Many states, such as California, Illinois and New Jersey already face multi-billion dollar deficits that must be remedied. However, as investors drive the costs of bonds up, many states may soon join those three with high budget deficits, and some states may even be insolvent.

Unlike the federal government, which can simply print more money by abusing the dollar’s status as the world’s reserve currency (such as QE1 and QE2) to handle deficit issues, state governments must buy bonds from the open market. However, as debts continue to rise, investors demand a higher yield from those bonds. This forces state governments to pay more in interest, which puts them further in debt.

Some analysts are comparing this situation to the financial collapse of 2008. Meredith Whitney, who forecast Citigroup’s downfall said, “The similarities between the states and the banks are extreme, to the extent that states have been spending dramatically, growing leverage dramatically.” This essentially is a recipe for bankruptcy and disaster if left unchecked.

Several states are not just cutting fat from the budget to make ends meet, they are also forced to cut muscle and even bone as well. New Jersey Governor Chris Christie had to cancel a tunnel project, despite the widespread economic benefits it was projected to provide. “The bottom line is I don’t have the money,” Christie told 60 Minutes. “I can’t pay people for those jobs if I don’t have the money to pay them.”

This crisis is preventing state governments from doing necessary infrastructure work, and developing economic programs, another reason why the unemployment rate remains high. However, as long as unemployment is high, states will be unable to collect tax money from large numbers of people, and as long as they cannot collect taxes, they will have to rely on a combination of bonds and reduced spending.

Outstanding municipal debt has soared to $2.2 trillion today from $1.4 trillion in 2000. State and local borrowing as a percentage of the country’s GDP has risen to an all-time high of 22 percent in 2010 from 15 percent, with projections that it will reach 24 percent by 2012, according to the Wall St. Journal.

As we begin a nationwide debate next year about tax and budget reform, the importance of the federal and state governments to control spending is now a dire and paramount issue. “I think next to housing this is the single most important issue in the United States, and certainly the largest threat to the U.S. economy,” Whitney said.

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