Fed’s a mess, but state finances are looking good

October 11, 2013, 6:39 PM UTC

FORTUNE – While the U.S. federal government struggles to gets its finances in order and avoid default, budgets in America’s cities and states are improving.

The development is unexpected and a near reversal of the financial strains municipalities went through in the wake of the 2007 financial crisis. Property tax revenue plummeted as home prices collapsed, causing widening budget gaps across several municipal governments. A chunk of President Obama’s $787 billion stimulus package rescued cash-strapped states, but that wasn’t enough to keep some from predicting financial Armageddon.

In 2011, famed Wall Street analyst Meredith Whitney predicted a wave of as many as 100 municipal bond defaults. Her forecast freaked out investors, but they were left puzzled (and relieved) when that never quite transpired. As it turns out, the muni alarms were misplaced; instead investors should have zeroed in on the federal government as Congress struggles to avoid defaulting on the nation’s debt.

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True, some cities aren’t doing very well at all, such as Detroit and Stockton, Calif. Delaware hasn’t gone bankrupt, but it’s the only state left that risk falling back into a recession, according to a September report by Moody’s Investors Service. Despite the uneven recovery, states and cities generally have bounced back as the job and housing markets slowly improve. California expects to have a budget surplus this year, after multi-billion dollar shortfalls in recent years; Utah is even offering to help the federal government reopen three national parks as the U.S. enters the 11th day of a partial government shutdown Friday.

For 13 quarters in a row, state tax revenues have grown, rising by 8.6% during the first quarter of 2013 from a year earlier, according to an August report by the Rockefeller Institute and the Census Bureau. 

Finances across U.S. cities have been healing, too. In a survey of city finance officers by the National League of Cities, 72% say their cities are better able to meet fiscal needs this year than last. It’s a stark contrast from 2009, when only 12% of finance offices thought that. During the recession, cities cut spending sharply. As the economy recovered, sales and income taxes have picked up. So have revenues from property taxes — the result of an improving housing market.

By contrast, the federal government could technically default any week now, although many would say that’s unlikely. But some of those people probably also thought the government wouldn’t shut down either.

MORE: Default would be catastrophic for big banks

U.S. Treasury Secretary Jack Lew says Congress must raise the nation’s borrowing limit by Oct. 17 or else it will have no way to pay its bills and risks defaulting on its debt. Oddly enough, it’s not so much that the money isn’t there, but rather political stalemate and sniping that has left Americans vulnerable to a default.

Of course, the muni bond alarmists didn’t see this coming.