I do not know what will happen if California defaults but I do remember what happened when NYC defaulted on its general obligation bonds in 1975 (I owned some). Investment banks, banks and the state government sat down and restructured the debts and imposed restrictions on the fiscal activities of the city. Essentially, there were institutions that could intervene and impose an acceptable restructuring.
Who is going to do that for Greece? The European capital market institutions would not be able (or even willing) to step up to the plate and negotiate a restructuring. The ECB is not allowed to. And the EC is not up to it.
There is an alternative -- the IMF has specific experience in this regard. But, allowing the IMF in would be an admission that the Euro area has not quite made it as currency union. The IMF, given its historical origin with exchange rate mechanisms, would convey a message that the big Euro players would not like to see. It would tar the reputation of the Euro even if there are no contagion effects on other PIIGS. Moreover, allowing Greece out of the Euro (or kicking) it out would be even worse.
That is why, I think, the Germans will pay up. They will pay to maintain the reputation of the Euro. Americans underestimate the commitment to the Euro.
Read the whole thing. Thanks to Mark Thoma for the pointer.
Some random remarks of mine follow:
1. Suppose Germany bails out Greece. Will the German taxpayers/voters stand for it?
2. In my opinion, the people who said that the euro would never work have been proven correct. If there were no euro, then Greece could reduce its deficit and at the same time devalue its currency. If you cannot devalue, then if Keynes is correct, the reduced deficit is going to cause a horrific recession. So if Germany or the IMF imposes conditions on a bailout that require Greece to tighten its belt, there could be rioting in the streets in Greece. On the other hand, if Germany does the bailout and Greece gets off scot-free in terms of being able to run deficits, I assume there will be rioting in the streets in Germany (not to mention a bad case of moral hazard in the other PIIGS.)
3. The PIGGS have government health insurance. Would you feel protected by it if you lived in one of those countries now?
4. The first phase of financial crisis gave capitalism a bad name. This phase may give European social democracy a bad name.