The global financial crisis could be heading to a blue state near you: that is the latest grim news from the New York Times:  “Mounting Debts by States Stoke Fears of Crisis.”  Normally a cheerleader for the free spending (in bluespeak, compassionate) policies of the public sector union dominated, high tax, high cost states like California, Illinois and New York, the Times now warns that fiscal ruin could be at hand.

The problem is state debt.  New York, California and Illinois look more like Greece to their bondholders every day.  Since the November elections, investors have been dumping their bonds, and hedge funds are betting against them, perhaps realizing that a Republican House is not going to offer generous, condition free bailouts.

“It seems to me that crying wolf is probably a good thing to do at this point,” Felix Rohatyn told the Times.  Rohatyn is the legendary investment banker called in to bring New York city back from the dead in the 1970s and he remains one of the most respected voices in American business life.

The Times story compares blue state debt to the subprime crisis and the Greek meltdown.  A deeply disturbing graph shows a true panic underway as investors pull money out of mutual funds that invest in municipal bonds even faster than at the height of the market collapse in October 2008.  With as much as $4 trillion in off-the-books pension and health care liabilities, the worst hit states may soon be unable to operate without massive federal support.

The crisis could come much faster than Washington thinks.  States and municipalities sold more than $55.6 billion in debt this November even as individual investors reduced their holdings of mutual funds containing these funds by $5.37 billion in the two weeks ending November 24.  If supply keeps rising while demand sinks, sooner or later prices are going to crash.

If things go wrong in the markets for blue state debt, watch out.  If big blue states like New York, California and Illinois hit a point of market failure when private investors will no longer buy their bonds, Washington will have to decide what to do.  Fast.

It will be ugly, and it will hurt.

Will GOP legislators bail out the public sector unions and shovel cash into the maw of improvident and badly managed blue states like so many steaming German taxpayers bailing out the lazy Greeks?  Or will Congress sit on its hands while vital state services close down, unemployment spikes, and the financial markets panic?  Will all parties turn to the Fed to buy up state bonds?  If so, on what conditions and terms?

While an unprepared, polarized Washington argues, markets will be melting down.  Risk unnerves bondholders; the sight of clueless debates among angry politicians makes markets unhappy in good times.  In times of crisis this is a scenario for total panic.

It’s hard to overstate the havoc that a meltdown in the state and municipal bond market would cause.  Many private investors and retirees are heavily invested in securities long thought safe.  Worse, many pension funds, including state pension funds, have large positions in the muni market.  The meltdown could feed on itself as falling bond prices would undermine state pension fund reserves and raise the interest rate on new debt issues.  The panic will intensify and spread, sucking new states into the maelstrom — as more and more European countries have been affected by a crisis once limited to Greece.

Bond investors are much more skittish than stock buyers.  Any risk of default sends them running for the exits.  Without swift federal action, a crisis in the market for some cities and states would inevitably lead to sharp spikes in interest rates for other state and city governments whose positions suddenly looked risky.  Massive layoffs of government employees would be inevitable in a widening range of affected states, throwing the weak recovery off course and quite possibly bringing on the much-feared second dip of the recession. Many banks and other financial institutions like insurance companies hold significant portfolios of state debt; if those bonds tank in value, we could go back to the darkest days of the financial crisis of 2008 as big banks and insurance companies come running to Uncle Sam for more bailouts.

More TARP, anyone?  More huge bailouts of big banks?  More eye-popping federal deficits as world credit markets grow increasingly skittish?

None of this is happening tomorrow.  For one thing, fears about the eurozone are temporarily boosting US markets as nervous investors eye the chances that Spain, Italy and even Belgium will join the growing list of crisis victims. But Americans should not gloat; as Wolfgang Munchau points out in the Financial Times, the ineptitude and gridlock among European economic authorities is a major force in the market uncertainty there. We could quickly face the same problems here as Tea Party Republicans wrestled with Blue State Democrats over potentially the biggest state rescue package in American history.  The US government is less unwieldy than the many-headed Brussels monstrosity, but if Congress and the President are wrangling and small groups of Senators are blocking legislation at a moment of real financial crisis, things could get very ugly here very fast.

Back before the midterms, investors were justified in thinking that Democratic majorities in Congress would rally behind a Democratic president seeking to save the top Democratic states from a financial meltdown.  (Much of last year’s ‘stimulus’ actually consisted of emergency cash transfers to strapped states in order to prevent mass layoffs and service cuts.)  Now it is much less clear where the states stand and what kind of help will be available.  Uncertainty equals risk for bond investors: the White House and the Congress need to plan now to deal with the possible crisis.

A sudden storm in the muni markets will not be fun for Republicans in office.  It’s hard to see the Tea Party forgiving legislators who plump for a vast federal bailout of the big blue states (unfunded state and local pension liabilities plus unfunded health care pledges could total about $4 trillion); it’s hard to see voters forgiving a Congress that doesn’t protect the country from a massive financial breakdown.

But if Republicans will be damned if they do and damned if they don’t, Democrats will just be damned.  The prospect of a blue state fiscal crisis is an uncomfortable and threatening one for the GOP; it spells potential catastrophe for the Democrats.  The bankruptcy of the big blue states would symbolize the bankruptcy of Democratic party policies to wide swathes of the voting public.  Tensions within the Democratic Party would explode: unionized public sector workers would simply not be able to emerge from this kind of crisis without savage layoffs and agonizing cuts in their pay, benefits and pension packages.  All the promises (mostly) Democratic politicians have made to them over decades will be exposed for the hollow frauds they were.

Some Democratic voters, heavily dependent on state spending because they are state employees or because they rely on state and local spending for vital services, will want the party to fight for them.  But very few non-affected Americans want to be taxed or for the federal government to take on large amounts of new doubt to bail out the cushy pensions of public employees. Nor will voters in the non-bankrupt states want to bail out the ne’er-do-wells without strict conditions and limits.

There will be a racial dimension as well.  African-Americans will be disproportionately affected both by cuts in state services and by public sector layoffs and compensation cuts.  They will expect a Democratic Party to which they have been faultlessly loyal for many decades to stand up for their interests in a time of grave crisis.

Cuts from cash strapped state budgets are already rippling through the country — and they are not making people happy.  Cities across New Jersey are making massive cuts in their police forces.  Public colleges and universities are already reeling in many states; over the weekend the Times also reported that SUNY Albany has stopped allowing new students to major in languages like Latin, Russian and French.  (“Orwellian”, screamed an article in Le Monde.)

The fiscal meltdown of the big blue states, if financial Armageddon actually arrives, will be the biggest domestic crisis for the American people since the Depression, and the biggest crisis for the Democratic Party since the Civil War.  Smart contingency planning now in both Washington and the states is the best way to try to prevent the crisis from happening, if that is still possible; if the crisis comes after all, advance planning can keep a serious problem from turning into a historic disaster.

Let’s hope a shell shocked White House, a triumphant GOP and an overburdened Federal Reserve are devoting some time to thinking this through in advance.  Once a long threatening crisis actually starts, it is much too late to plan.