Sovereign Bail-Outs and Fiscal Rules in a Banking Union

This paper studies optimal fiscal rules in a two-country economy in which cross-country linkages between sovereign debts and banking sectors motivate bail-outs among countries. The first-best sovereign borrowing, which is contingent on countries' output gap, cannot be achieved in the presence of asymmetric information on a country's potential output. Because bail-out induces overborrowing, fiscal rules can be implemented to prevent the ensuing inefficiency. A mechanism can be designed to induce a country with low potential output (i.e., a small negative output gap) to run an optimal budget deficit upon receiving a (ex-post) transfer from the other country. We characterize conditions under which this `cyclically- contingent' fiscal mechanism Pareto dominates an alternative `cyclically-adjusted' fiscal rule imposing a unique ceiling on a country's borrowing, independently of its potential output.