Disclaimer. Don't rely on these old notes in lieu of reading the literature, but they can jog your memory. As a grad student long ago, my peers and I collaborated to write and exchange summaries of political science research. I posted them to a wiki-style website. "Wikisum" is now dead but archived here. I cannot vouch for these notes' accuracy, nor can I even say who wrote them. If you have more recent summaries to add to this collection, send them my way I guess. Sorry for the ads; they cover the costs of keeping this online.
Rodden. 2002. The dilemma of fiscal federalism: Grant and fiscal performance around the world. American journal of political science 46 (July): 670-687.
Roughly, this is the general problem Rodden deals with: If the central government transfers lots of grants/subsidies to the regions 'and' the regions can take on external debt on their own, then the regions will take out loans to effectively force the center to increase its payout to that region--because, if the center doesn't doesn't send more money to the region, the region goes bankrupt (as a result of the loans) and won't be able to continue providing schools and other services, which would result in unrest and anger at the central government. Thus, having just one of these two variables (transfers from the centers or regions that can independently take on external debt), you're fine (because having no transfers but freedom to take on debt means that the region's voters will hold their regional leaders accountable for bad fiscal policy; and having transfers but no loans keeps region from going into debt in the first place), but having both creates the problem. Federations are more likely than nonfederations to have both these variables.
'Y' is balanced in the long term when either
'Y' will be persistent deficits when "subnational govts are simultaneously dependent on intergovernmental transfers and free to borrow--a combination found most frequently among constituent units in federations."
You could either stop transfers or stop external debt. But since the center can't credibly commit to stop transferring money (cutting off services), you're more likely to see the center trying to limit regions from taking on external debt.
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