— James Saft is a Reuters columnist. The opinions expressed are his own. —

(Correcting name of academic to Peter Reuter on Feb 27)

Want to help fund the bank bailout, ease California’s budget crisis and shore up strained U.S. finances? Legalize drugs, tax the trade and save on interdiction, domestic enforcement and the prison and court system.

I’m only partly joking.

It won’t solve all of the U.S.’s problems and lord knows will cause some new ones, but the money is undeniably big enough to make a dent.

After all, it certainly helped Franklin Delano Roosevelt, who legalized alcohol in 1933 in the midst of the Depression and after more than a decade of prohibition, thus bringing a half a billion in 1933 dollars into public coffers in the form of tax revenue. By 1936, alcohol taxes were 13 percent of Federal revenue.

California Governor Arnold Schwarzenegger has a similar opportunity. He is facing a $42 billion budget deficit, his prisons are filled to bursting, in substantial part with people in on drug-related crime, and he will soon be forced by judicial edict to start freeing people. He also has an offer from a group call Let Us Pay Taxes, which claims to represent the marijuana industry and is willing to pay $1 billion annually in taxes if only he will legalize. No doubt they are low-balling.

The U.N. estimates the value of the U.S. cannabis market at $64 billion annually, while a paper by academics Jonathan Caulkins and Peter Reuter calculates that about half of the costs of drugs are in one way or another attributable by factors linked to interdiction and its perils (click here to read Render’s paper in pdf format).

But even if you cut the U.N. number in half and only tax it at 50 percent, a lower tax than many states and localities put on tobacco, you’d still get more than $15 billion nationwide. If California consumes its 13 percent share, in line with GDP, and I am betting it does, you are looking at something on the order of $2 billion even before you take account of lower costs. Harvard economics professor Jeffrey Miron has a lower estimate, at $7.7 billion annually nationally in lower spending and $6.2 billion in extra revenues.

Of course, these figures could fluctuate wildly depending on levels of compliance and market factors.

But why stop at cannabis? Just as Roosevelt decided that prohibition of alcohol was a failed policy the U.S. could no longer afford, perhaps the costs of re-building the U.S. banking system and lifting the country out of a severe recession will prompt another radical plans. I wouldn’t bet on it, but strange things are happening all over.

A BILLION HERE, A BILLION THERE

And if we start including other drugs the billions will only mount. There is another $100 billion in annual illegal drug sales in the U.S. outside of cannabis, which might produce another $25 billion annually in revenue by the same maths. The U.S. Federal government alone spent $13 billion on the drugs war in 2002, not counting prison costs.

Then there are other costs of the American drug interdiction efforts internationally, not least in Afghanistan, where opium revenue fuels the Taliban. The U.S. spends more than $1 billion a year there on anti-drug efforts, but opium money undoubtedly raises the total costs for the U.S. by much more.

The stream of income from all of this extending into the future is very valuable indeed and would go a way towards paying the price of fixing the banking system.

This brings us to another point of weakness for the U.S.; namely its ability to fund all of the costs it has already taken on and is likely to have to shoulder in the next several years. Moody’s credit rating agency did what everyone has pretty much taken for granted for a while not long ago, acknowledging that the U.S.’s AAA credit rating is being “tested” and falls into a category below those on the top shelf like Canada and Germany.

It’s not all wine and roses though. Cheaper legal drugs may lead to a spike in use, which might hit productivity and impose lots of costs, such as higher health and other welfare costs. All of those prison, military and law enforcement jobs are a huge source of stimulus, and the cut backs implied by legalization would raise transitional problems.

Moreover, drug legalisation, just like for alcohol, is essentially a moral and political decision about which reasonable people can disagree. It’s also, to put it mildly, not very likely.

Still the war on drugs rolls on, costing billions, creating huge incentives for violence and crime, imprisoning hundreds of thousands and seemingly never much closer to victory. The waste and misery involved must make it rival the sub-prime bubble as a misallocation of resources.

Perhaps one stone will end up killing two birds.

— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click here. —