Decentralization and macroeconomic management

There is a vast and growing body of literature covering the potential efficiency and welfare gains from decentralization. The literature has also amply discussed the potential trade-offs between decentralization and income redistribution, as well as various mechanisms designed to attenuate these trade-offs. By contrast, in the literature on fiscal federalism there has been relatively little emphasis on the effects of decentralization on macroeconomic management, although policymakers world wide increasingly have to grapple with these effects. This is the focus of the present paper, which draws on a range of country experiences in this area. The paper discusses the constraints that a high degree of decentralization places on the central government.s ability to carry out its traditional stabilization functions; the macroeconomic impact of subnational governments operations, both under balanced budget and deficit conditions; and the case for, and possible approaches to, the control of subnational government borrowing. The paper concludes that decentralization--as desirable as it might be on efficiency, as well as political, grounds--can entail significant costs in terms of the effectiveness of the central government in stabilizing the economy. The paper explores various ways to minimize these costs, including the setting of hard budget constraints on subnational governments and a more active involvement of these governments in the central government.s macroeconomic management and adjustment efforts.