Causes of soft budget constraints need further investigation

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In the two decades since János Kornai first coined the phrase, soft budget constraints have entered the lexicon of mainstream economics. Soft budget constraints, as Gérard Roland noted, are frequently identified with moral hazard, confused with the absence of budget constraints, and thought to be synonymous with subsidies. They are not, however, a form of insurance or guarantee (the types of activities most associated with moral hazard). They are, Roland explained, an ex ante—but crucially not an ex post—budget constraint that may ultimately take the form of a subsidy but is not planned as a subsidy.

Countries may pledge never to bail out troubled firms or projects, but their resolve often falters in the face of serious problems. These ex post changes of heart are at the core of soft budget constraints, which Roland defined as a “dynamic commitment problem” triggered by specific institutional environments. Soft budget constraints may persist even when not desired, and steps, such as privatization, that should harden budget constraints may not do so in all circumstances. Generally, he found, conditions in socialist and transition economies tend to soften budget constraints, while characteristics of market economies, notably competition, tend to harden budget commitments. But, he added, as the Chrysler bailout or the resolution of the U.S. savings and loan crisis demonstrated, soft budget constraints can occur in market as well as socialist or transition economies.

Soft budget constraints in socialist economies

The key question in comparing hard and soft budget constraints in market and socialist economies, Roland said, is how poorly performing projects and firms are dealt with and whether institutional arrangements tend to encourage or discourage better-quality projects, increased effort, and innovation. An organization or government faced with poorly performing projects or firms has two options: refinance or liquidate. What distinguishes the socialist decision-making process from the private sector one is the degree to which it factors in social welfare (such as the benefits of keeping workers employed). Social benefits often tip the balance in favor of refinancing, leading to an ex post optimal decision in socialist economies that would, Roland said, be considered absolutely inefficient from an ex ante perspective.

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