Sovereign bail‐outs and fiscal rules in a banking union

In this paper, we study optimal fiscal rules in a two‐country economy in which cross‐country linkages between sovereign debts and banking sectors motivate bail‐outs among countries. The first‐best sovereign borrowing, which is contingent on the output gap between the countries, cannot be achieved in the presence of asymmetric information on a country's potential output. Because bail‐out induces overborrowing, fiscal rules can be implemented to prevent the ensuing inefficiency. A mechanism can be designed to induce a country with low potential output (i.e., a small negative output gap) to run an optimal budget deficit upon receiving a transfer (ex post) from the other country. We characterize conditions under which this fiscal mechanism Pareto dominates a “cyclically adjusted” fiscal rule imposing a unique ceiling on a country's borrowing, independently of its potential output. We apply our setting to a discussion of the implications for fiscal rules within the European Monetary Union.