Central Regulation of Local Government Borrowing: A Game-Theoretical Approach

In this paper the author considers whether central authorities should regulate local sector borrowing. Local government's debt policy is modeled as the outcome of a two-period game between three agents: Central government, local government, and a bureau which produces services on behalf of local government. A key assumption of the model is that neither central nor local government is able to undertake long-term budget commitments. Two rationales are found for central regulations. First, local government is prevented from using deficits strategically to extract higher grants from central authorities. Second, the debt limit gives credibility to local government's budget policy towards the bureau.