INTRODUCTION

The implicit assumption in this recent World Bank book on Mexico is that democratization leads to decentralization and that the latter leads to development. In all fairness, the publication and the Bank have been careful to point out that not all decentralization is good for development. This chapter argues that, in practice, not all democracies have equally auspicious forces driving the decentralization process.

Decentralization can, but does not necessarily, improve accountability, equity, and government performance. From the citizen's point of view, the specific benefits that decentralization can bring about depend on the way they are represented politically as well as the kinds of institutions that form and implement government policy. Moreover, the costs and benefits of decentralization depend largely on the entry points and intermediate goals for the transition from the centralized state to a decentralized public sector. There is no standard path toward decentralization; and countries also rarely plan their path toward a final version of the decentralized state – the process is more often the result of internally inconsistent accumulated reforms adopted over time in response to changes in the political balance.

This chapter is centered on two interconnected developments that account for the main challenges for Mexico's decentralization today.

Federalism in general, and fiscal federalism in particular, are crucial axes of Argentina's history, of Argentina's current situation, and of Argentina's possible futures. This paper provides a tour of the recent history of fiscal federalism in Argentina and an overview of its current configuration and main problems.

Federalism is ingrained in the Argentine political system in several ways that are crucial for national policy. Provincial governors are important players in the national game, as they are often party bosses wielding substantial leverage over national politicians via electoral mechanisms and party practices. Provinces are also heavily dependent on central monies for their finances, leading to a particular intertwining of national and subnational politics and policies. This federal connection is, in turn, intertwined with some more general characteristics of the workings of the Argentine policymaking process, which is characterized by the inability to establish and enforce efficient intertemporal agreements. This inability maps into policies that are either too volatile (responding to political opportunism) or too rigid, as a protection against that opportunism. These policy characteristics are particularly salient in the federal fiscal domain.

After a brief description of some general characteristics of Argentina and of its fiscal federalism in Section I, Section II focuses on the relationship between federalism and the market-oriented reform process of the 1990s. The 1989 economic crisis provided the incentives that led to the initiation of the reforms, triggering a series of delegation patterns conducive to the adoption of the reform agenda.

This book asks a very specific question: Under what conditions do the actions of state and local governments strengthen or undermine the overall fiscal discipline of government? Yet the question is posed with an eye on older and larger questions about the relationship between decentralization, federalism, and the efficiency and accountability of government. Thus, it is useful to situate current debates about fiscal discipline within a larger current of intellectual history that runs through the classics of political philosophy to modern public economics. Moreover, an important first step in doing theoretical and empirical work on this topic is to cut through the array of definitions and measurements of decentralization and federalism used in diverse literatures and settle on some concepts that will be used throughout the book. In doing so, this chapter also serves to highlight the ways in which the approach taken in this book departs from previous studies.

After introducing in broad terms the classic themes that motivate modern research, this chapter reviews the contributions of welfare economics and public choice theory to the notion that federalism and decentralization can enhance the efficiency and accountability of government. It pays special attention to theories suggesting that decentralization, especially in the context of federalism, can enhance overall fiscal discipline. Next, these abstract arguments are confronted with attempts to define decentralization and federalism with more precision and pin them down with cross-country empirical measures.

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.

This book has made much of a distinction between fiscal sovereignty and semisovereignty among constituent units in federations. By the middle of the twentieth century in the United States, Canada, and Switzerland, voters and creditors had come to see the states, provinces, and cantons as sovereign debtors. On the other hand, detailed case studies of Germany and Brazil in the 1980s and' 90s analyzed what can go wrong in federations where subnational entities are semisovereign: They are allowed to borrow freely even though fiscal and political institutions send strong signals to voters and creditors that the central government can ultimately be held responsible for their debts. Yet a more basic set of questions remains unanswered: Why do the institutions that bolster subnational fiscal sovereignty – above all, a limited center and wide-ranging subnational tax authority – so often slip away? In the long run, why do some federations maintain distinct spheres of fiscal sovereignty among the constituent units while others do not?

All modern countries are artificial constructs put together by a combination of brute force and bargaining after a long period in which the only sovereignty – political or fiscal – extended to small communities. At the beginning of the twentieth century, state and provincial governments resembled fiscal sovereigns in Argentina, Australia, Brazil, Canada, Germany, Mexico, Switzerland, and the United States, among other federations, and the same can be said about local governments in many unitary systems.

Sacrificing subtlety for breadth, the last two chapters made broad arguments about fiscal and political structures and supported them with aggregate cross-national data. This approach is advantageous above all because it provides a context to guide the selection of countries for more-nuanced case studies and the raw material for more-refined arguments. Faced with an overwhelming array of countries, data, and stories but limitations on time and tractability, this chapter explains how the arguments and results above point to a clear strategy for (1) placing existing single-country studies in a comparative framework, and (2) selecting countries to analyze more carefully. At the heart of Chapter 4 was a two-by-two table depicting aggregate transfer dependence on the horizontal axis and subnational borrowing autonomy on the vertical axis. Analysis of credit ratings suggested that in countries on the right, where transfer dependence is higher, the center is more likely to be perceived as an implicit guarantor of subnational debt. Yet as long as such countries also sit near the bottom of the table, where subnational governments are unable to borrow independently, the resulting moral-hazard problem is circumvented. Indeed, the empirical model estimated long-term balanced budgets for these subordinate subnational governments.

Thus, the bailout game is most interesting in the top two quadrants of the table in which subnational governments are relatively free to borrow. Most of the occupants have a long history of federalism.

Alexis de Tocqueville was not alone. Federalism, especially the American variety, is one of the world's most admired and copied political innovations. Starting at least with Montesquieu, political philosophers have pointed out the advantages of decentralized, multilayered government structures and, at least since Rousseau, advocated their adoption in a wide variety of settings around the world. Tocqueville's enthusiasm and Rousseau's practical advice have been taken up with renewed vigor in the late twentieth century, as transitions from centralized authoritarianism to democracy in countries from Eastern Europe to Latin America and Africa have been marked by the decentralization of authority to state and local officials.

A basic problem of federalism is now painfully clear. After a good deal of bargaining, state representatives sign a constitutional contract, as in postwar Germany or postauthoritarian Brazil, setting the rules of the game for future interactions. A critical component of the bargain is that these rules are difficult to change. At the original contracting stage, states (especially small ones) insist on strong institutional protections out of concern for future expropriation and opportunism on the part of the other states or the federal government. In addition to constitutional protections backed up by courts, these contracts usually directly include the states as veto players over key legislative issues and require supermajorities or even unanimity for the renegotiation of the basic contract.

But as we have seen, the original contracts were not negotiated by benevolent planners behind veils of ignorance. They are political bargains that often deviate dramatically from the optimal distribution of authority laid out in fiscal federalism textbooks.

The peril of decentralization is that along with increased responsibility for local officials – and the potential for increased local accountability – comes increased local self-seeking that can impose externalities and undermine the provision of national collective goods. The previous two chapters have explored a serious implication for fiscal discipline and macroeconomic stability: Subnational governments might manipulate the central government's cofinancing obligations and make fiscal decisions that shift their burdens onto others. This can create a cooperation problem.

This final chapter draws together the key conclusions of the book, places them in a larger context, and assesses policy implications. It starts by revisiting the basic paradox that motivates the book: two seemingly irreconcilable views of federalism. It then summarizes the arguments and evidence that have been mobilized to show that vastly different incentive structures from one country to another – and from one province to another – can help sort out some of the promise and especially the perils of fiscal federalism in recent decades. These findings allow for some fairly solid conclusions about conditions under which the perils of fiscal federalism are greatest, and these translate into some useful contemporary policy implications – especially for newly decentralizing countries. Finally, this chapter concludes with a discussion of future research that might address some questions that have been raised but not answered in this book.

Hamilton's Paradox Revisited

This book started with the paradox of Alexander Hamilton's writings and actions in the realm of fiscal federalism. He believed that federalism – if it implies divided sovereignty – inevitably leads to inefficiency at best and at worst “renders the empire a nerveless body” (Federalist 19). Yet as part of his centralization strategy, he was forced to throw some bones to his opponents from Virginia. He joined in writing some essays that, while pointing out its perils, defended the principle of divided sovereignty more eloquently than any treatise before or since.

This project started in the late 1990s with the simple observation that however compelling and elegant, leading theories of federalism in economics and political science had little to do with most of what was interesting about developments in federations around the world. Optimistic theories promised that decentralization would yield improved efficiency and governance in a wide variety of countries. Yet disastrous debt accumulation among state and provincial governments in Argentina and Brazil had direct negative implications for macroeconomic and political stability, and the literature seemed to provide no hint of an explanation. Moreover, similar problems have existed on a smaller scale for some time in several countries and are sprouting up along with transitions to democracy and fiscal decentralization in others. Next, I learned that episodes of unsustainable borrowing by states and provinces, followed by rancorous debates about federal bailouts, are as old as federalism itself. I set out to rethink theories of federalism and fiscal decentralization, develop some testable arguments about the causes of fiscal indiscipline in multitiered systems of government, and confront them with data from around the world.

Much of the book was written before I realized that Alexander Hamilton had already done something like this. Upon rereading The Federalist and then moving on to explore his other writings, I gained an appreciation not only of Hamilton's imprint on the United States, but also his imprint on theories and analyses of federalism.

The problem of unconstrained borrowing by states in the presence of a perceived federal guarantee was a mere annoyance in postwar Germany when compared with Brazil in the 1990s. While unsustainable borrowing and bailouts were limited to the smallest states in Germany, this case study discusses a pattern of fiscal indiscipline and bailouts that extended to a majority of Brazilian states. Moreover, the crisis of fiscal federalism in Brazil had direct implications for macroeconomic stability.

Brazil is the most decentralized country in the developing world. It has a long history of federalism and decentralization and has become considerably more decentralized over the last two decades. On average during the 1990s, the states and municipalities were responsible for over one-third of all revenue collections, close to half of all public consumption, and almost 40 percent of the public sector's net debt stock. Political and fiscal decentralization were key components of Brazil's transition to democracy in the 1980s. An examination of Brazil's experiences since then demonstrates the severity of the challenges for macroeconomic management posed by fiscal decentralization in the context of inequality, political fragmentation, and robust federalism. Above all, Brazil has been forced to deal with one of the most serious and persistent subnational debt problems in the world.