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Bailouts in federations : is a hard budget constraint always\ud best?

By Martin Besfamille and Ben Lockwood


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. \u

Topics: HC
Publisher: Wiley-Blackwell Publishing, Inc.
Year: 2008
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