I May Have Been Overly Optimistic. . .

. . .in last week's post about what's ahead in 2011. According to Atlantic's Megan McArdle:

When we talk about government response to economic crisis, we tend to focus on the federal government; for one thing, it’s big, and it’s right there in Washington, where it’s easy to keep track of. But economic contraction is often felt most keenly by state and local governments, which deliver highly visible services like schools and police and fire departments.

Unlike the federal government, almost all states have to enact budgets that are nominally balanced. A recession may be the worst time to raise taxes, but it is also the worst time to cut services. Unfortunately, states have to do one or the other. And sometimes, as in those Depression-era school districts, they’re forced to do both.

This may be one of those times. State revenues collapsed in 2009, and though they’re now slowly recovering, the Rockefeller Institute reports that [they dropped as much nearly 17 percent on a year-on-year basis at the height of the recession]. At their current pace, receipts will take more than five years to recover to their 2008 levels. Some states, such as Alaska and Texas, had accumulated substantial rainy-day funds before the crisis, but most have relied on federal aid and budget gimmicks to stave off radical cuts. This year, the stimulus money will run out, and the new Republican majority in the House of Representatives is unlikely to allocate more--particularly since many of the worst problems are in blue states like California, New Jersey, and Illinois.

California has forced people to pay estimated taxes early, while giving IOUs to many of its suppliers. Illinois simply isn’t paying its suppliers at all. New Jersey’s new governor has already gotten into a bruising fight with the teachers union, and recently announced that he was scrapping an $8 billion second rail tunnel to New York City.

Such fiscal problems have been building for a long time. Politicians love to bestow goodies on their constituents, especially retirement benefits for public-sector workers--largesse that some future sucker ultimately has to pay for. Decades of this kind of behavior have left a lot of states with growing structural deficits. Many states have tried to paper over these shortfalls by issuing bonds or raiding special funds such as pensions; as a result, the overall debt of state and local governments has risen from $1.7 trillion in 2004 to $2.4 trillion in 2010, a 40 percent increase. The unfunded liability of the pension systems should also be added to that figure; according to economists Joshua Rauh and Robert Novy-Marx, that liability is more than $3 trillion, just for the states alone. Even when tax revenues eventually recover, this problem will not go away. . .

States with a permanent mismatch between taxes and spending will not be able to squeak by on budget gimmicks and backdoor borrowing forever; either they’ll find a way to bring their budgets into balance, or they’ll run out of money and default on their obligations. The path they choose will make a big difference in the future of the states, and of their citizens--and in the life of the nation as a whole.

Two words: sovereign default.