One of the most profound spillover effects of the current economic crisis is that it has also exposed a festering fiscal health crisis in state and local government. "Drunken sailor" spending in recent years and declining property values (and thus reduced property tax revenues) have combined to produce massive state and city budget shortfalls.

A recent study by the Center for Budget & Policy Priorities found that at least 41 states have recently faced, or are facing, budget deficits. Today 13 states are staring at budget shortfalls in excess of $1 billion in fiscal year 2009, with California ($31 billion) and New York ($6.4 billion) leading the pack. Moody's recently reported that 30 states are in recession, and 19 more are at risk.

At the local level, New York City is facing a $2.3 billion shortfall, and its transit agency, the New York Metropolitan Transit Authority, is $1 billion in the hole (both figures are larger than some state deficits).

How governments find themselves in this position is obvious: They're addicted to spending taxpayer dollars. Kudos to New York Gov. David Paterson for a refreshing bit of political honesty, telling The Wall Street Journal last week that, "What's actually more embarrassing than the fact that we have such a huge deficit now, when bonuses are down and capital gains are down, is the fact that when there was...wealth, we overspent."

This hasn't stopped the big spenders from seeking a federal bailout. In September, we saw California Gov. Arnold Schwarzenegger fire the first shot across the bow, hinting at possibly needing $7 billion in federal assistance to keep the state's doors open. The Governator has increased state spending by over 40 percent since he made his failed promise to blow up the boxes of state government.

Several weeks ago we saw a parade of governors and mayors on Capitol Hill asking for a bailout of state and local government. On that occasion, South Carolina Gov. Mark Sanford was the voice of fiscal sanity, offering a cautionary warning that "[t]his $150 billion may in fact further infect our economy with unnecessary government influence and unintended fiscal consequences."

Most recently, the mayors of three big cities—Philadelphia, Atlanta, and Phoenix—sent a letter to Treasury Secretary Hank Paulson asking the feds to use a portion of the $700 billion bailout to assist struggling cities.

States are looking to the feds for help because the two usual go-to sources of funding for state and local governments—taxes and bonds—are going to be severely constrained in the coming years. The political will to raise state and local taxes is almost non-existent. And the tough credit market means states—especially those with big deficits—are going to have a hard time borrowing, prompting some analysts to believe we've seen the end of an era of relatively cheap money and easy borrowing for governments.

So what's a state to do to climb out of the fiscal hole they've dug themselves into? It's simple: Spend within your means and partner with the private sector more often to deliver more services.

Texas is currently the envy of the nation with an $11 billion budget surplus. How did the state do it? For starters, the Texas Constitution gives the state Comptroller of Public Accounts (a chief fiscal officer, of sorts) the responsibility to certify the state's budget and send back any spending bills that the state can't afford. It's an elected position and the current comptroller, Susan Combs, launched a "Where the Money Goes" website to boost transparency and show taxpayers where their money is going. Having a third-party enforce prudent fiscal forecasting and spending helps to avoid the situation so many states now face—governors and legislators gravitate to the rosiest of revenue projections to help justify new spending, and then when the mythical money doesn't materialize, the state faces a budget "crisis."

Texas also engages in performance-based budgeting—tying a given programs' funding to its effectiveness at meeting clear performance targets. A Sunset Advisory Commission conducts mandatory periodic reviews of all state agencies to find duplicative or unnecessary programs that must be cut. Since the Sunset Commission was created in 1977, over 47 governmental agencies have been eliminated and another 11 have been consolidated.

Similarly, Washington state and South Carolina apply a performance budgeting model in which state activities are ranked in order of priority and effectiveness. The administration then "purchases" (funds) the activities from the top of the list down until all available revenues have been used up, ditching the lowest priority activities and eliminating poor-performing, unnecessary, or wasteful ones.

Policymakers also seem to be increasingly recognizing that privatization and competitive service delivery are proven tools for doing more with less. Competitive sourcing allows the private sector to compete for jobs and contracts that are currently performed by the government. Federal employees actually won 83 percent of the job competitions from fiscal year 2003 through fiscal year 2007. But the competition still helps save a lot of money. Taxpayers saved $25,000 for every job that was put up for competition because even when the government kept the job it significantly improved efficiency and reduced costs.

Privatization is also coming back into vogue these days, partially buoyed by the successful track record of former Florida Gov. Jeb Bush. The state engaged in over 138 privatization initiatives saving taxpayers over $550 million in aggregate during Bush's term (1999-2007). When many other states were raising taxes, Bush's privatization initiatives helped Florida to shed almost $20 billion in taxes and over 3,700 positions in the state workforce.

And at the urban level, Chicago Mayor Richard Daley, a Democrat, has been on a privatization tear in recent years. Under his watch he's privatized over 40 services and activities, saving taxpayers millions. Since 2005, Daley has initiated long-term lease agreements with the private sector for the Chicago Skyway toll road, Midway Airport, four major downtown parking garages, and the city's parking meter system downtown. Chicago netted over $5 billion in the process to pay down city debt, establish a $500 million rainy day fund, and shore up public pensions.

There are ways for cities and states to dig out of this fiscal mess. Making taxpayers pay for a federal handout won't solve a problem rooted in a state government's addiction to spending. As state and local governments begin to reckon with the magnitude of their fiscal crunch, privatization and more prudent fiscal stewardship will be the key to "right-sizing" government and avoiding future binge spending when economic conditions do improve.

Leonard Gilroy is the director of government reform at The Reason Foundation.