Congress warned over states' bankruptcies

US lawmakers were warned yesterday that allowing states to declare bankruptcy would upend the $2.8 trillion (£1.7 trillion) municipal bond market, making it much harder and more expensive to fund local government, and potentially destablising the economic recovery.

A House of Representatives committee was examining the extent of the financial distress in state and local governments, which has become a major topic of concern on Wall Street and among individual investors, and examining ways to prevent the need for a federal bailout of any of the lower rungs of government.

"The perfect storm is brewing; already state and municipal governments are coming to Washington, hat-in-hand, expecting a federal bailout like everybody else," Republican Congressman Patrick McHenry said. "But the era of the bailout is over."

The White House has floated a plan to allow federal aid to states to help to fund unemployment benefits, so that the states do not have to raise taxes on business. However, the plan ran into immediate opposition on Capitol Hill.

The House Oversight and Government Reform Committee yesterday included testimony from the Manhattan Institute for Policy Research and the Centre on Budget and Policy Priorities – two lobby groups from opposite sides of the political spectrum but with the same view on the question of allowing states to go bankrupt.

"Congress is right to worry about how to avoid bailing out states and their investors," said the Manhattan Institute's Nicole Gelinas. "State bankruptcy is not the answer." She said the suggestion that states could default on their debts would scare investors on an even larger scale than the suggestion that smaller local government authorities will default.

Data from the Investment Company Institute yesterday revealed that investors had pulled money out of the sector for the 13th consecutive week. Net outflows of $1.17bn brought the total withdrawn from the sector since early November to $34.7bn.