The Debt Crisis Beneath the Surface

A decrepit region faces a looming default, forcing its leader to issue grave public warnings urging the populace to accept austerity measures if they hope to persevere. Hundreds of miles away, one of the world's largest economic engines is sputtering, its unemployment rate persistently high and its budget deficit causing problems. Leading politicians have preferred to quibble over minutiae as widespread protests continue to gain strength.

Across the Atlantic, Greece and Italy have their own problems.

Debt in the USA
The two examples presented above are those of Detroit and California. Detroit faces $45 million in shortfalls and is currently the only major American city to have its bonds rated speculative (or "junk") grade by Moody's. California's struggles are fairly well-known, having garnered extensive coverage from Meredith Whitney during her long muni bond midnight ride. Michael Lewis also undertook an interesting investigation of California's debt troubles, recently chronicled in Vanity Fair and discussed during an October visit to Fool HQ.

However, these are far from the only contributors to America's next big debt problem. There were only 13 states with AAA credit ratings in the wake of Standard & Poor's downgrade of the U.S., and six must now close gaps of more than 20% of their anticipated budgets in fiscal 2012. The sum deficit across all states is $103 billion, which seems small compared to a reported $2.2 trillion cost of all state budgets.

Uncle Sam's free ride is over
The seemingly small deficit (a billion here, a billion there...) obscures the American Recovery and Reinvestment Act's backstopping of state finances the past few years, assistance that is shortly about to end. Only $6 billion is earmarked for fiscal 2012, and states will have to find a way to make up the difference on their own. Whitney found that state tax receipts flatlined in 2007, but research by the Federal Reserve Bank of St. Louis paints a direr picture: Tax revenues have actually fallen every year since the start of the recession.

Lacking a printing press, states have turned more and more to bond issues to make up the difference, forcing them to pay a greater amount toward debt service. A CNNMoney profile on Whitney found that half of Nevada's budget, 40% of Michigan's, and 20% of Arizona's, California's, Connecticut's, Ohio's, and Illinois' individual budgets now go toward paying off their debts.

Down to the end of the line
This leads us back to Detroit. Local governments rely on state assistance to meet their budgets, and tightening fiscal flows couldn't be coming at a worse time. Jefferson County, Ala., was one of several casualties this year on a list that includes Central Falls, R.I., and Harrisburg, the Pennsylvania state capital.

Jefferson County and Central Falls have already begun the default process. Harrisburg's situation is dire, but it recently suffered a legal smackdown from the state of Pennsylvania. The city's efforts to declare bankruptcy were stymied by state law, and its next step is receivership. Detroit must extract tough compromises from unions and pensioners or bankruptcy will be virtually unavoidable.

Whitney predicted a default wave costing hundreds of billions of dollars, which could have swept over as many as 100 municipalities. That has not yet come to pass, but local governments are hardly out of the woods. Their pension woes reflect those of the states, in a garish funhouse-mirror sort of way. While state pensions are underfunded to the tune of $700 billion annually, many local governments already struggle under pension costs four times as onerous as those handled by the states.

A vital link looks weak
Don't cheer the death of government just yet. State and local spending is a major component of the U.S. economy -- in 2008, these governments spent a total of $9,000 per citizen, amounting to 14% of GDP. One of eight workers in the U.S. is a state or local employee. If all those jobs were to vanish, unemployment would more than double to 21.5%. It would be absurd to suggest that all these jobs are at risk of extinction, but budgetary woes and pension problems are a steep hill to climb, and not everyone can make the ascent.

The big squeeze
Jefferson County, for example, is slowly losing population as employment opportunities evaporate. Detroit's decline from its Industrial Age peak has been precipitous, and the city has lost a quarter of its population in just the past 10 years. Saving dying municipalities will take much more than a cash infusion from higher levels of government, especially when the best labor is still mobile enough to pack up and look elsewhere for work.

Ford (NYS: F) and General Motors (NYS: GM) , despite their Detroit roots, now operate more factories outside Michigan than within it. Cajoling them with tax breaks isn't likely to change the equation, as more cars can be built with fewer workers with every incremental improvement in technology, and other states offer less-unionized alternatives.

San Jose, Calif., the capital of Silicon Valley, is swimming against a pension tide. Lewis' Vanity Fair piece paints a grim picture but glosses over the tax specifics. Cisco (NAS: CSCO) and IBM (NYS: IBM) , which employ more than 19,000 workers, pay a combined $50,000 in annual business taxes to the city. The property and income taxes their employees pay don't seem to be enough to keep the city's fiscal head above water -- police and firefighter payrolls take up 75% of the city's discretionary spending.

How will it end?
If I knew a solution, I would offer it. The problem starts with the states but ends in thousands of municipalities across the country. Many may find themselves unable to handle the swell of pension demands as local government workers retire in greater numbers. Reducing workforces will do nothing to solve the underlying problems of poor revenue growth and inadequate employment. While a few states may prosper as the best workers move to low-tax regions, the end result is harmful for the entire country.

Where do you see this leading? Let me know in the comments section below.

At the time thisarticle was published Fool contributor Alex Planes holds no stake in any company mentioned here. Add him on Google+ or follow him on Twitter for more news, insights, or the occasional attempt at wit. The Motley Fool owns shares of Cisco Systems, International Business Machines, and Ford Motor. The Fool owns shares of and has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended buying shares of General Motors, Ford Motor, and Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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