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Bailouts In Federations: Is A Hard Budget Constraint Always Best?

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  • Martin Besfamille
  • Ben Lockwood

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.

Suggested Citation

  • Martin Besfamille & Ben Lockwood, 2008. "Bailouts In Federations: Is A Hard Budget Constraint Always Best?," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 49(2), pages 577-593, May.
  • Handle: RePEc:ier:iecrev:v:49:y:2008:i:2:p:577-593
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