So how do you keep California from imploding? Well, step one is that you have to keep your eye on the problem: unemployment and a contracting economy. That means not simply trying to score as many points as possible politically. For Republicans, tax hikes are off the table. For once, I agree with them. The problem is, keeping step one in mind, is extreme cuts can’t be either because of the “Fifty Little Hoovers” problem.

There are three basic solutions that don’t involve contractionary fiscal policy, which will hurt regardless of whether it is done through increased taxes or through cuts.

(1) If there is any TARP money left, close California’s general fund budget deficit in whole or in part with that money. Or, in the alternative, give money like this directly. This probably won’t be too popular in the rest of the country, but the amount and the locality are hardly unprecedented (AIG, GM, etc.)

(2) Pass a second stimulus package for the whole country, but make sure that California gets as much new money injected into its economy as it is losing from state spending and its halo effects. (This means more money, since for every state dollar spent, there is a halo effect.) This faces other political difficulties, but it keeps the purse strings in D.C. instead of Sacramento, which appears entirely untrustworthy.

(3) Let the U.S. treasury guarantee California bonds. This way, California can run a deficit, but at an affordable price. You could even charge a premium and it would still be way cheaper than what California can get on the open market. We bailed out Mexico in 1995, and there was really not much recourse there. Here, the federal government has the sovereignty to get its money back if it needed to.

Number 3 of course could be seen as a bailout, but that’s for the politicians to handle. In reality, it’s a guaranty, nothing more. Much of the “California Bailout” speculation has focused on doing it, but making it so painful that it doesn’t set up a moral hazard situation for other states.

Where was that concern with AIG? California is not just too big to fail. If it fails, so does the US economy. There is no separation. There’s no opting to insure counterparties’ losses. Number 2 may ultimately be necessary, but seems like it would be more of a political fight than before. Number 3 seems like the best solution. It would probably come with some strings attached (again, why was that not a concern with AIG et al.) but I think we can live with that.