7 called Traffic Light Law of 1997 introduced a rating system for territorial governments, based on the ratios of interest to operational savings and of debt to current revenues. Highly indebted local governments (red light) were prohibited from borrowing, and intermediate cases (yellow light) were required to obtain permission from the Ministry of Finance. The law often did not have the desired effect, however, as some governments with a red-light rating obtained new financing without permission of the Ministry of Finance, and departments often changed from yellow to red, rather than moving from yellow to green, as expected. In a new attempt to implement fiscal rules to stabilize subnational finances, Colombia passed Law 617 in 2000, which functioned in many ways as a Subnational FRL; despite the fiscal crisis at the national level in 2001-02, Law 617 had some success at the subnational level and laid the foundations for subsequent steps. In June 2003 the government passed the Fiscal Responsibility Law, which applied to the national as well as the subnational governments.

**Peru** is a unitary state, with even more of a centrist tradition than Colombia. Decentralization came relatively late to Peru, as part of a democratic reaction after Fujimori’s exit in 2001.  The 2002 decentralization law foresaw having half or more of public sector spending managed and to some extent allocated by subnational _—_ governments—districts, and municipalities compared to the previous situation where SNGs managed less than 10 percent of public spending.  In contrast to the experiences of the other Latin American countries discussed here, the behavior of subnational public finances in Peru never deteriorated to the point where it adversely affected the country’s financial sector or macroeconomic stability. As they contemplated fiscal decentralization and saw the macroeconomic problems that decentralized countries had had in the 1990s, the authorities passed the FRL and other measures to assure that fiscal decentralization did not lead to fiscal imbalances.  As discussed below, the restraint measures in Peru succeeded perhaps too well, preventing effective fiscal devolution.

# **III. FRLs – Purpose, Incentives, and Authority**

Before delving into the content of FRLs (section IV), we need to understand why governments might pass such laws, how they fit in the political context, how they address the timing of borrowing-lending decisions, which level of government passes them, and to which governments the FRL applies.

## **A.** **_Aligning fiscal incentives_**

In a normative theory of good government, voters want to avoid the effects of a fiscal crisis—inflationary finance, sudden increase of taxes, disruption of service, and increased borrowing costs—so their government would equally want to avoid the crises. In practice, governments may fail to follow sustainable fiscal policies for a variety of reasons discussed in this section (see Alesina 1994 for a survey and Saeigh and Tommasi 2000 for applications to federations). Multiple levels of government multiply the possible reasons for failure of fiscal responsibility. To deal with these problems, governments have adopted various institutions to try to restrain themselves, including balanced-budget rules, autonomous central banks, and congressional oversight