July 10 (Bloomberg) -- It’s time for investors in U.S. Treasuries to toke up, or at least support offers by pot smokers to help narrow California’s budget gap by paying taxes on marijuana.

Ludicrous as that legalization ploy may sound, California and its Governator aren’t in a position to dismiss any possible help. Neither are holders of U.S. government debt who would suffer if California’s slow-mo meltdown eventually ripples across the entire country.

So far, the prospect of a California collapse hasn’t worried investors outside municipal markets. U.S. debt holders piled into $19 billion of 10-year notes offered on Wednesday, pushing yields below 3.4 percent.

And California isn’t going to fall apart in a matter of days. While the recent issuance of IOUs to cover some bills is unsettling, the state is able to meet most of its obligations.

Governor Arnold Schwarzenegger and his dysfunctional legislators may even find a way out of the current imbroglio. The possibility that banks such as Wells Fargo & Co. and Bank of America Corp. may stop accepting the IOUs as of today, for example, may spur legislative compromise.

Even so, that’s not going to solve California’s long-term, structural issues. Today’s problems follow a similar budget mess, and a temporary resolution of a $42 billion deficit, in February.

Debt Downgrade

Unless California overhauls the way it is managed or the U.S. economy stages an incredible comeback, the state’s budgetary woes will only deepen.

While saying the state’s default risk “remains low,” Fitch Ratings downgraded California earlier this week. It said California’s governmental gridlock “could persist, further aggravating the state’s already severe economic, revenue and liquidity challenges.”

Plus, the enduring recession makes it more likely that California’s $26.3 billion budget gap will worsen, especially since the state is at the epicenter of the housing crisis and has higher unemployment than much of the rest of the country.

So what would President Barack Obama do if given the choice between allowing a California default and taking on more debt on behalf of taxpayers?

Do the math. It only involves one figure -- 55. That’s the number of Electoral College votes held by California, the most of any state.

Tough to Abandon

It would also be tough to let California go to the wall after saving Michigan and the United Auto Workers via General Motors Corp. and Chrysler Group LLC, not to mention keeping Manhattan afloat through the bailout of Wall Street.

Then there is the threat a California default poses to the entire U.S. municipal finance system. On its own, California’s almost $80 billion in outstanding debt is a small slice of the municipal securities market, which the Securities and Exchange Commission recently estimated at about $2.6 trillion.

The problem: if California defaulted, already gun-shy investors would likely hustle out of municipal issues just to be on the safe side.

The last thing shaky credit markets need is another run. That prospect would certainly stifle opposition on Capital Hill to any rescue.

Legislators are also mindful that mom-and-pop investors hold plenty of municipal debt. And a lot of them are senior citizens, the most-active voting block.

Broader Bailout

Not that the administration would necessarily cast a rescue as a California bailout. A program to give all states a helping hand would be more politically palatable.

Perhaps Stimulus Round II, already being floated in Washington, would be a possible vehicle. Or the federal government may choose to provide a backstop, rather than actual funds, for state and local debt.

That was what California State Treasurer Bill Lockyer proposed in May, when he asked U.S. Treasury Secretary Timothy Geithner for help.

While a cash bailout would be the worst case for Treasury investors, even a substantial increase in government liabilities will cause angst. And, if California got such a backstop, plenty of other states and municipalities will want the same.

“If the states’ debt burdens are piled onto the federal debt, it should further increase the cost of borrowing for the federal government,” says Axel Merk, president and portfolio manager of Merk Investments LLC, a Palo Alto, California-based currency fund manager. “I don’t think it will happen, but the risk of it happening is real.”

Buying Time

Even California’s efforts to buy time with IOUs hold risk. In 1932, Chicago was hit with “the largest and most important bank panic of the Great Depression” after the public lost faith in IOUs issued by that city, according to an article by Joseph Mason, a Louisiana State University banking professor.

The acceptance by large banks of California’s IOUs, given their questionable value, is also “probably not prudent at this time,” Mason wrote.

The flip side is that if California ever defaulted, and the federal government did nothing, Treasuries would probably rally on any market disruption.

Investors who count heavily on that outcome, though, may already be smoking something.

(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: David Reilly at dreilly14@bloomberg.net

Last Updated: July 9, 2009 21:01 EDT