As a further validation of the mechanism at work, we conduct a series of checks. First, given that the FD Law also imposed limits to the indebtedness of municipal governments, we corroborate that the unwinding of crowding out of private firms is also present at the municipal level. That is, conditional on the public indebtedness of a state, we find that bank lending to the private sector increases more in municipalities with ex ante higher per capita public debt following the FD Law. Second, we use firm balance-sheet data to examine the evolution of real outcomes of firms after the Law and find that—consistent with the state-level GDP and employment results—firms headquartered in states with ex ante higher indebtedness grow more their liabilities, assets, and sales after the Law. For instance, a one-standard-deviation increase in a state’s public indebtedness is associated with an increase of 6 percent in firm liabilities, 7 percent in firm assets, and 1.2 in firm sales. These effects are stronger for firms headquartered in municipalities with branches of banks more exposed to local public debt. Third, consistent with the employment growth observed in the secondary sector, we document that in ex ante more indebted states, banks channel substantially more lending to firms in the secondary sector after the Law. Fourth, we corroborate that private-sector borrowers operating in sectors less dependent on public spending (i.e., less affected by the contraction in government spending) benefit relatively more from the unwinding of the crowding out.<sup>9</sup> Our paper contributes to the literature on local fiscal multipliers (Nakamura and Steinsson (2018); Adelino, Cunha and Ferreira (2017)) and, more generally, the literature on the impact of fiscal austerity.<sup>10</sup> Alesina, Favaro and Giavazzi (2019b) use cross-country panel data to analyze 9 To rule out that our results are driven by the most indebted states, we adopt a difference-in-difference approach where the treatment variable is discrete and equal to one for states above the median indebtedness in the quarter prior to the FD Law and zero otherwise. We find that our results remain very similar under this specification. Another threat to our identification is that the FD Law also established procurement rules intended to guarantee that subnational debt was obtained at the lowest financial cost. Such rules could have induced local governments with ex-ante lower debt to increase their indebtedness, in which case our estimates would be positively biased. To rule this out, we examine changes in bank lending by local governments and confirm that ex-ante less-indebted local governments did not expand their bank liabilities after the Law. Furthermore, we also find that our results hold when restricting the sample to states with ex-ante similar debt-to-net-income ratios but subject to different debt ceilings. Additionally, given that Mexico is an oil producer country, we also rule out that our results are explained by the global collapse in energy prices of mid-2014 (all our results hold if we drop from the sample the oil producing states). Finally, we rule out that our results are driven by variations in external conditions. Given that northern states are more exposed to external shocks due to stronger economic relations with the United States, we split the sample into northern and non-northern states and confirm that our results are not geographically concentrated.

10 Chodorow-Reich (2019) studies the effect of an increase in spending in one region of a monetary union, concluding that an average point estimate for a cross-sectional multiplier is 1.8. Using a panel of OECD countries, Guajardo, Leigh and Pescatori (2014) find that fiscal consolidation has contractionary effects on private demand an on GDP.

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