Three years ago, Palestinian Prime Minister Salam Fayyad launched an ambitious plan to build effective, responsive, and clean government institutions. The results were impressive, and Fayyad was hailed as a figure who was making true progress toward a two-state solution even as formal negotiations faltered.

These days, however, the entire project is under dire threat. The political and social worldview that informs Fayyad's vision has been undermined by Hamas's apparent ability to leverage armed conflict to its political advantage. To reverse this disturbing trend, the international community and Israel need to recognize that Palestinian institution building is a strategic priority -- not merely an economic or technical one. Urgent steps on all sides are required to save this project, or its vision for Palestinian independence and peace with Israel may give way to more confrontational approaches, to the detriment of all.

There is no denying the progress that has been made. Under Fayyad, the Palestinian Authority (PA) eliminated structural corruption in ministries and other public agencies under its control. Palestinian security forces have been providing both Palestinians and Israelis with unprecedented security. In 2011, the United Nations, World Bank and the International Monetary Fund all issued reports certifying that the PA fully met the criteria for independence. The PA "is well positioned for the establishment of a state at any point in the near future," read a 2011 World Bank report. In April 2011, international donors noted, "Palestinian institutions compare favorably with those in established states."

It has been downhill since then. In stark contrast to the situation in 2011, Fayyad's government is now unable to meet payroll for more than 140,000 public sector employees -- including teachers, nurses, police officers, and civil servants. The PA's institutions are on the verge of collapse. One million Palestinians are threatened with the prospect of falling into poverty over the course of the coming year as a result of the economic crisis.

The ongoing PA fiscal crisis was aggravated by the Palestine Liberation Organization's failed 2011 bid for Palestine to be granted member-state status at the United Nations, which led to a reduction in U.S. and European Union aid. This is now compounded by Israel's decision to withhold Palestinian tax revenues in retaliation for the successful 2012 push to win non-member observer state status at the United Nations.

According to the 1994 Paris Protocol, Israel collects taxes accruing to trade transactions with the Palestinians -- amounting to 50 percent of the PA's monthly budgetary commitments -- and is obliged to transfer the revenue to the PA. In practice, this gives Israel an easy way to plunge the authority into fiscal crisis whenever it wants to put pressure on the Palestinian leadership.

Israel also announced plans to use the withheld money to pay the Israel Electric Company more than $350 million in outstanding bills owed by Palestinians. But these debts are not owed by the PA government -- they are owed by privately owned Palestinian electric companies in the West Bank and Gaza. The latter, of course, are under the control of Hamas, which does not distract itself by trying to collect money from consumers. Israel's decision not only harms the PA, it directly benefits Hamas -- and bails out deadbeat Palestinian businessmen -- all at the expense of ordinary Palestinian public sector employees and their families.

Politically, this move also undercuts the one Palestinian leader who has been unwavering about working openly with the global community and Israel. Fayyad has consistently worked to create and maintain law and order, and rooted out systemic corruption within the ministries and agencies under his control. The tumult of the recent war in Gaza again demonstrated the effectiveness of PA governance, as Palestinian security forces successfully maintained order in the West Bank under difficult circumstances. Today, however, Fayyad is increasingly identified in the public consciousness with the inability of the government to pay public sector salaries.

Hamas, meanwhile, is riding high after its recent conflict with Israel. Its regional standing is being buoyed diplomatically by allies like Egypt's Muslim Brotherhood-led government and Qatar, which recently promised an additional $400 million in aid and rebuilding projects for Hamas-held Gaza.

The pressure from Hamas's resurgence, Israel's withholding of Palestinian revenues, and reduced donor aid could eventually lead to the PA's collapse. Strikes and demonstrations in the West Bank based on economic grievances began a few months ago, and have become a recurring feature of the Palestinian political landscape. Hamas and some Fatah officials have been trying to use the non-payment of salaries to settle scores with Fayyad and derail his policies.

Fayyad responded to Israel's withholding Palestinian tax revenues by calling on the Palestinian people to voluntarily buy Palestinian, rather than Israeli, products. It was an economic response to an economic measure: Fayyad never used the word boycott, as some reports mistakenly suggested. He did not single out settlement products, nor did he call for, or initiate, any official measures. But all of his statements were sensationally, and often inaccurately, covered in the Palestinian and international press.

This all comes in the context of Israel's announcement of an aggressive expansion of its settlement enterprise, including the construction of more than 5,000 new housing units mainly in highly strategic areas in and around Jerusalem. These proposed settlement plans, if completed, would make it exceptionally difficult -- if not impossible -- for East Jerusalem to serve as the capital of a Palestinian state, and threatens to cut off the city from the rest of the West Bank almost entirely. The danger these plans pose to the two-state solution was noted by the State Department, the 14 other members of the U.N. Security Council, and the European Union, all of whom expressed deep concern at Israel's announced settlement projects. The Palestinian public's faith in the viability of a two-state solution is at an all-time low -- and this despair is spreading regionally, internationally, and even among pro-peace Israelis.

The erosion of the two-state solution and the weakening of the PA is leading the Israeli-Palestinian conflict to a crisis point. This has been exacerbated by the financial and political crisis facing the Palestinian security forces, whose members are not being paid and whose self-image as protectors of the Palestinian national project is being undermined both within the public and its own ranks. This is the single most urgent reason to take early and effective measures to end the fiscal crisis.

The current trends are ominous: Hamas is growing stronger in both Gaza and the West Bank, while the financially strapped PA is struggling to present a viable alternative. If this continues, the world will witness what Fayyad recently termed a "doctrinal defeat" of those who work for progress through nonviolent strategies. The message being conveyed to the Palestinians is that a policy of partnership with Israel, the United States, and the international community is fraught with more risk than open confrontation.

It is not too late to correct this course and prevent the situation from deteriorating further. President Barack Obama's administration and Israel must have a frank, friendly conversation about this issue, which is vital to both countries' national interests. Specifically, they should ensure that funding is injected into the projects still being pursued by the PA to prevent its collapse and restore its credibility. It is not too late -- but time is running perilously short.