Optimal Regional Insurance Provision: Do Federal Transfers Complement Local Debt?

We study optimal regional insurance provision in federations with regionally and privately observable shocks to the degree of intergenerational externality (DIE) induced by local intergenerational public goods (IPGs), or to the degree of technological progress (DTP) for producing the IPGs. Federal transfers provide interregional insurance, and local debt provides intergenerational insurance. If optimal federal transfers increase (decrease) with a region's debt level, we say the two insurance policies are complements (substitutes). We address such questions as whether it is efficiency-enhancing to adopt both schemes for providing regional insurance and how the answer varies with these two different economic shocks. The paper's main results are twofold: first, under the DIE shocks, federal transfers and local debt act as complements in implementing the asymmetric information optimum when borrowing and spending decisions are decentralized at the regional level; second, under the DTP shocks, they act as complements with observable output of IPGs, but act as substitutes with observable expenditure on the IPGs.