Red tide rising

Greece, Ireland, and other European nations have created huge debts that they now can't cover without taking painful austerity steps. Is the United States during the next decade driving off the same cliff?

No one seriously expects the federal government to default. After all, the feds can print more money and use inflation to devalue its debt in relative terms. Federal Reserve Chairman Ben Bernanke has taken steps in that direction already with his "Quantitative Easing" program. But states-and the 8,900 different local government entities authorized to take on debt and obligations on behalf of their constituents-don't own printing presses.

That's why some economists and experts in public debt financing are warning that it will take the default of only a couple of big states-or, more likely, a couple of big cities-to trigger a 2008 bank meltdown-style crisis in this country. That, in turn, could cripple the broader debt markets that will be critical to financing corporate growth and job creation as the nation struggles to recover from the deepest recession since World War II.

A number of states are in less-than-great shape, but even the worst among them have middle-of-the-road bond ratings. And structurally, their debt tends to be a relatively small part of their annual budgets. Troubled Illinois, for example, owes about $2 billion on its debt annually, but that's just 4 percent of its total budget. So it's unlikely to default on such a small account, thereby driving up its own cost of borrowing significantly. It would freeze state employees' salaries first, or take any of a number of other austerity measures.

The bigger problem for the states-and the big problem for most cities and other local governments-is the retirement money and healthcare coverage promised to current and former employees. Economists Joshua Rauh of Northwestern University and Robert Novy-Marx of the University of Chicago calculate that the 50 states have combined pension obligations-essentially off-balance sheet debt-of $5.17 trillion, $3.2 trillion of which remains unfunded. That's more than three times what the states owe their conventional bondholders, and it doesn't take into account the cost of future healthcare coverage for which state and local governments are on the hook.

A small but growing number of experts in public finance are ringing the alarm, warning that the day of reckoning may be only two years, or less, away. A larger number, however, figure that states and local governments have time, probably a decade, to get their debt and off-balance sheet obligations back under control. But that doesn't mean they have lots of time to waste if they're going to complete the restructuring by 2020. Changing local and state government finances is a notoriously slow and difficult process, subject to the whims of entrenched public employee unions and tax-averse voters.

Timothy Blair, head of Illinois' State Employment Retirement System, says there's no denying that problems exist in state finances. His agency has received only a third of the money it is owed by the state through the first six months of the current fiscal year, and the Illinois legislature is considering borrowing up to $4 billion more in 2011 to meet its pension obligations. But Blair also says the alarmists are hyperventilating.

"We're not always going to be in this situation," he said. "I would imagine that in the middle of the Great Depression it looked like the world was going to end. But it didn't. Things will get better. They always do. While it looks like our options are limited now, I have to believe that at some point we'll get back to natural growth in revenues."

Adam Stern, an attorney and public debt analyst at Breckinridge Capital Advisors in Boston, takes a less sanguine view, saying "a very challenging decade" stands in front of the states and cities: "All the sacred cows are going to get slaughtered," he said, referring to public employee unions' health and retirement benefits and the low local tax rates voters cherish.

Stern says he's no alarmist, but "we do have these significant structural problems. And if we don't begin to address them over the next couple of years, in three or four years we will be in a significant bind. The bond markets will be watching over the next couple of years to see who's going to come up with credible plans and who's not." ­-Dan Reed is a journalist in Dallas, Texas