XREAP2007-14
public debt. The condition (1) can then be decomposed inta a restriction ρ> 0 for the different tiers
of government,
N
ρ=ρ1 +∑ρi >0.
i=2
(2)
As long as the aggregate reaction of the federal government and the different regional governments is
strong enough to offset rises in debt with higher surpluses, public debt is sustainable. It matters little
which government is stabilising debt in this case. We may test condition (2) with a system of fiscal
rules like (3),
b*
t* + μ1,t
(3)
* * .
sN,t = PNbt + μN,t
Now suppose the federal government is the only government to stabilise debt, while all regions
disregard debt. In this extreme case, the federal government bears completely the brunt of debt. This
would be a serious problem of soft budget constraints. We can test whether the federal government
N
consolidates more than the regions consolidate jointly in (3). The condition ρ1 > ∑ ρi is sufficient
i=2
to have a problem of soft budget constraints, even if (2) holds. 8
Usually, fiscal control mechanisms that are written in the constitution require regional governments to
pay only attention to its own debt burden. Even in the few countries that have recently devolved more
fiscal powers to regions, there are no agreements to share the historical debt burden of the federation
(e.g., Belgium, Spain). Hence, one might prefer testing a fiscal rule (4) for each tier of government
individually:
si,t = ρbi*,t + μi,t . (4)
8 In contrast, if the federal government were to pursue unsustainable fiscal plans, general government debt might
still be sustainable if regions bail out the central government. These ‘top-down’ soft budget constraints are a
rather odd assumption though. A weak center and strong regions exist in a few (con)federations. But in cases like
Argentina or Brazil, regions have usually shifted their fiscal problems to the federal level, pressuring the central
government to use its privileged access to central bank financing in the common currency.