A Fiscal Federalism Analysis of Debt Policies by Sovereign Regional Governments

This paper takes a fiscal federalism approach to analyzing debt issue by subfederal (regional) governments. Households have a short-run attachment to a particular region but are free to migrate between regions in the long run. Regional governments choose their fiscal policies independently. It is shown that the Nash equilibrium of regional fiscal policies is one where migration is efficient and households are insured against the idiosyncratic part of shocks occurring in the region in which they live. However, regional governments issue too much debt relative to the level that would be issued under a coordinated policy, such as that which might be carried out by a federal government.