California's Economy: Too Big to Fail?

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California is not alone in its fiscal misery. All but three U.S. states face budget gaps in the 2010 and 2011 fiscal years, with a collective shortfall of $350 billion, according to the Center on Budget & Policy Priorities, a Washington-based nonprofit. Michigan, whose economy was among the country's weakest even before the bankruptcies of General Motors and Chrysler, has also asked Washington for help. Treasury officials are considering helping the state's auto suppliers stay afloat to prevent mass layoffs.

While California is a huge state, some economists believe the harshest shocks from its distress may be confined to its borders. A hit to the technology or entertainment industry would be worse, economically speaking, for the rest of the U.S. than losses of state jobs for California services such as schools, universities, and hospitals, they say. "Losing private-sector jobs in export industries that drive the state's economy has more of a contagion effect," says Richard Ciccarone, managing director of McDonnell Investment Management in Chicago. "[Loss of] government workers have an impact, but the multiplier effect is not as big as in other industries."

Nearby states also would undoubtedly feel some pain. "The [economic] connection is not that strong unless you're talking about neighboring states with a trade connection like Nevada and Arizona," says Rajeev Dhawan, director of Georgia State University's Robinson College of Business. For example, Las Vegas would suffer if Los Angelinos make fewer trips to the city. "The further from California the state is, the less directly affected it will likely be."

Still, Boyd says that a default by California or any other state—or even severe spending cuts to balance their budgets—would take considerable stimulus out of the U.S. economy when it can least afford it. He says that state and local economies are pro-cyclical, meaning they are exacerbating the downturn even as the federal government pumps money into the economy. "States are raising taxes and cutting spending, while the feds are trying to achieve exactly the opposite."

Says Dhawan: "The fiscal landscape at the state and local level is more brutal than at the federal level, where you hear talk of 'green shoots' emerging. The exterior paint may look O.K., but the inside of the house is crumbling."

Herbst is a reporter for BusinessWeek in New York. With reporting by Nanette Byrnes and Christopher Palmeri

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