In fiscally decentralized countries, sub-national governments (SNGs) may face soft budget constraints and consequently invest and borrow too much. The policy literature claims that, with competitive capital markets and central governments imposing hard budget constraints (HBCs), inefficient...

This article analyses hard and soft budget constraints in a federation, where there is a moral hazard problem between the central and the regional governments. Regional governments can avoid a bailout from the center by exerting costly effort. In this setting, a hard budget constraint is not...