The world's governments are growing increasingly dependent on credit markets. This dependence is strengthening investors' capacity to reward or punish governments for their policy responsibilities, size, and other potential drivers of investor profits. This project examines sources of market punishments and rewards as they relate to local and regional governments. It addresses two questions. First, do international rating agencies penalize local and regional governments for spending on health care, education, and other core social service functions? Second, which governments borrow on the best terms: those representing large or small jurisdictions?

The researcher argues that investors penalize governments for rigid social commitments: high levels of spending on health care and other politically sensitive social services. These commitments benefit large numbers of voters and unionized service providers and are correspondingly difficult to cut. This limits the fiscal flexibility that local and regional governments may require to balance budgets, causing investors to demand higher interest rates on public bonds and loans. But these reactions are offset by several national-level factors, including sub-national authority to adjust revenues and expenditures, national fiscal and economic performance, and the likelihood of national bailouts.

The researcher also argues that, contrary to received wisdom, small governments often borrow on better terms than do large issuers. Although investors value the debt of large issuers for its liquidity, they also value diversification. Investing in the relatively scarce debt of small governments allows investors to diversify away from the more plentiful instruments of large issuers. But the relative advantages of size also depend on market conditions and their interactions with investors' liquidity preferences. Liquidity needs increase with market volatility, inducing flights from the securities of small to the securities of large governments. The intensity of these flights depends on investors' liquidity preferences, which vary across time and countries.

This work tests these claims using a wide range of quantitative and qualitative methods and data, including broad cross-national analysis of credit ratings and methodologies, a more focused statistical look at regional borrowing costs in Canada and Germany, and semi-structured interviews with bond underwriters and investors.

This work advances interdisciplinary research in political science and economics. First, it stands as the first broadly cross-national analysis of the effects of financial globalization on sub-national provision of social services. Scholarship to date has focused almost exclusively on the national level, while provision of social services has been decentralized to significant degrees. Second, this project advances research on economic agents' preferences over social spending. Third, the project contributes to work on fiscal federalism and sub-national bailout guarantees. Contrary to a large literature, it finds little evidence linking bailout guarantees to sub-national fiscal dependence, but it does find evidence linking guarantees to other factors. Finally, it advances debates about the merits of fiscal decentralization for big and small governments.

This research makes several broader contributions. It sheds light on the sustainability of decentralized social spending in an age of austerity and financial uncertainty. It also enhances understanding of the links between public borrowing costs, government size, and the mark-to-market accounting practices increasingly prevalent across the globe. In addition, it illuminates the determinants of sub-national bailout guarantees.

Project Report

Intellectual Merit: This research contributes to an emerging body of work on the political economy of federalism. This literature seeks to explain the economic and political implications of systems of decentralized governance. At a more micro-level, it seeks to explain the role of decentralized institutions in shaping the incentives of elected officials. Our work contributes to these efforts, but departs from them in important ways. Specifically, it examines the ways in which investors, ratings agencies, and other credit market participants interpret these incentives and their implications for subnational default risk. These perceptions underlie risk premiums, credit ratings and other observable constraints on subnational fiscal policy. Prior to our study, the literature had yet to establish a direct empirical relationship between these perceptions and aspects of the fiscal federal environment. Ours was the first to decompose subnational credit risk into its logical components, link these beliefs to features of the fiscal federal environment, and to test these linkages on micro-level data. These data consisted of bailout probabilities and standalone credit ratings generated by the major international credit rating agencies as well as measures of bailout beliefs collected from interviews with investors in and underwriters of subnational debt in Canada and Germany. Our findings overturn the conventional view that market constraints are weakest for governments that depend heavily on transfers from higher tiers of governments. The prevailing wisdom claims that dependent governments borrow more and at lower rates than their fiscal performance dictates because investors interpret transfer dependence as an implicit national guarantee on subnational debt. However, our research shows that the effects of transfer dependence are overstated and that, if anything, dependence increases default risk. Not only does dependence fail to send compelling bailout cues, but it also harms local creditworthiness by restricting units' ability to raise additional tax revenues during periods of fiscal distress. We find positive relationships between bailout expectations and other aspects of the fiscal federal environment, including subnational responsibility for universal social services, and formal national commitments to redistributing risk and wealth across territorial units. However, we caution against overstating the importance of fiscal federal variables. Not only do their effects decline with levels of national economic development, but most variation in local default risk is driven by expectations of central government default. More generally, our findings have implications for debates about the redistributive and fiscal effects of transfer systems. Existing research associates decentralized taxing authority with smaller government and greater fiscal discipline. Decentralization is said to achieve these outcomes by, among other things, credibly committing national officials to letting subunits default. But our work suggests that decentralization exerts no such effect. We find it is not the level but the nature of transfers (e.g., their redistributive and risk-sharing properties) that sends investors the most compelling bailout cues. Broader Impact: Public debt is on the rise. This is true for both national and subnational governments. Governments need to adopt sustainable fiscal policies and institutions in order to sustain valued social services, capital investments, and public goods. Market constraints play an important role in determining the sustainability of fiscal policy. Fiscal federalism - the focus of this project - helps shapes these constraints. Our hope is that our findings inform public efforts to adopt fiscal policies and intergovernmental institutions that lead to optimal relationships between subnational governments and credit markets.

National Science Foundation (NSF)
Division of Social and Economic Sciences (SES)
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Brian D. Humes
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University of Wisconsin Madison
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