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Unformatted text preview: an important tool for manipulation of short-run demand, which affects
prices and employment levels. Spahn (1998) argues that Keynesian demand management argument has
overemphasized the need for centralized macroeconomic policies. According to him, any national fiscal stimulus would
be offset by an exchange-rate change in an open economy. With regard to economic shocks, Gramlich (1977) has
argued that may shocks are asymmetric and central policy instruments cannot be customized to address localized
effects of economic shocks.
To the extent that local debt has national repercussions suggests time-inconsistency problem. In most countries, due to
political concerns central governments cannot credibly commit to enforcing hard-budget constraint. Subnational
governments may then overspend, expecting to get more resources from the common pool of national resources, either
through additional discretionary transfers or bailouts. These can manifest themselves in the form of higher inflation if
bailouts are financed through central bank borrowing. 7
13 152 Rao, 1999.
Bird and Fiszbein, 1999.
Dillinger and Webb, 1999.
According to Prud'homme (1995), "Argentina provides a good illustration of the 'fiscal perversity' of subnational governments" and constitutional
reform of 1988 in Brazil "significantly reduced the central government's ability to conduct macroeconomic policies."
Fiscal decentralization has an impact on different macro indicators, such stability, public sector size, and economic growth. This section discusses
the impact of fiscal decentralization on macroeconomic stability, for discussions on public sector size and economic growth see Box 1 & 2.
Huther and Shah (1998) examine statutory aspects of central bank operations, such as the terms of office for chief executive officer, the formal
policymaking power, limitations on lending to the government and other 13 criteria and show that there is a positive correlation between central bank
independence and decentralization. Commission on Fiscal Imbalance Countries like Argentina and Brazil have had macroeconomic problems due to subnational debt reflects the fact that the
old institutional arrangements no longer function under the decentralized regime (Spahn, 1998). In countries without
institutional structures that support mature and stable decentralized system, subnational governments may use their
fiscal power irresponsibly causing macroeconomic problems. Therefore, in countries undergoing decentralization
process, institutional reform is required for an effective mechanism of intergovernmental cooperation.
Institutional reforms that minimize adverse incentives and promote transparency, accountability, and predictability should
be executed to have an effective fiscal decentralization (Wildasin, 1997; Bird, 2000). In the absence of these
characteristics governments would settle their intergovernmental fiscal transactions on ad hoc basis, responding to the
fiscal distress of lower-level units with a variety of special loans, grants, negotiated tax-sharing agreements, directedcredit programs, and other emergency bailouts, rather than establishing firm transparent rules which would govern the
form and extent o...
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