Why Illinois budget Armageddon will spread to other states

• Illinois finally passed a budget Thursday evening after a two-year impasse.
• But even with the big tax hikes in the measure, Illinois still may not avoid a debt downgrade to "junk" status.
• Ratings agencies S&P and Moody's are part of the problem, not the solution.

What do you get when even the perceived sober truth tellers don't really tell the truth?

What do you get when political leaders refuse to lead, refuse to compromise, and refuse to see beyond the next election?

Here's what you get: the sorry state of Illinois.

Who's to blame? A lot of the same old suspects you see in a lot of states, especially the politicians and state worker unions.

But in the case of Illinois, a new villain has come onto the scene in guise of the sober, supposedly truth-telling entities known as the ratings agencies.

First off, let's look at some of the ugly details. Illinois finally did pass a budget Thursday evening, ending a two-year impasse. But the damage is still massive as the state has $15 billion in unpaid bills. It has a staggering $251 billion in unfunded pension liabilities, in a widely quoted and accepted figure according to the Illinois Policy Institute. And in what may be the most obvious public embarrassment, Illinois even suspended its participation in the the Powerball and Mega Millions lotteries because it couldn't guarantee its share of the jackpot payouts.

Enter Moody's and Standard & Poor's. Things started to change earlier this year as soon as those agencies started to say that they may make Illinois the first U.S. state with a "junk" rating on its debt. S&P even inched the state's credit rating to just one notch above junk in June.

Suddenly, things started to move. Even though new budget measures proposed by the Democrats included a whopping personal income tax rate increase of 32 percent and a corporate tax rate increase of 33 percent, the ratings agencies urged all the lawmakers to vote for the deal.

That clearly scared enough Republican legislators to cave on voting for tax increases that, on paper, would increase state revenues by $5 billion. The Illinois Senate overrode Governor Bruce Rauner's veto last week and now the House has followed suit. At least now, Illinois can start making headway on those unpaid bills and avoid further financial penalties and budget downgrades for not passing budget. That makes the ratings agencies heroes, right?

Wrong and wrong.

Let's get real. There isn't enough taxable money in Illinois to cover that pension liability. And analysis after analysis shows it's the expanded pension liabilities that are the main source of Illinois' fiscal problems. When Governor Rauner tried to reform those pensions and shrink those liabilities, the municipal unions dragged him to court time after time. And they won time after time as state judges refused to budge or find any legal way out of the state's constitutional promises to honor all pension obligations no matter how financially untenable. These retirees are asking for every penny but by not compromising they risk getting nothing at all when the state can't pay.

That was bad enough, but by endorsing tax hikes and the simple act of passing yet another "kick the can down the road" budget, Moody's and S&P are helping to perpetuate the problem instead of solving it. It's not that the ratings agencies didn't mention the pension issue, but they undermined any warnings about it by pushing for a bill that did not address that problem. Who knows what kind of positive reactions from the politicians and even the courts the ratings agencies could have induced had they been more honest and clear about the pension issues and the spending problems in general? Instead, they pushed for tax hikes as if they're an answer. They aren't.

Oh, but it gets worse. Even though the bill has been passed, Moody's says it may still make that downgrade to junk status because, of a lack of "broad bipartisan support" and the unsolved pension problems. That sure seems like Moody's is playing both sides of this game. First, it pushes for a tax hike bill, and now it reserves the right to later say it wasn't enough when reality hits Illinois anyway.

This is not the first time the ratings industry has acted as a dissembling enabler for continued out of control government spending. When S&P downgraded the U.S. federal debt in 2011, it made specific and clear statements calling on Republicans to agree to tax increases and blaming them for the problem, while only more generally mentioning the need to reform the real issues in our budget posed by the unsustainable Medicare, Medicaid, and Social Security programs. In other words, if you think what happens in Illinois stays in Illinois, you're sadly mistaken.

Of course, there's plenty to blame Republicans for at the state and federal levels when it comes to spending. In general, they haven't proven to be much more fiscally responsible when they've been in power compared to the Democrats. And while he had the right idea from the beginning, Republicans like Rauner are generally useless if they who fail to win over enough political or legal support for needed reforms.

Rauner made a potent argument against the tax increase bill while standing in front of a South Side Chicago bar Thursday when he said: "Don't listen to Wall Street. Don't listen to a bunch of politicians who want power, listen to the people of Illinois." But that clear argument was too little, too late. In the end, the word of nameless, faceless, and un-elected ratings agency wonks held more sway over members of Rauner's own party than their duly elected governor.

And it's a shame really, because these companies do have that power to persuade but they've misused it time after time or simply failed to use it all. Many combinations of that misused and unused power were to blame in the housing crisis that led to the financial collapse of 2008.

But no matter how persuasive S&P and Moody's are, their ability to get tax hikes passed in Illinois or anywhere else in America amount to just a drop in the bucket compared to our massive federal and state entitlement debts. S&P and Moody's may seem like they have a clear message, but they've really just muddied the waters. This is not help, it's just another form of avoiding the hard truths.

That makes the ratings agencies part of the problem, not the solution. The people of Illinois will just be the latest folks to pay for that as they cough up more in taxes and get no significant dent in their state's debts to show for it. But as long as the voters and the politicians don't see the agencies and their off-the-mark warnings for what they really are, Illinois-level pain will come to the rest of us soon enough.

Commentary by Jake Novak, CNBC.com senior columnist. Follow him on Twitter @jakejakeny.

For more insight from CNBC contributors, follow @CNBCopinion on Twitter.

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