Journal Issue

Causes of soft budget constraints need further investigation

International Monetary Fund. External Relations Dept.
Published Date:
January 2000
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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.

Cumulative resource constraints make it infeasible to bail out all firms, but, Roland explained, the stage is set for a transfer from strong performers to weaker ones. This penalization of good performers may partially explain the relative lack of innovation in socialist economies. Previous research, he observed, demonstrated that soft budget constraints led socialist economies to downplay lessons learned from experience (little energy was expended, in fact, on screening results) and to overemphasize the prescreening process. This reliance on prescreening tended to discourage the type of risk taking, accidental discovery, and learning from experience that fueled innovation.

Research has also suggested that shortages in an economy tended to curb soft budget constraints by lowering the perceived benefits of refinancing poorly performing operations, according to Roland. More curiously, price liberalization increased soft budget constraints—at least in the short run—because state-owned firms competed with consumers for scarce resources—driving up prices and crowding out consumers—while performing worse and worse.

Increased enterprise autonomy in a socialist economy could also exacerbate moral hazard issues. In enterprises where there was little hope of boosting profits, reduced state monitoring simply encouraged a drop in effort and an increase in soft budget constraints.

Private ownership and banking

For the private sector, returns on investment are the sole concern. Roland found that when social welfare ceased to be a primary objective in an economy, budget constraints hardened.

Increased competition and demonopolization provided a key impetus toward harder budget constraints. In this regard, Roland was critical of early transition policies that favored privatization schemes but neglected competition.

Greater competition helps to harden budget constraints by reducing returns to investments (which stimulates greater attention to the bottom line) and by improving the quality of projects (fewer poor-quality projects are submitted and few poor performers are bailed out), Roland said. Increased entry of new firms, greater competition, and larger excess capacity all contribute to harder budget constraints.

Decentralized banking and credit were also essential if budget constraints were to harden. Roland contrasted the sharply divergent experiences of Korea and Taiwan Province of China during the Asian crisis. Korea, with its centralized financial system and soft budget constraints, fared far worse than did Taiwan Province of China, whose decentralized financial system and hard budget constraints seemed to shield it from the worst of the regional tumult. Decentralized financial systems also seem better able to mobilize resources to underwrite innovative sectors.

Ultimately, Roland concluded, soft budget constraints represent a specific incentive problem in socialist and transition economies. A great deal more empirical analysis needs to be done to develop a fuller understanding of how institutional factors affect the hardness or softness of budget constraints.

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