Bailouts, Budget Constraints, and Leviathans

Abstract

Recent research on federations, particularly in the developing world, emphasizes the importance of hard budget constraints and a strong central government to attenuate intergovernmental economic conflicts. Such research fails on two counts. First, it does not explain how hard budget constraints emerge or become self-enforcing. Second, it does not take into account the insight of the market-preserving federalism literature that central governments strong enough to impose restraint on regions are likely too powerful to be checked in a manner consistent with the longterm health of markets. Unfortunately, the market-preserving federalism literature itself provides little insight into how to move from a market-distorting to a market-preserving equilibrium. This article answers these theoretical shortcomings with reference to the evolution of political competition at the regional level and the representation of those regions at the national level. More specifically, whereas regional competition determines the subnational demand for soft budget constraints, the coalition of those regions at the national level determines the likelihood of their provision. Empirically, the research relies on a case study of the state debt crisis of the 1840s when the United States made a definitive movement toward market-preserving federalism.

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