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

For those who were worried that Wall Street had perhaps lost its creative juices after its recent spasm of busts and bailouts, fear no more. At the beginning of the month, California ran out of cash and began issuing funny-money IOUs to its creditors. As soon as that happened, the smart guys on Wall Street created a whole new market trading the IOUs. No doubt the IOUs will soon be bundled into more exotic financial instruments, which will be cut up into tranches, graded lazily by the ratings industry, and sold off to unsuspecting investors in Abu Dhabi and Helsinki.

What a perfect metaphor for our economic circumstances! California is literally drowning in red ink and political gridlock, with deficit figures that are staggering and portend worse news for the future at the same time that a bailed-out Wall Street is profiting from a new, and essentially useless, trading vehicle.

But the worse news is that what we are seeing in California is what other states—perhaps most of them—will go through soon. States are being squeezed in two directions. Rapidly declining tax revenues are creating short-term cash flow crises. Meanwhile, their long-term pension obligations are rising rapidly, even as the pension funds that were supposed to cover them have been devastated by the Wall Street decline, creating enormous long-term unfunded liabilities. These two forces are creating both short-term and long-term pain for states.

The magnitude of the numbers is shocking. In 35 of the 41 states with income taxes, revenues are down from the previous year. (Overall, income taxes accounted for 36 percent of all state tax revenue in fiscal year 2008.) Some of the largest states are suffering the most significant drops: New York revenue is down 49 percent; California, 20 percent; Michigan, 23 percent; New Jersey, 18 percent; Ohio, 15 percent; and North Carolina, 9 percent.

"Sales and use" taxes accounted for about 31 percent of state tax revenue in fiscal year 2008, and here there is a significant but slightly lower drop, because the purchase of essentials, which supply the bulk of sales taxes, has dropped less precipitously than taxable income. But the numbers are still sobering: Half of all states have seen drops in year on year revenue, with the largest states suffering again: California down 13 percent; Michigan, 8 percent; Ohio, 6 percent; Washington, 14 percent; and Minnesota, 11 percent.

The corporate income tax accounts for only about 6 percent of state tax receipts, and the figures resemble those for the personal income tax, with two-thirds of states suffering revenue declines: Alaska is down 32 percent; Connecticut, 33 percent; Florida, 25 percent; Maine, 23 percent; North Carolina, 26 percent; New York, 21 percent; and California, 8 percent.

The hole these tax losses create in state budgets is enormous, and as the length of the recession increases, it will only deepen.

The other threat to state governments—and local and federal governments, too—is long-term pension obligations. Governments at all levels have long underfunded their pension obligations. Before the stock market crash, the problem of underfunded pensions was real but, perhaps, manageable. The collapse of pension fund values has turned this problem into a crisis.

The shortfall in public pension funds is now estimated to be about $1 trillion. While these liabilities do not come due at once, and a Wall Street rebound could shrink that gap, the reality is ugly. In New York alone, where the state pension fund lost $44 billion, or about 28 percent of its value, during the last year, local government contributions to the pension fund are going to have to triple over the next six years to make up the shortfall. Local governments will have to supply an extra $5.5 billion per year. That tax burden alone—traditionally derived to a great extent from the property tax—could break the backs of many communities.

Where does this leave us? The Obama administration's first stimulus package offered a Band-Aid for state budgets. As the recession worsens and states face California-like catastrophes, more fundamental thinking is going to be needed.