Innovation in financial governance reforms: for better or for worse?

The global financial crisis has put public budgets throughout the European Union under severe pressure. Government responses to the financial crisis have mainly focused on cutbacks to balance the budget. In this paper, we focus on a specific case of innovation in financial governance in Italy that aimed to minimize the severe effects of financial constraints on local government, while managing deficit control goals at the central level. The regulatory innovation consisted in a system of agreements between levels of government based on the ability to exchange fiscal deficit permits. While this system keeps the aggregate government-wide deficit unchanged, it allows individual local governments to deviate from their initial fiscal balance targets by obtaining deficit permits from governments that have a surplus. This paper critically analyzes this innovation from three perspectives: the governance model inherent to this mechanism, the new financial management practices emerging at the local level, and the effectiveness of the mechanism with regard to declared goals and objectives. Findings from this study show that a critical element limiting innovation in fiscal governance seems to be connected to the simplistic observation that the overall budgetary position of the country’s government results from the algebraic sum of all individual government bodies’ financial results. At the core of this understanding are collateral effects that occur when local priorities are distorted by the need to achieve detached fiscal targets set in a top-down manner by the central government, as exemplified by the unexpected investment crunch in Italy induced by fiscal targets calculated on a mixed accrual-cash basis.