State governments are in even more trouble than they seem to be. Here's how to save them.

Two critical areas must be addressed. First, public pension liabilities have to be restructured. Since many state constitutions prohibit retrospective realignments—that is, lowering pensions that have already been guaranteed—states will need to lower guarantees for new employees radically, shifting from defined benefit plans to defined contribution plans. Second, and more fundamentally, states will need to shift more funding of health care and education to the federal government. In health care, where Medicaid is the primary state expenditure item, there currently exists a federal-state burden sharing arrangement. As the health care reform process continues in D.C., Washington must recognize that requiring greater state expenditures is simply not realistic at this time.

In education, we have already lived through the period of mandates without funding: the No Child Left Behind experiment. If we are finally serious about addressing our educational failings with standards set in Washington, the capital must also begin to fund the incremental costs of those improvements. The state reservoir is dry.

The danger we face from incipient state bankruptcy is both short-term and long-term. Short term, state spending cuts will exacerbate the economic decline. While we don't want public-sector spending to be our long-term engine of growth, state cuts now will merely deepen and lengthen the Great Recession. Longer term, a failure to support needed education spending will put us further behind in the single most important area of government investment—our intellectual capital.

But if everything does fall apart, at least Wall Street now has plenty of experience repackaging bad debt—whether subprime mortgages or state IOUs.