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Geoff Daniel looks at the rising mountain of US municipal debt and its potential to cause another crisis.

Europe's sovereign debt crisis has allowed the US to renew its condescending attitude to its slow-growth counterparts across the Atlantic. Though home to the global subprime mortgage meltdown, any pangs of guilt the US may have felt have been assuaged knowing Europe had its very own subprime borrower in Greece.

Ostensibly, the US debt and deficit levels are nothing to write home about. The US federal debt and deficit for 2010 were estimated at around 90% and 9% of GDP respectively. It is at this level of debt that experts believe economic growth begins to suffer.

In addition to this is the "unfunded liability" of federal programmes like social security, Medicare and Medicaid. The perennial bugbear of the American right, funding these entitlements is doubtless a long-term challenge.

But those who talk of America's federal government going bankrupt miss one of the signal lessons of the crisis. Every time there's been a convulsion of the global financial system, demand for US Treasury debt has soared.

In December 2008 with the financial system in its darkest hour, yields on short-term US debt fell into negative territory. This implies that buyers of debt were actually paying the US Treasury for protection.

Ironically, the financial crisis that originated in the US caused a flight of capital back to the US Treasury. All of this would suggest the US government and its ability to finance its debt, cannot be compared to its counterparts around the world.

Just below this level of the American political edifice is what's known as municipal government. These are states and cities that elect their own assemblies, mayors and governors.

Municipal governments finance themselves partly through taxes, partly through borrowing. The latter part of this financing model has grown hugely in the last decade. Last year, municipal government borrowed approximately $300bn. It is here that America's version of Greece may be found.

In June, Warren Buffett said: "I don't think Moody's or Standard & Poor's [rating agencies] or I can come up with anything terribly insightful about the question of state and municipal finance five or 10 years from now, except for the fact there will be a terrible problem and then the question becomes: will the federal government [help]?"

He has said public officials could be tempted to default on bonds whose payments are guaranteed by insurance companies rather than push through needed tax increases and spending cuts.

Berkshire Hathaway's CEO has caught people's attention. Not only is he the world's most lauded investor, a branch of his company insures municipal debt. Berkshire Hathaway Assurance has reduced its exposure to this market. In 2009, it insured only $40m of municipal debt, as against $595m in 2008.

And this, when all but two of America's states face deficits and another round of debt issuance. The two biggest, California and New York, have deficits of $55bn and $21bn. This amounts to 65% and 38% of their respective general-fund budgets. This is a more relevant measure since so much of the states' GDP is mobilised for federal taxation purposes.

A former mayor of California's largest city, Los Angeles, wrote an article for the Wall Street Journal in which he said, "between now and 2014, the city will likely declare bankruptcy". On a much smaller scale, Harrisburg, the state capital of Pennsylvania, has accrued a debt of $288m - to split between 55,000 people. But no story has been as shocking as that of Jefferson County, Alabama.

Jefferson County, which includes the state capital Birmingham, was ordered to build a new sewage system by the courts. Through graft that would put Greece to shame, the cost ballooned from $250m to over $3bn. It then issued bonds to finance its design and construction, with some of Wall Street's giants advising.

Jefferson County later restructured its debt, exchanging a fixed-rate for a variable-rate. The latter left the county exposed to the spikes in bond yields of the last years. It now has a debt mountain of just under $4bn, which many consider unserviceable.

The US federal government is already helping its beleaguered municipalities as part of the 2009 stimulus package. Build America Bonds (BABs) allow municipalities to borrow vast sums and have the federal government pay 35% of the interest.

As one of the main planks of the stimulus package, BABs have been extraordinarily successful with over $100bn sold. But the federal government's patience could be wearing thin, as states continue to run deficits. The IRS is investigating bond pricing amid rumours that it could withhold the subsidy from certain states.

The global nature of finance is evident here too. According to Citigroup's director of municipal strategy Patrick Brett, European investors are buying US municipal debt. If this is the case, a debt crisis in this most American of markets could have global implications.

"You're in a world where they [municipal bonds] are the potential cause of another crisis," says Alan McQuaid, chief economist at Bloxham Stockbrokers. "They are a risk but the federal government's going to do what it has to."

Buffett said the same thing in a different way when he was before the US inquiry into the financial crisis. "How would I rate state and major municipalities? I mean if the federal government will step in to help them, they're triple A. If the federal government won't step in to help them, who knows what they are?"

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