Preventing Local Government Defaults: No-Bailout Policy and Its Alternatives

Fiscal decentralization introduces the risk that subnational governments act fiscally irresponsible in the belief that a higher 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 theory and practice and between 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. Fiscally responsive behavior of subnational governments seems to depend on 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