Coping with extreme events: on solving decentralised budgetary crises

Abstract

ABSTRACT Extreme events create both macroeconomic and budgetary problems for decentralised governments. Decentralised governments are unequipped for macroeconomic stabilisation policies and have very limited fiscal space. At a practical level there are three options to replace lost funding from an extreme event: decentralised governments can anticipate and save for these budgetary rainy days themselves, they can issue debt, or the central government can step in and provide aid when such extreme events occur. This paper examines the impact of these options on the unemployment rate. Using the 2008 financial crisis as an extreme event and employing a panel data approach, it is found that both grants and rainy day funds during the crisis reduced future unemployment on the margin relative to periods outside of the crisis; the same is not true of debt. It is also found that grants and rainy day funds are substitutes: greater grant funding implies a somewhat smaller effect of own savings on future unemployment.