A Wall Street Journal editorial  discusses the severity of the budget crises in three states: California, New Jersey, and New York. While all states are suffering decreased revenues this fiscal year, the problems in these states have been especially severe, resulting in possible downgrades  for California’s bonds which are already the lowest-rated in the country.
The Journal states:
A decade ago all three states were among America’s most prosperous. California was the unrivaled technology center of the globe. New York was its financial capital. New Jersey is the third wealthiest state in the nation after Connecticut and Massachusetts. All three are now suffering from devastating budget deficits as the bills for years of tax-and-spend governance come due.
During booms in the business cycle, high tax rates accompanied by an increased level of government services are palatable to taxpayers, but as these three cases exhibit, high-tax policies can quickly become unsustainable as incomes fall.
Eileen’s last post  explains that state and municipal policy makers including Rudolph Giuliani are currently discussing reforms toward greater fiscal responsibility in order to promote prosperity in their localities, but these reforms are going to be difficult to enact for states that are already deeply indebted.
A great asset of the American federal system is that policy variation across the states allows citizens and law makers to observe how various fiscal policies function in the real world. As described by the authors of the newly published 2009 edition of Rich States, Poor States , constituents do in fact “vote with their feet” by moving to states with policies that fit their desires. This year’s index demonstrates that states in the South and West are generally gaining domestic population  from the Northeast where taxes and government involvement in the economy are generally higher.
Unfortunately, the same experimentation at the federal level carries much greater costs. Until now, federal aid has allowed for irresponsible fiscal policies to continue at the state level, but this policy may be coming to an end . If the federal debt and deficit approach the unsustainable levels that states such as California, New Jersey, and New York have reached, no entity will be able to bail it out. Additionally, economic policies at the federal level do not provide the same sort of natural experiment within the country and carry a higher risk of severe negative consequences.
The article continues:
At least Americans have the ability to flee these ill-governed states for places that still welcome wealth creators. The debate in Washington now is whether to spread this antigrowth model across the entire country.
While government systems can never incorporate the feedback mechanisms of the market, the federalist system allows for a sort of competition between states and localities in which competition allows successful programs to thrive and spread. However, this system only works when unsuccessful local policies are not subsidized by the federal government and when authority is sufficiently devolved to allow states to differentiate their policies from one another’s.