Causes and Effects
Studies in Fiscal Federalism and State-local Finance series
Edited by Ehtisham Ahmad, Massimo Bordignon and Giorgio Brosio
Chapter 13: Incentives facing local governments in the absence of credible enforcement
Very often, financial crises precede sovereign debt crises. As crises occur, they require restructuring or, at least, containing government debt, which in turn challenges the sustainability of public finances. Following the 2008 and 2009 financial crises, the sustainability of public finances has been called into question in heavily indebted countries within the Euro zone, as well as others, some of which, such as Ireland and Spain, were well within Maastricht limits in 2007. Furthermore, as central and subcentral governments are mutually dependent, concerns have arisen – and do persist – about the effects of the former’s conduct and performance spilling over onto the latter, and vice versa. However, it is essential to disentangle financial crises caused by adverse macroeconomic shocks, which are beyond the governments’ control, from those caused by strategic behaviour, which depend on the decisions made by economic agents (von Hagen and Dahlberg, 2002). Sub- central governments (henceforth, SCGs) are little motivated to manage public resources efficiently if they expect the centre (CG) to provide financial aid and, perhaps, to bail them out, as the need arises. Essentially, the CG suffers from a lack of dynamic commitment. This commitment problem has long been known as one of soft budget constraint (SBC). The SBC concept was originally introduced by Kornai (1979, 1980) in his studies on socialist and transition economies under stress.
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