No state has defaulted on its loans since the Great Depression. But the New York Times warns that states and municipalities could be closer to that rare and grim fate than ever before. Federal stimulus cash is drying up in 2011, just as states face what might be their most crushing budget shortfalls, as weak tax revenue fails to provide for large spending demands. If they cannot close the gap with spending cuts and tax increases, they may be forced to revisit their promises to bond holders.
The Times story focuses on the chance that some states and cities do the unthinkable and default. This is an unlikely scenario for at least two reasons. First, if states have to break promised payments, they won't start with their investors. They'll start by writing IOUs to contractors, delaying payments to government agencies, and things like that, to protect their credit with lenders. Second, despite Washington's weak appetite for government spending, the prospect of a failed state would generate significant political pressure for a bailout tied to harsh future reforms painful enough to discourage other states from seeking government help.
Default is unlikely. Deep cuts, on the other hand, are very likely. As the Times explains, the worst time for state budgets is often in the years after a recession, when rainy-day funds have been depleted the easy cuts are off the table. The state stimulus tap is effectively dry by 2011. That means you should expect to see states and local government continue to lead the country in job losses over the next few months.