget.  He said that if the Legislature doesn't give him a budget that meets his expectations, he won't sign it.

It's unclear how long the latest round of furloughs could last, as Schwarzenegger and lawmakers enter the 5th week of the new fiscal year without a balanced budget.  Earlier this week, the governor hinted that he might not sign a budget before he leaves office next January unless it includes pension, tax and spending reforms.

State Controller John Chiang has warned that he will start issuing IOUs in August or September if the budget stalemate drags on in the Legislature.  Chiang said the cash-saving measure is necessary because the state is projected to run out of cash in October.  While thus far IOUs have been honored at face value, it is increasingly likely that recipients may ultimately have to take a substantial discount, if the budget crisis isn't resolved.  In the 19th century, when several states had to issues notes, holders lost about half face.

Los Angeles, like many other cities, is struggling with a budget crisis of its own.  The situation is so grave that city officials have been involved in tense negotiations with the Department of Water and Power (DWP) over the transfer of funds into the city treasury.

On Tuesday, executives with the DWP issued a sharply worded defense of their decision to withhold $73.5 million from city coffers in the middle of a recent fight over electricity rates, saying they did so to protect the utility's credit rating and its customers.

After a lengthy standoff between the council and DWP over proposed rate increases, City Controller Wendy Greuel reviewed the utility's records and concluded that, contrary to its claim, the utility could have made the promised transfer to the cash-strapped city budget without first being granted the increase.  Official with the DWP, in turn, accused Greuel of making misleading statements.

Unlike investor-owned power companies that pay regular dividends to stockholders, the DWP transfers more than $200 million each year to the city's general fund, which pays for police, fire and other basic services. This year, that transfer was broken into two installments — $147 million followed later by $73.5 million.

With so many states, cities and counties in financial trouble, it would seem inevitable that some will be forced to default.  It's highly unlikely that California, which has the 8th largest economy in the world, on a stand-alone basis, would be allowed to go under.  However, cities have fewer options to plug their budget gaps.  If even one major city becomes unable to meet their debt obligations, the spillover into the investor community will be most severe. 

And, if cities begin to default with police and fire support becoming extremely understaffed, can civil disobedience be far behind?

Marko's Take