Governments may fail to follow sustainable fiscal policies for a variety of reasons, however (see Alesina 1994 for a survey), and they have adopted various institutions to try to restrain themselves, including balanced-budget rules, autonomous central banks, and congressional oversight committees. Since the late 1990s, governments have added FRLs to the potential and actual arsenal.

_Dealing with Free Riders._ Suppose that multiple governments share the same currency, central bank, domestic credit market, and (at least to some extent) international credit reputation. Then they will share a common interest in sustainable fiscal balances for the country in the aggregate, to maintain stable prices, a healthy financial system, and good access to international credit. Individual governments’ interests would diverge from the common interest, however, in that electoral pressures, etc., would motivate them to follow unsustainable, or at least risky, fiscal behavior. The individual government would bear only part of the cost of this, but would still receive all of whatever benefit accrued. They could benefit from this, however, only if (most of) the other governments continued to follow good fiscal behavior. So, there might be a prisoners’ dilemma, or a situation where the equilibrium of isolated individual choices leads to suboptimal outcomes for all. All the governments would, therefore, benefit from having a system of rules to discourage such defection and free-riding. Inman 2003 develops the prisoners’ dilemma model formally for this situation and shows how restrictive are the conditions under which the central government can take a hands-off, nobailout approach under which the market successfully establishes SN fiscal discipline. No Latin American or other developing countries have these conditions (Rodden and Eskeland 2003).

In a federal country, one of the multiple governments —the federal government—already exists for the purpose (among others) of protecting the common interests, has much greater fiscal weight than the others, and typically has special powers, like running the central bank and regulating the financial sector. The federal government also provides transfers to the subnational governments, which often are the main source of SN revenue and give the federal government additional leverage over them. But this may not be enough. Rules of revenue sharing and other rules of the federal system (like the constitution) may restrain the federal government’s power over the SNGs. Political considerations may bias the decisions of the federal government away from the optimal; these could be the national political cycle or subnational ones (Braun and Tommasi 2004). For instance when a state government of the same political party as the national government faces a close election, the national government might be inclined to condone the state’s fiscal misbehavior by offering a debt bailout or rescheduling guarantee. Also, under some configurations of political institutions, the national executive might need to purchase blocks of legislative votes through provincial fiscal favors, in ways that also break the intertemporal Wicksellian connection, by which voters demand fiscal discipline to protect their interest as taxpayers. Thus the agreement to protect the common interest would not only need to restrain the fiscal behavior of the individual subnational governments but also restrain the behavior of the federal government.

Sub-national debt markets in both developed and developing countries have three important agency problems. First, sub-national borrowers as agents have an incentive not to repay their lenders as principals because they perceive that they will be bailed-out by the central government in case of default, resulting in moral hazard. Second, sub-national borrowers as agents have an incentive not to reveal certain characteristics about themselves to lenders as principals, resulting in adverse selection. Third, banks are implicit agents of the nation, entrusted to maintain the nation’s payment system and creditworthiness, and they often abuse this trust by lending to uncreditworthy SNGs (in collusion with the SNGs) with the expectation of a national government bailout in case of trouble. The incidence of these agency problems varies considerably depending on the structure of the sub-national debt market in each country. For instance, the credibility and prudence of a no-bailout commitment by the national government in the event of subnational default depends partly on whether the creditors to the defaulting subnational government are foreign or domestic.

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