Sovereign bail-outs and fiscal rules in a banking union

In this paper, we study optimal fiscal rules in a two-country economy in which cross-country linkages between sovereign debts and banking sectors motivate bail-outs among countries. The first-best sovereign borrowing, which is contingent on the output gap between the countries, cannot be achieved in the presence of asymmetric information on a country's potential output. Because bail-out induces overborrowing, fiscal rules can be implemented to prevent the ensuing inefficiency. A mechanism can be designed to induce a country with low potential output (i.e., a small negative output gap) to run an optimal budget deficit upon receiving a transfer (ex post) from the other country. We characterize conditions under which this fiscal mechanism Pareto dominates a "cyclically adjusted" fiscal rule imposing a unique ceiling on a country's borrowing, independently of its potential output. We apply our setting to a discussion of the implications for fiscal rules within the European Monetary Union.