It's the year 2013. A large U.S. state can't come up with the cash to make a bond payment. A default would ricochet through markets worldwide. What happens next?
That's the scenario that a high-powered panel gathered to address this week at a conference in New York. For seasoned observers, the chance that a state would default on its debt ranges from remote to impossible. Yet the fact that the risk is being openly discussed shows the depth of the worries over the finances of states and cities.
Strapped for cash and committed to huge spending as their employees age, these governments are a looming vulnerability in the U.S. financial system. They also represent a drag on economic growth as deficits force them to slash services and staff.
The Great Recession left a yawning hole in state budgets as revenues collapsed. California faced a $19-billion (U.S.) shortfall this year. This month, it finally approved a budget, 100 days late, that filled the breach - for now - through cuts, delays and optimistic assumptions.
While California is usually the poster child for fiscal trouble, other states aren't far behind. By next spring, Illinois will face a deficit of $15-billion, or half of the state's yearly day-to-day spending. Nevada, too, will confront a budget hole of similar proportions.
The bad news is that absent a robust economic recovery, the situation only gets harder from here. Stimulus spending from the federal government, some of which went directly to help states, is nearly gone. Within a few years, pension and benefit payments due to retirees will swell, presenting states and cities with another fiscal ordeal.
It's that gloomy picture that is sparking the discussion of more extreme scenarios. Meredith Whitney, a financial analyst best known for her bearish views on U.S. banks, sounded an alarm last month, saying the predicament for states felt disturbingly familiar.
"I see a lack of transparency and an abundance of complacency on the part of investors and politicians, just as we saw before the banks imploded," she said. Her prediction: Cities could start defaulting on their debt as states, consumed with their own problems, stop sending funds their way.
Investors are nervous. Earlier this year, worried investors drove up the price of derivative contracts that insure holders against a state defaulting on its debt. Judging by the current prices of those contracts, investors think California and Illinois are less creditworthy than Egypt, Bulgaria and Vietnam, according to Markit Group, a data provider.
Experts who focus on public finance say default at the state level remains highly unlikely. California's Treasurer has said that the only thing that would prevent the state from repaying its debts is "thermonuclear war." The last time a U.S. state failed to pay its debt was in 1933. Arkansas had borrowed heavily to build roads and later found itself overwhelmed by its interest payments.
Unlike the federal government, states must balance their budgets for general spending. They borrow to build roads, schools and bridges, among other things. So while they have a growing debt load, it is not crushing. What's more, unlike cities, there is no bankruptcy procedure for states, which are sovereign entities in the U.S.
Dan Fuss, a veteran bond fund manager with Loomis Sayles & Co. in Boston, says a default by a state would "not be politically acceptable." Smaller entities, though, could face that risk, whether cities or other governmental units, like utilities or school districts.
Mr. Fuss doesn't minimize the states' troubles. "It's a huge headache," he says. "The brutally hard part is that a lot of good things for society are funded through the states." That includes a big portion of the spending on education and health care.
Experts say states will have to cut spending and raise taxes. They'll also try to shift some of their burdens - by asking the federal government to shoulder more and by reducing their own assistance to cities, which in turn creates other stresses.
Then there's improvisation. "If states have shown us anything, it's that they can find gimmick after gimmick after gimmick" to massage their finances, says Donald Boyd of the Rockefeller Institute of Government at the State University of New York. "They're creative, they're good at it."
Even if states manage to muddle through their current deficit problems, the longer-term dilemma of pension payments remains. One study by the Pew Center on the States estimated a $1-trillion gap between what states have set aside for pensions and what needs to be saved to meet such obligations.
"The piper must be paid," noted a report Wednesday from economists at Toronto-Dominion Bank. "Difficult budget financing choices will continue to exist long after cyclical budget gaps are closed."
If the conference in New York this week is any guide, more radical measures could emerge one day. The panel simulated a near-default in 2013 by "New Jefferson," a fictional U.S. state, though more than one participant slipped and called it "California" during the discussion.
Former Treasury secretary Robert Rubin was one expert on the panel, together with several distinguished economists. Pretending to be the U.S. president's advisers, they agreed to help the state make an imminent bond payment, but only in exchange for strict conditions. One idea they floated: an oversight authority that would effectively take fiscal decisions out of the state's hands.