Fiscal Stability during the Great Recession: Putting Decentralization Design to the Test

There is a longstanding debate in the economics literature on whether fiscally decentralized countries are inherently more fiscally unstable. The Great Recession provides a fertile testing ground for analyzing how the degree of decentralization does actually affect countries’ ability to implement fiscal stabilization policies in response to macroeconomic shocks. We provide an empirical analysis aiming at disentangling the roles played by decentralization design itself and several recently introduced budgetary institutions such as subnational borrowing rules and fiscal responsibility laws on country’s fiscal stability. We use OECD countries’ data since 1995, which includes both a boom period of worldwide economic growth and the Great Recession. Our main finding is that well-designed decentralized systems are not destabilizing. But, in addition, sub-national fiscal and borrowing rules should be at work to improve the overall fiscal stability performance of decentralized countries.Length: 29 pages