What to do about California?

Megan McArdle ponders whether or not California is just too darn big to be allowed to fail. As she writes, a California bankruptcy will affect all of us economically, not just those in the state.

I am not under the illusion that this will be fun. For starters, the rest of you sitting smugly out there in your snug homes, preparing to enjoy the spectacle, should prepare to enjoy the higher taxes you're going to pay as a result. Your states and municipalities will pay higher interest on their bonds if California is allowed to default. Also, the default is going to result in a great deal of personal misery, more than a little of which is going to end up on the books of Federal unemployment insurance and other such programs.

Then there are the actual people involved. Whatever you think of, say, children who decided to be born poor, right now they are dependent on government programs, and will be put in danger if those programs are interrupted.

However, we don't have the money to put off California's day of reckoning. We won't suddenly find the money in the federal budget. We're too busy bailing out the car and banking industries and trying to pull out of the recession. But even if we had the money, that will just be the start of a torrent of state and local leaders running to Washington demanding a similar deal. I'm sure that New York and Michigan are taking notes so that they will get their own handouts. And, as she writes, we will see the principle of moral hazard played out across the land.

But once the treasury has bailed out a single state, there will be a strongly implied guarantee on all such debt. So you don't give them the keys to the vaults, but you do leave a window open, point out where the money's kept, and casually mention that you've given the armed guards the week off.

I don't see how the government can make a credible committment not to bail out various localities who overspend, if it's already done so. And if that's the case, there's no way to avoid the moral hazard, so we might as well go ahead and offer the explicit guarantee in exchange for some sort of say in how the money is procured and spent.

So, it's going to be a terrible mess, but California needs to finally face up to the problems it has gotten into.

On the other hand, I don't really see another way out of it. If Uncle Sugar bails out California, California will not fix its problems. Perhaps you want Obama to make it fix the problems, using the same competence, power, and can-do spirit with which he has repaired all the holes in the banking and auto manufacturing sectors. But Obma is not in a good position to do this. California Democrats are a huge part of his governing coalition. All Obama can do is shovel money into the bottomless pit of California's political system.

Moreover, even if the administration could fix any of the core problems of California--and New York--and the banks--and the automakers--and the energy industry--they can't fix them all. Especially given how thinly staffed Treasury is. The president and his cabinet only have so much attention, more than all of which seems to be occupied by the problems already on their plate. They don't really have the time, knowledge, energy, or staff to take on running a whole 'nother government.

California will go bankrupt, muni and state debt will spike, the federal government will backstop humanitarian programs and very possibly all state and local debt, and eventually, California will figure out whether it wants higher taxes or lower spending. But we will not actually make the world a better place by enabling the lunatics in Sacramento to pretend they can have both.