The previous chapter argued that in order to bring the theory literature closer to evolving empirical realities around the world, the old notion of decentralization as a clean division of sovereignty among vertically arranged governments must be replaced by an approach that highlights the murkiness and contestability of sovereignty in a world with opportunistic, politically motivated actors. The previous chapter also reviewed some rather attractive and time-honored arguments linking decentralization, federalism, and fiscal discipline, but then examined cross-country data suggesting that modern forms of decentralization and federalism seem inconsistent with their basic assumptions.

In order to pave the way for an explanation of the wide range of experiences related to decentralization, federalism, and fiscal discipline around the world, this chapter takes a political economy approach to the issue of sovereignty over debt in multitiered systems. It presents a dynamic game of incomplete information played between higher and lower-level governments, each of which has incentives to see that the other government undertakes painful adjustment to negative income shocks. A key lesson is that when sovereignty is unclear or disputed, actors use the information available to them and assign probabilities to the likely ultimate locus of authority in the event of a conflict.