During the height of New York City’s financial crisis in the 1970’s, President Gerald Ford had the good sense to turn down Mayor Abe Beame’s request for a federal bailout. The refusal prompted the famous New York Post headline, Ford to City: Drop Dead. More than 30 years later, as California Governor Arnold Schwarzenegger makes a similar plea to Washington, I hope President Obama will show similar restraint. Unfortunately, given Obama’s recent string of unwise economic decisions, it’s hard to imagine that his judgment will suddenly improve.

A federal bailout would spare California from having to make spending cuts needed to bring its budget into balance. The matter has become urgent since California voters rejected several tax-hiking ballot initiatives. Rather than taking the vote as a signal to dramatically curtail spending, the state turned to the feds. If they get a free pass, the politicians can avoid fixing any of their past mistakes or preparing California for the future.

California, like many states, expended its bureaucracy as the nation’s bubble economy inflated. When condos flipped like hamburgers and homeowners flush with equity spent like lottery winners, extra tax revenue flooded into Sacramento. However, instead of saving the money for a rainy day or paying off prior debts, the state government simply ballooned its spending. Now that the bubble has burst, and revenues are severely depleted, it is time for California to reconsider its excesses.

Governor Schwarzenegger’s claim that a federal guarantee is not a bailout is ludicrous. No one in the private sector will lend California any money because the state can’t pay it back. Just like AIG and GM, it needs federal help to stay solvent. And although the Federal balance sheet is in far worse shape than California’s, there is one crucial difference: Washington has a printing press, and Sacramento does not. With the ability to pay off debts with newly created funds, a federal default is not a concern.

However, if Obama comes to the rescue, none of the needed cuts will be made. Instead, California will continue to operate its bloated bureaucracy and will be in constant need of more bailouts. In other words, if Schwarzenegger gets his bailout, look for him to utter his famous line — I’ll be back.

But it’s not just Schwarzenegger who will be back, but governors from all the other states as well. After all, if the Federal government bails out California, by what right can they deny similar aid to other states? The bailout will send a clear message that states do not need to cut spending.

Similar to the reckless behavior that resulted from federally guaranteed mortgages, federal guarantees on state debt will counteract the market’s attempt to force states to act responsibly. As the market accurately prices-in the heightened risk of default, California faces staggering increases in its borrowing cost. Under normal circumstances, this pressure would force the state to act prudently now to diminish the risk of a future default. However, by allowing California to evade the bond market vigilantes, the stage will be set for much bigger losses.

The moral hazards created by state bailouts are tremendous. With federal guarantees given to profligate states, those states that had shown greater fiscal responsibility will face higher interest rates —as their bonds lack a federal guarantee. This creates the perverse incentive for all states to act irresponsibly.

Just as government-guaranteed mortgages lead the market to make overly risky home loans, federally guaranteed state obligations will set the stage for yet another crisis.

Federal backing of California bonds would effectively turn them into Treasury bonds, with the added appeal of being exempt from California state income tax. Therefore, the Treasury will be at a competitive disadvantage when it looks to issue its own debt to Californians. If it then has to guarantee the bonds of all the other 50 states, why would any Americans buy Treasuries when they can get identical credit quality on better terms from the states? The only real buyers left would be foreigners, who are already queasy about the Treasuries they own.

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The need to make good on state and federal obligations will further depress the appeal of all U.S. dollar-denominated debt. As a result, as real buyers flee the market, the Fed will have to run its printing presses even faster to pick up the slack. This will set into motion a self-perpetuating spiral of money printing and Treasury sales with a predictable result: hyperinflation.

In the meantime, by redirecting credit to California that otherwise would have gone to more credit-worthy borrowers, the government will worsen the credit crunch for the rest of the country. Since there is only a finite supply of credit, money borrowed by California will no longer be available to other borrowers. The effect is a less efficient allocation of capital that further undermines national productivity.

The only rational policy choice for Obama is to send Schwarzenegger packing. If he does, California will have no choice but to cut spending or default on its bonds. My guess is that, with their backs to the wall, the California legislature will choose the former. However, even if they default, at least the losses will be borne by those who freely assumed the risks. With a bailout, the losses will be shouldered by those who were not even parties to the transactions. If we go this route, we can all say hasta la vista, baby to our prosperity.

Peter Schiff is president of Euro Pacific Capital and author of The Little Book of Bull Moves in Bear Markets and Crash Proof: How to Profit from the Coming Economic Collapse.

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