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2011: Year of Recovery, Year of Reckoning

This is what the case for optimism really looks like: Goldman Sachs' most famous analyst Jim O'Neill has proclaimed 2011 the Year of the United States. He sees stock market gains of up to 20 percent and job growth accelerating on the back of strong earnings and even better spending.

Sounds great! But how do we square this with the fact that states and cities are facing record deficits next year? How can we really expect an export comeback when our trading partners from Europe to Japan all seem on the cusp of a debt crisis?

The story of 2011 is a face-off between two forces: The Recovery and The Reckoning. In the U.S., incomes and hiring prospects are going up, while private debt and tax rates are staying down. That's the recovery. But public debt at the state, federal and international level hovers ominously over our economy. That's the reckoning.

FOLLOW THE DEBT

The easiest way to understand the recession, the recovery and the reckoning is to follow the debt. In the recession, credit froze all around the developed world, and private debt threatened to bury the financial markets. So governments from Spain to the United States pulled private debt onto their own balance sheets, essentially turning it into public debt. This stabilized the financial sector.* But now the debt is coming due, and not everybody can afford to pay it.

The United States federal government is safe (for now). But to the east and west of Washington, most governments are not so lucky. To the east, weaker Eurozone states like Greece, Ireland, Spain, and Portugal* that ran up huge deficits to support their economies are now facing sky-rocketing borrowing rates. Today they're cutting services and raising taxes to win back the trust of the bond markets. It remains to be seen if this austere pain will prevent a full-fledged wave of defaults, or merely delay that inevitability.

City, state and federal governments from Las Vegas to Lisbon saved the world from the recession. Now it's time to save the governments.

To the west of Washington, states and cities are feeling a historic pinch after three years of less money and more obligations to help the needy.  As the federal government winds down its stimulus in 2011, states face a cumulative $130 billion deficit that will result in higher taxes, lower services, and thousands of public sector layoffs. Cities with expensive pension bills have little choice but to reduce their retirement benefits or raise taxes. In Philadelphia, for example, property taxes climbed 10 percent last year.

THE PENDULUM SWINGS BACK

When the economy crashed, the private sector went on life support and the center of gravity shifted to Washington. The metro areas that relied on government spending -- to support health care, education, military or the public sector -- weathered the recession most successfully.

But now the pendulum has swung back hard in the opposite direction: The private sector is recovering and it's the public sector that's feeling the hangover. Income and spending has increased in every month but two in the last year, while spending has particularly zoomed up in the last half year. Job postings have soared to a three-year high. The private sector is back.

The public sector -- not so much. States and local governments have already laid off more workers in the last half year than any other sector of the economy. It will only get worse as state and city deficits yawn without government stimulus money to plug the hole. State capitals, so buoyant during the recession, could face the biggest pinch.

The point is that debt doesn't disappear. It moves. Three years ago, we had to worry about over-extended families and businesses. Now we have to worry about over-extended governments -- especially in the Eurozone and in our states and cities. How do we fix this?

There are only three ways to fix a public debt crisis: raise taxes, cut spending, or find a sugar daddy. The third option is the least painful but also the least permanent. For two years, the U.S. government has poured money into states and cities to keep them afloat. The European Central Bank is trying something similar to support Greece and Ireland. But these are temporary solutions to a long-term problem. Eventually, these governments will have to learn how to tax and spend reasonably and sustainably. In the meantime, their reckoning period poses the greatest threat to what should otherwise be a slam-dunk recovery.


___________

*Sometimes this was the result of governments like Ireland explicitly taking on sick banks' obligations. Other times, this was the result of governments expanding their income security programs to give cash-needy folks more money to pay their bills. In both cases, government is giving money it doesn't have to families and companies without money -- going into debt to protect people who have gone into debt.

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Derek Thompson is a senior editor at The Atlantic, where he writes about economics, labor markets, and the entertainment business.

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