Potential output and fiscal rules in a monetary union under asymmetric information

We analyze fiscal rules within a Monetary Union in the presence of (i) asymmetric information about member states' potential output and, therefore, output gap and (ii) bail-out among member states. In our framework, bail-out lowers the scope for signalling (discrimination) by member states (lenders). In the presence of asymmetric information, bail-out and national governments' shortsightedness make the first-best fiscal rule non-implementable as member states are tempted to run excessively high deficits. The Monetary Union designs a mechanism such that member states with high output gap (i.e., in a recession) run higher budget deficits by making an ex-post transfer to the Union. We find that the first-best deficit is contingent on the cycle - i.e., on the member state's output gap - and, all else equal, can be implemented provided the member states' ability to repay its own debt upon the realization of a bad shock is sufficiently high. A downward distortion in the deficit run by a member state during an expansion is otherwise introduced. Finally, the Monetary Union cannot discriminate among types of borrowers when national governments are excessively shortsighted.