BAILOUTS IN FEDERATIONS: IS A HARD BUDGET CONSTRAINT ALWAYS BEST?

Martin Besfamille and Ben Lockwood

International Economic Review, 2008, vol. 49, issue 2, 577-593

Abstract: This article analyses hard and soft budget constraints in a federation, where there is a moral hazard problem between the central and the regional governments. Regional governments can avoid a bailout from the center by exerting costly effort. In this setting, a hard budget constraint is not always optimal because it can provide excessive incentives for high effort, and thus discourage investment that is socially efficient. Thus, a hard budget constraint can imply the opposite kind of inefficiency that emerges under a soft budget constraint, where the common pool problem can give rise to inefficiently low effort and overinvestment. Copyright ©2008 by the Economics Department Of The University Of Pennsylvania And Osaka University Institute Of Social And Economic Research Association.

Date: 2008
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