Fiscal Rules, Bailouts, and Reputation in Federal Governments
Expectations of bailouts by central governments incentivize overborrowing by local governments. In this paper, we ask if fiscal rules can correct these incentives to overborrow when central governments cannot commit and if these rules will arise in equilibrium. We address these questions in a reputation model in which the central government can either be a commitment or a no-commitment type and the local governments learn about this type over time. We find that if the central government's reputation is low enough, then fiscal rules can lead to even more debt accumulation relative to the case with no rules. This is because the punishment for violating the fiscal rule worsens the payoffs of preserving reputation. Despite being welfare reducing, binding fiscal rules will arise in the equilibrium of a signaling game due to the incentives of the commitment type to reveal its type.
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Document Object Identifier (DOI): 10.3386/w23942