Detroit is the wake-up call for American cities

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The former Packard Plant in Detroit.

Detroit's bid to restructure its debts in bankruptcy court—approved by a federal judge Tuesday—marks the beginning of a painful reckoning after decades of financial mismanagement and economic decline.

But while its bankruptcy filing is an extreme remedy, Detroit's fiscal ailments are being widely felt in cities and states across the country.

On the same day federal Bankruptcy Court Judge Steven Rhodes rendered his historic opinion on Detroit's future, the Illinois legislature ended months of acrimonious debate over how to close a $100 billion pension funding gap that is crippling the finances of the nation's fifth most populous state.

Like Detroit's, Springfield's solution involves cutting benefits for current and future retired state workers, a move expected to save about $160 billion over 30 years and cut the unfunded liability by at least 20 percent, according to Illinois House Speaker Michael Madigan, D-Chicago. State workers will have to work longer to qualify for benefits, and retirees will get smaller cost-of-living increases, among other changes.

"This bill will ensure retirement security for those who have faithfully contributed to the pension systems, end the squeeze on critical education and health-care services, and support economic growth," Gov. Pat Quinn, a Democrat, said in a statement.

Labor unions called the measure unfair and unconstitutional, threatening legal action if Quinn signs it. Detroit's public employee union has also signaled it will appeal Rhodes' decision.

Illinois is not alone. Years of shortchanging its pension funds have left Kentucky, Louisiana, New Jersey, Connecticut, Massachusetts and Hawaii with pension liabilities amounting to more than 100 percent of total state revenues, according to Moody's Investor Service. In nine states—Texas, Colorado, Kansas, North and South Carolina, West Virginia, Pennsylvania, Maryland and Rhode Island—pension liabilities have swollen to more than 80 percent of state revenues.

(Read more: Detroit's next bankruptcy battle: Who foots the bill?)

As in Detroit, playing catch-up with underfunded pensions has become one of the heaviest weights on cash-squeezed local governments, crowding out spending on services and investments in infrastructure. It's also forced smaller cities like Stockton and San Bernardino in California to seek the shelter of bankruptcy court to reorganize their debts.

Bankruptcy experts generally agree that no matter how stressed a city's finances, a bankruptcy filing will likely remain a last resort. But Rhodes' decision Tuesday to treat Detroit's pension obligations like any other debt—if it survives the city union's appeals—will also strengthen local officials' hands across the country when it comes time to negotiate benefit cuts with public worker unions.

Those unions have argued that—before inflicting painful cuts on their hard-earned benefits—city officials should try harder to collect back taxes or look for assets to sell. On Wednesday, the auction house Christie's said the Detroit Institute of Arts' collection and was worth between $452 million to $866 million. Some creditors think the collection could fetch much more.

"In a perfect world, if you could liquidate the art collection, you should theoretically have the ability to pay creditors 100 cents on the dollar," said Randye Soref, a bankruptcy attorney with Polsinelli in Los Angeles. "But it doesn't fix the long-term problem. It's a Band Aid."

(Read more: Warren Buffett: Detroit has 'huge potential')

To be sure, few cities are in as deep a quagmire as Detroit. In fact, since the bottom fell out of the housing and financial markets five years ago, most American cities have recovered from the historic hit to revenues. High-tech hubs like Boston, Seattle and San Francisco are churning out tens of thousands of high-wage jobs a month. Once-moribund economies in Pittsburgh and Chattanooga, Tenn., have been revived by local governments targeting investment and offering incentives to new businesses.

Those turnaround cities have demonstrated that the best way to avoid being the next Detroit is to keep diversifying your local economy—the higher tech the better.

But the financial squeeze that left the Motor City unable to pay its debts has been building in many city halls around the country—for many of the same reasons.

Pensions aren't the only legacy liability. Older cities coping with crumbling infrastructure have borrowed nearly $1.7 trillion over the past decade to repair or replace broken-down schools, decaying bridges and highways, and leaky water pipes. Since 2000, total municipal debt outstanding has swollen by more than 160 percent to $3.7 trillion, according to SIFMA.

That borrowing spree was often supercharged with a toxic ingredient—so-called interest rate swaps—that were supposed to protect taxpayers from the risk of higher interest rates driving up borrowing costs, Instead, falling interest rates have left hundreds of cities and states on the wrong side of the bet.

Detroit officials are proposing the city borrow some $350 million to pay off the Wall Street bankers on the winning side of the city's remaining swaps. But that new loan—known as "debtor in possession" financing—will have to be paid back, leaving the city with less money to restore services.

As Detroit has demonstrated, cutting services to balance the books in the short term only drives away more taxpaying residents and business, further shrinking the revenue pie. Once the downward spiral begins—with service cuts driving away taxpayers, further eroding the tax base and forcing deeper cuts—the vicious cycle can be very difficult to break.

(Read more: America's cities on the edge)

Outside intervention might help. But with taxpayers loathe to backstop cities with bailouts, many of the nation's hardest hit localities have been left to somehow "bootstrap" themselves back into financial health. Some of those, including Detroit, are still scrambling to replace cuts in aid from states that slashed their budgets back into balance after the Great Recession.

For now, bankruptcy will give Detroit a shot at writing down its debts far enough to close an annual spending gap of about $200 million a year. In Rhodes' words, it gives the city "a fresh start."

But for Detroit and other cities in financial distress, balancing the budget is only the beginning. Once the bleeding stops, the real work begins.

That means fixing broken street lights, cleaning up blighted neighborhoods, reviving a failing school system, restoring public safety and emergency response, and rebuilding an economic infrastructure that has been hollowed out over decades.

There's little doubt that will require a huge investment. But there's little indication where that money will come from.

—By CNBC's John Schoen. Follow him on Twitter @johnwschoen .