Fiscal Rules, Bailouts, and Reputation in Federal Governments

Expectations of bailouts by central governments incentivize over-borrowing by local governments. In this paper, we ask if fiscal rules can correct these incentives to over-borrow when central governments cannot commit and if they 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 local govern- ments learn about this type over time. Our first main result is that if the reputation of the central government is low enough, then fiscal rules can be welfare reducing as they can lead to even more debt accumulation relative the case with no rules. This is because the costs of enforcing the punishment associated with the fiscal rule worsens the payoffs of preserving reputation and incentivizes the no-commitment type to re- veal its type earlier relative to an environment without rules. This early resolution of uncertainty makes over-borrowing more attractive for the local governments. 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. The model can be used to shed light on the numerous examples throughout history where tight fiscal rules were instituted but were not enforced ex-post, such as the Stability and Growth Pact.