Posted at 08:52 PM ET, 07/30/2011
By Suzy Khimm

No matter how the debt-ceiling fight is resolved in Congress, it’s going to end poorly for the states.

If the country defaults, the states will be plunged into an immediate financial crisis: Investor confidence in government assets across the board would plummet — including the municipal bonds that states and local governments have traditionally relied upon to pay for new schools, roads, utilities, sewage systems and other basic infrastructure.

According to Dan White, an economist for Moody’s Analytics, states and local governments would see their credit ratings drop and their borrowing costs rise, and they would be forced to abruptly slash services and employees for the near future.

What’s more, one out of every three dollars of state spending comes from the federal government — $478 billion alone in 2010, according to the Pew Center on the States. And if the federal payouts slowed under a default, the states would struggle mightily to pay their existing bondholders. National default could lead to state default.

But what’s been largely ignored is how the very solution to the debt-ceiling crisis could also squeeze state and local governments that are already strapped for cash.

Among the biggest items on the chopping block in Congress are education and Medicaid spending — federal dollars that make up the largest parts of most states’ budgets. Nearly every state government has already set its budget for the next year — some for the next two years — under the assumption that federal spending would remain more or less consistent. If such money is abruptly pulled, states won’t suddenly be able to change their spending obligations or raise taxes.

“They’re going to have to eat that in some way, and many will pass [the cuts] onto local governments,” said Frank Shaforth, director of the Center for State and Local Government Leadership at George Mason University.

Amid the recession and dropping revenues, there’s already been an uptick of bankruptcy filings by cities, towns and rural districts across the country over the past two months and there could be more if Washington follows through on its promise to slash spending as soon as possible.

“The cities and counties that already in bad shape — they’re the first ones to go,” White said.

Even if state governments hold special sessions to cut spending further, their cuts will still “filter through to the local government,” he added. “Public-sector workers get laid off. There’s higher employment and lower spending.”

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