I don't understand your first paragraph. Taking their own IOUs is equivalent to reducing the debt. The problem is that they effectively want to borrow money against the IOUs for free, by refusing to accept the IOUs as tax payments.
Incorrect. If I am the state of California and you are a bondholder to whom I owe $1 in daily interest, which must be paid in cash, accepting IOUs in the form of tax receivables doesn't reduce my debt to you at all.
Taking them in reduces the liability 9and thus the interest payable) on the outstanding IOUs, which I agree looks like a good thing. Thing is that California needs the cash now whereas it has invoked its authority to pay on the IOUs later, because the state's contractual promises to its bondholders are more onerous than the promises it makes to its suppliers.
Unfair? Sure. States need cash more than they need goods, so they give better terms to suppliers of liquidity than they do to suppliers of goods and services.
In a best-case scenario for CA, it could pay down its entire debt with IOUs. After that, its finances would somewhat improve because the IOUs pay (I think) three percent interest rather than whatever the bonds do. But then, imagine if the bond holders could sell those IOUs to California citizens for 99 cents on the dollar so that they could pay their taxes with them. The state would suddenly have its own paper on its books and would then need to borrow 26 billion dollars overnight, and the bond market would spank them. Of course, in that same scenario, they could conceivably just pay out the IOUs again, which is how a normal currency works.
Taking them piece meal as taxes would do the same thing, more slowly.
