Fiscal Rules, Bailouts, and Reputation in Federal Governments
Expectations of transfers by central governments incentivize overborrowing by local governments. In this paper, we ask if fiscal rules can reduce overborrowing if central governments cannot commit. We study a model in which the central government’s type is unknown and show that fiscal rules increase overborrowing if the central government’s reputation is low. In contrast, fiscal rules are effective in lowering debt if the central government’s reputation is high. Even when the central government’s reputation is low, binding fiscal rules will arise in the equilibrium of a signaling game.
We thank Fernando Alvarez, Marina Azzimonti, Marco Bassetto, Charlie Brendon, V.V. Chari, Russ Cooper, Pierre-Olivier Gourinchas, Marina Halac, Juan Carlos Hatchondo, Boyan Jovanovic, Patrick Kehoe, Ramon Marimon, Leonardo Martinez, Diego Perez, Debraj Ray, Thomas Sargent, and Pierre Yared for valuable comments. We also thank Ananya Kotia and Victor Duarte Lledó for sharing their dataset with us. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Alessandro Dovis & Rishabh Kirpalani, 2020. "Fiscal Rules, Bailouts, and Reputation in Federal Governments," American Economic Review, vol 110(3), pages 860-888.