Despite the headlines predicting more doom and gloom for the municipal bond market, there’s new reason for optimism. The “heartland of America” is the scene of a great experiment, and the results will impact the future of municipal bonds.

The broad iShares S&P National Municipal Bond Fund (NYSEArca: MUB) is down more than 6 percent in the past three months. It’s even worse for funds focused on particular states, such as the iShares S&P California AMT-Free Municipal Bond Fund (NYSEArca: CMF), which has lost a tenth of its value in that period.

They’ve been beaten up pretty badly in recent months, and their future depends on how cities, counties and especially states face down their budget deficits.

Supreme Court Justice Louis Brandeis referred to the states as “laboratories” for government policy experiments. There’s no better example of this than the fiscal policy experiment now being conducted by Illinois and its neighboring states as they pursue two diametrically opposed strategies to address budget deficits.

We are about to witness a critical step toward resolving the great fiscal policy debate in this country: How much government do we want, and how can we best pay for it?

The states facing the most serious budget crises are California, New York, New Jersey and Illinois. New Jersey, under Governor Chris Christie, has focused on reducing state spending and holding the line on taxes. The new governors of California and New York both gave inaugural speeches emphasizing the need to rein in spending. Illinois took a different tack. Early this month, Illinois passed legislation to substantially increase individual and corporate taxes in an effort to close its budget deficit. Meaningful spending cuts were not included.

There could be a problem comparing the results of these two separate approaches. California, New York and New Jersey are coastal states—very different politically and even culturally from the heartland. Fortunately we also have alternative policies proposed by other Midwest states that seem to want to compete for the hearts, minds and tax dollars of Illinois citizens.

Wisconsin is going so far as to urge Illinois businesses to “escape to Wisconsin” where corporate income taxes are lower (and might eventually disappear). Michigan, Indiana and Ohio are promoting their tax advantages and business-friendly environments to businesses and individuals in Illinois and beyond.

It’s not very often that we get a large-scale social experiment offering such widely different philosophies affecting relatively homogeneous subjects. Think North and South Korea or East and West Germany. The results of “the great Midwest experiment” are likely to be scientifically significant and less subject to political interpretation.

Corporate and individual taxpayers in Illinois will be able to decide which policy most agrees with their political philosophy and hopes for the future. It’s possible that some won’t be casting their vote at the ballot box so much as voting with their feet.

This bodes well for the rest of us. The subject of government spending and taxation will be one of the central issues of the 2012 elections. What happens in the Midwest will help shape the debate and, hopefully, show us the best way to regain fiscal stability and produce sustainable economic growth—not only for the states but for the entire nation.

Kent Grealish is a partner at Quacera Capital Management, a fee-only advisory firm. He welcomes comments and suggestions for future columns at: kent@quacera.com .