Uncertainty and the Preferred Instrument for Fiscal Discipline Under Multitier Government

We often observe public borrowing constraints because they are effective measures in enforcing political commitment to fiscal discipline. In a federation, however, penalties are helpful in providing flexibility in fiscal adjustment. This paper examines how this trade-off is affected by uncertainty. The model incorporates exogenous uncertainty, with respect to both the damages and savings of the public deficit. In addition, the model accommodates for externalities and asymmetric information as a result of a multitier government structure. Results indicate that strongly asymmetric uncertainty in regional budgetary policy makes a borrowing constraint undesirable. The latter is stressed as exceptionally disturbing as EMU member states are still considered to be asymmetric in their stochastics, while stressing borrowing constraints as the principal instrument for fiscal discipline. Uniformity moreover adds to the shortcomings of the fiscal rules in place.