Fiscal Rules, Bailouts, and Reputation in Federal Governments

Transcription

1 Fiscal Rules, Bailouts, and Reputation in Federal Governments Alessandro Dovis and Rishabh Kirpalani ASSA Meeting 2017

2 Overview In federal states, local gov ts may over-borrow if central gov t cannot commit Central gov t has incentives to bail out local gov ts ex-post Examples: Argentina, Brazil, German länders, EMU One proposed solution is to use fiscal rules Defined as borrowing limits and punishments if these are violated Example: Stability and Growth Pact

3 Overview In federal states, local gov ts may over-borrow if central gov t cannot commit Central gov t has incentives to bail out local gov ts ex-post Examples: Argentina, Brazil, German länders, EMU One proposed solution is to use fiscal rules Defined as borrowing limits and punishments if these are violated Example: Stability and Growth Pact Why can the central gov t commit to rules and not to no-bailout clauses?

4 This Paper Study effects of fiscal rules when the central gov t cannot commit No-bailout clauses Enforcing fiscal rules Local gov ts uncertain about the type of the central gov t Enforcement type: committed to enforce fiscal constitution Non-enforcement type: cannot commit Compare equilibrium outcomes with and without fiscal rules

5 Fiscal Rules Can Promote Fiscal Indiscipline When reputation is low (low probability of facing commitment type) There exists parameters such that the debt is higher with rules With binding rules type of the central gov t is revealed earlier Rules increase cost of maintaining good reputation Knowing type of the central gov t earlier reduces cost of issuing debt for local gov t ex-ante

6 Equilibrium Fiscal Rules If rules can be detrimental when reputation is low: Why do we observe rules in equilibrium? Outcome of a signaling game between two types of central gov t When reputation is low Commitment type finds optimal to set tight rules No-commitment type initially mimics Rules are violated and not enforced by no-commitment type

7 Related Literature Lack of commitment and bailouts: Chari and Kehoe (2007, 2008), Cooper Kempf and Peled (2008), Rodden (2002) Using fiscal rules to overcome commitment problem: Beetsma and Uhlig (1999), Alfaro and Kanczuk (2016), Hatchondo, Martinez and Roch (2015), Amador et al (2006), Halac and Yared (2014) Reputation: Phelan (2006), D Erasmo (2008) Uncertainty as commitment Nosal and Ordonez (2013)

8 MODEL

9 Environment t = 0, 1, 2 Small open economy composed of two regions, i {N, S} Representative citizen has preferences over local public good U = 2 β t u (G it ). t=0 Assume throughout: coefficient of absolute risk aversion small Benevolent local governments Tax revenues: Y it with Y S0 < Y N0 and Y it = Y for t 0 Benevolent central government Can make transfers T it such that i T it = 0 Commitment type with probability π: always follows constitution No-Commitment type with probability 1 π

10 Fiscal Constitution Two Clauses: No bailout clause: T it = 0 Fiscal rule: ( b, ψ) Debt limit: b Punishment ψy if b i1 > b, where ψ <

11 Timing and Actions At t = 0, the local gov ts choose G i0 and b i1 subject to G i0 Y i0 + qb i1. At t = 1 No-commitment type decides whether to make a transfer {T i1 } and to enforce fiscal rule σ {0, 1} Local gov ts update their priors about central government type Choose G i1 and b i2 subject to G i1 + b i1 Y i1 σψy1 bi1 > b + T i1 + qb i2. At t = 2 No-commitment type decides whether to make a transfer {T i2 } Local gov t consumes G i2 = Y b i2 + T i2

12 Timing and Actions At t = 0, the local gov ts choose G i0 and b i1 subject to G i0 Y i0 + qb i1. At t = 1 No-commitment type decides whether to make a transfer {T i1 } and to enforce fiscal rule σ {0, 1} Local gov ts update their priors about central government type Choose G i1 and b i2 subject to G i1 + b i1 Y i1 σψy1 bi1 > b + T i1 + qb i2. At t = 2 No-commitment type decides whether to make a transfer {T i2 } Local gov t consumes G i2 = Y b i2 + T i2 Characterize perfect bayesian equilibrium (pure strategies)

13 Forces in the Model Overborrowing Central gov t ex-post wants to equalize local public good provision Local gov ts anticipate transfers and do not internalize full cost of debt issuance If π < 1 inefficient front-loading of public good consumption qu (G it ) < βu (G it+1 ) Reputation lowers incentives to overborrow Local gov ts anticipate transfers with lower probability If enforced, fiscal rules lower incentives to overborrow If local gov t overborrows, it must pay penalty

14 FISCAL RULES PROMOTE FISCAL INDISCIPLINE

15 Fiscal Rules Can Promote Fiscal Indiscipline If reputation is low (π low enough) and β β then There exists parameters such that the debt is higher with rules Without rules (ψ = 0) Unique equilibrium outcome where fiscal constitution is enforced in period 1 (no bailout) central gov t type is not revealed at t = 1 (late revelation) With binding rules (ψ (0, ψ) and b low enough) Unique equilibrium outcome where rules are violated by the South and not enforced by the no-commitment type in period 1 central gov t type is revealed at t = 1 (early revelation)

16 No Rules: Incentives to Enforce Constitution at t = 1 Without rules only decision is about bailout Costs: Dispersion in local public good provision Benefits: Less over-borrowing due to maintained reputation Euler equation without bailout, π = π u (Y b i1 + qb i2 ) q = βπu (Y b i2 )+ β ( 2 (1 π) u Y b ) i2 + b i2 2 Euler equation with bailout, π = 0 u (Y b i1 + qb i2 ) q = β ( 2 u Y b ) i2 + b i2 2 For π > 0, if debt more dispersed higher incentive to not enforce constitution

17 No Rules Late Revelation For π 0 Costs are second order Local gov ts expect a bailout almost surely in period 2 So adjust their borrowing to keep today consumption constant qu (G i1 ) = βπu (Y b i2 ) + β ( 2 (1 π) u Y b ) i2 + b i2 2 so for π 0 G N1 = G S1 Benefits are first order So for low level of reputation optimal to enforce constitution

18 Rules: Incentives to Enforce Constitution at t = 1 With rules decision is about bailout and enforcement of fiscal rule Costs: More dispersion in local public good provision Enforce penalty on local gov t that violates the rule (which already has low marginal utility) Benefits: Less over-borrowing due to maintained reputation So for π 0 costs of enforcing constitution are no longer second order: Rules increase costs of maintaining good reputation

19 Rules: Incentives to Enforce Constitution at t = 1 With rules decision is about bailout and enforcement of fiscal rule Costs: More dispersion in local public good provision Enforce penalty on local gov t that violates the rule (which already has low marginal utility) Benefits: Less over-borrowing due to maintained reputation So for π 0 costs of enforcing constitution are no longer second order: Rules increase costs of maintaining good reputation Rules Early Revelation When reputation is low optimal not to enforce

20 How Early vs. Late Revelation Affect Debt Issuance? With early revelation Debt issued in period 1 is contingent on central gov t type Lower marginal cost of issuing debt in period 0 Two channels: Strategic Prudence More borrowing in period 0

21 How Early vs. Late Revelation Affect Debt Issuance? Without rules, b S1 must equate qu (Y S0 + qb S1 ) to β 2 q πu (Y b S2 (b 1, π, 0)) + β2 2q + β2 2 (1 π) u (1 π) u ( Y B 2 (b 1, π, 0) 2 With rules, b S1 must equate qu (Y S0 + qb S1 ) to β 2 ( ( q πu Y b S2 b b 1, 1, ψ )) + β2 2q + β2 2 (1 π) u (1 π) u ( Y B 2 (b 1, 0, ψ) 2 ( Y B 2 (b 1, π, 0) 2 ) ) b S1 b N2 (b 1, π, 0) ( Y B 2 (b 1, 0, ψ) 2 ) ) b S1 b N2 ( b b 1, 0, ψ ) where B 2 ( b b 1, π, ψ ) = b S2 ( b b 1, π, ψ ) + b N2 ( b b 1, π, ψ )

22 How Early vs. Late Revelation Affect Debt Issuance? Without rules, b S1 must equate qu (Y S0 + qb S1 ) to β 2 q πu (Y b S2 (b 1, π, 0)) + β2 2q + β2 2 (1 π) u (1 π) u ( Y B 2 (b 1, π, 0) 2 With rules, b S1 must equate qu (Y S0 + qb S1 ) to β 2 q πu (Y b S2 (b 1, 1, ψ)) + β2 2q + β2 2 (1 π) u (1 π) u ( Y B 2 (b 1, 0, ψ) 2 ( Y B 2 (b 1, π, 0) 2 ) ) b S1 b N2 (b 1, π, 0) ( Y B 2 (b 1, 0, ψ) 2 ) ) b S1 b N2 ( b b 1, 0, ψ ) b 2 contingent on type of gov t with rules and not without

23 Strategic Channel If type of central gov t is known North reduces its debt more in response to an increase in South inherited debt Because knows that there will be debt mutualization for sure Hence b N2 (b 1, π, 0) b < b N2 (b 1, 0, 0) S1 b S1 This reduces marginal costs for the South

24 Prudence Channel (if marginal utility convex) u u /2 Y b S2 (π) Y b S2 (1) Y B 2 (0) Y B 2 (π) G S2

25 EQUILIBRIUM FISCAL RULES

26 Equilibrium Fiscal Rules So far rules taken as given Show in paper that under veil of ignorance fiscal rules are welfare reducing when reputation is low Why do we observe rules in equilibrium?

27 Equilibrium Fiscal Rules So far rules taken as given Show in paper that under veil of ignorance fiscal rules are welfare reducing when reputation is low Why do we observe rules in equilibrium? Outcome of a signaling game between two types of government: For π close to zero, if β < β, there exist unique equilibrium constitution with no rules For π close to zero, if β [β, β], there exist unique equilibrium constitution with rules where - Rules are violated - Early resolution of uncertainty

28 Equilibrium Fiscal Rules So far rules taken as given Show in paper that under veil of ignorance fiscal rules are welfare reducing when reputation is low Why do we observe rules in equilibrium? Outcome of a signaling game between two types of government: For π close to zero, if β < β, there exist unique equilibrium constitution with no rules For π close to zero, if β [β, β], there exist unique equilibrium constitution with rules where - Rules are violated - Early resolution of uncertainty Rationalize why we often observe central governments with low reputation setting up tough fiscal rules

29 Extensions Local gov t cannot commit to repay Monetary union as in Chari-Kehoe (2007) Small vs. big local governments With non-atomistic local government: - Rules can be beneficial even if no commit to enforcement - Weak implementation: multiple equilibria

30 Conclusion Fiscal rules proposed as solution to overcome overborrowing when central gov t cannot commit not to bailout local gov t If cannot commit, fiscal rules detrimental when reputation low Promote fiscal indiscipline Make it harder for central gov t to maintain good reputation Arise in equilibrium when reputation low even if detrimental Rationalize several historical examples when: Fiscal rules have been instituted but not enforced Stringent fiscal rules arise when the reputation of the government is low