Preventing local government defaults : no-bailout policy and its alternatives

Fiscal decentralisation introduces the risk that subnational governments may act in a fiscally irresponsible manner in the belief that a higher tier of government will bail them out if they run into trouble. The economic literature, therefore, prescribes a strict no-bailout policy. We survey fiscal rules and fiscal policies concerning subnational governments in 20 European countries and find wide discrepancies, both between the theory and practice and between the rules and actual policies. Countries with a no-bailout rule often do bail out subnational governments, sometimes on a large scale, while countries lacking such a rule sometimes do not, or only sparingly. The fiscally responsible behaviour of subnational governments seems to depend upon a balanced mix of policy measures, notably providing sufficient funding, adequate fiscal supervision, early intervention mechanisms and bailout rules that are sufficiently unattractive. A no-bailout rule is neither necessary nor sufficient.