Is It Is or Is It Ain't My Obligation? Regional Debt in a Fiscal Federation*

Abstract

This article studies the repayment of regional debt in a multiregion economy with a central authority: Who pays the obligation issued by a region? With commitment, the central government will use its economy-wide taxation power in support of its objective to smooth distortionary taxes and consumption across regions. Absent commitment, this tool of the central government may be exploited to induce it to bail out regional government deficits. We characterize the conditions under which bailouts occur and their welfare implications. In particular, we show when the gains from a federation may outweigh the welfare costs of a bailout. We use these insights to comment on actual fiscal relations in three quite different federations: the United States, the European Union, and Argentina.

Debt Fragility and Bailouts

“…This result highlights the role of consumption smoothing, as in Cooper, Kempf, and Peled (2008), as a rational for bailout beyond the desire, highlighted in Lemma 2, of avoiding costly default. These gains are illustrated in Figure 5 when A 1 = A 2 =Ã.…”

“…This maximization of a weighted sum of the strictly concave utilities obtained from the member countries, creates, as in Cooper, Kempf, and Peled (2008), a consumption smoothing motive for bailout. In the leading case where ∆ i equals the population share of country i, the federation prefers to equalize consumption across agents, given a fixed amount of resources.…”

“…The first entails the avoidance of a default cost through the spreading of the debt obligation across federation members. The second gain, following the consumption smoothing motive highlighted in Cooper, Kempf, and Peled (2008), arises when a bailout yields a more equitable consumption allocation across households in countries within a federation compared to default. One leading case for bailouts is when the country on the verge of default has lower output and consumption, both with and without a bailout, than the country providing the bailout.…”

Bank Bailouts, International Linkages and Cooperation

“…There are two possible states of nature S 1 1 Our setup is similar to Cooper, Kempf, and Peled (2008).…”

Decentralization and Overborrowing in a Fiscal Federation

“…Cooper, Kempf, and Peled (2008) compare intergovernmental transfers when the central government can or cannot commit in a two-period model. In their setup, the central government uses transfers to smooth cross-region consumption and cross-region distortionary taxes in the second period, which give local governments incentives to accumulate debt in the first period.…”