The government's incentives to bail out inefficient projects are determined
by the trade-off between political benefits and economic costs, the latter
depending on the decentralization of government. Two effects of federalism
are derived: First, fiscal competition among local governments under facto
r mobility increases the opportunity costs of bailout and thus serves as a
commitment device (the "competition effect"). Second monetary centralizatio
n, together with fiscal decentralization, induces a conflict of interests a
nd thus may harden budget constraints and reduce inflation (the "checks and
balance effect"). Our analysis is used to interpret China's recent experie
nce of transition to a market economy. (JEL E62, E63, H7, L30, P3).