People who warn about the insolvency of the U.S. government are wrong. A government that can legitimately print fiat currency can never really be insolvent, because more currency can always be printed to pay off debts and expenses. Because of their inability to print currency, U.S. states face real debt limitations. As California has discovered, a state can run out of money. Federal bailouts of insolvent U.S. states are politically unfeasible. To this point, they have been hidden under the veil of “stimulus” money, but economic stimulus packages will not be passed forever. There are, however, a couple of tools that are politically tolerable and produce the desired effect, but both of them have the undesirable side-effect of increasing federal expenses and the moral hazard of rewarding fiscal irresponsibility.
1. The federal government can buy state bonds. While this solves the immediate cash flow problem, it is even worse than a bailout in the long run. Racking up too much debt is the primary reason for state insolvency in the first place. Owing even more money only exacerbates the problem. This solution merely transfers the federal government’s fiat currency debt advantages to the insolvent states. The silver lining for states in this solution is that the Congress would have a fairly easy political sell if it wished to forgive state debt, and if it did so, states could use federal cash to pay their expenses and their debt. The bad news for the American people, of course, is that all of this would still mean more public debt at the federal level.
2. Big banks can cash state I.O.U.s. Small banks could try this too, but with risk of bankruptcy. When states run out of money, they must resort to writing I.O.U.s to their employees, creditors, and contractors. A large bank like Bank of America can cash these, and hold them to be paid later by the state, or by the federal government. Even if governments never pay the I.O.U.s, the large banks that hold them have little cause for concern. Between the goodwill they gain by cashing I.O.U.s, and the persistent doctrine of too-big-to-fail, it is inconceivable that such banks endangered by state I.O.U. exposure would not receive an “emergency” bailout.