Subnational borrowing and bailouts: When the federal government looks at the votes (differently) and its borrowing matters

Abstract

Sometimes it is difficult to find a rationale for episodes of bailouts in which the political motivations of the federal government are not clear cut. In other cases, the soft‐budget constraint of subnational governments (SNGs) seems to be based on unlimited federal resources. This paper aims to shed some light on both issues taking as a reference the workhorse model developed by Goodspeed. The principal change in its basic assumptions lies in allowing the federal government to borrow to finance its grants to SNGs. The results indicate that the way in which the federal government translates voters' preferences into electoral probabilities is crucial to determine grants. Moreover, the SNGs do not borrow excessively. When the model is extended to consider risk premium spreads in the SNGs debt and the option of transferring part of their borrowing to the upper level, the main outcomes remain.