That question, along with the prospects of the state defaulting on a mountain of debt, are bound to come up after Gov. Arnold Schwarzenegger telegraphed his intention to seek federal aid. Earlier this year, the White House ruled out any such help, and there's no reason to believe that anything has changed. The governor's request is built around the growing concern that California won't be able to pay its bills and won't be able to borrow any more money. That still seems unlikely, and besides, there's really no mechanism for a default to happen. Bill Watkins, a professor at California Lutheran University who runs the Center for Economic Research and Forecasting, explores several not-so-happy the possibilities at newgeography.
Unfortunately, a formal bankruptcy is not the likely scenario. There is no provision for it in the law. Consequently, absent framework and rules of bankruptcy, the eventual default is likely to be very messy, contentious and political. Other states have defaulted. Nine states defaulted on credit obligations in the 1840s. Most of those states eventually repaid all of their creditors (see William E. English "Understanding the Costs of Sovereign Default: U.S. State Debts in the 1840s," American Economic Review, vol. 86 (March 1996), pp. 259-75.) Unfortunately, the examples in the 1840s are not much help in anticipating the impacts of a modern default. Circumstances are different, and things have changed, a lot.
The worst case would be the mother of all financial crises. According to the California State Treasurer's office, California has over $68 billion in public debt, but the Sacramento Bee's Dan Walters has tried to count total California public debt, including that of local municipalities, and his total reaches $500 billion. Whatever the amount, the impact of default could be larger than the debt amount would imply. Other states - New York, Illinois, New Jersey, for example - are in almost as bad shape as California, and they could follow California's example. The realization that a state could default would shock markets every bit as much as when Lehman Brothers failed. Given the precarious state of our economy and the financial sector, another fiscal crisis would be disastrous, with impacts far beyond California's borders.
True enough, but no one is looking for theatrics, which is what would happen if the state announced that it was, in effect, going out of business. Also keep in mind that the economy is getting somewhat better and Schwarzenegger is on his way out, two additional reasons why muddling through is the more likely scenario. Not that muddling through solves anything - it's just that all other options are politically or economically unrealistic.