Understanding the Soft Budget Constraint: Notes and Summary
Introduction to Soft Budget Constraint (SBC)
Definition and Origin: The concept of the "soft budget constraint" (SBC) was introduced by János Kornai, with key publications in 1979, 1980, and 1986. It originated to describe specific economic behaviors within socialist systems, particularly those suffering from chronic shortages.
Relevance in Transition Economies: Initially observed in socialist economies, the SBC is now crucial in analyzing economic transitions from socialism to capitalism. It remains a significant policy concern for economies undergoing such transformations.
Broader Applicability: While initially conceived for socialist and transition economies, the SBC concept applies more broadly to capitalist economies. For instance, it helps explain the East Asian banking sector's collapse in the 1990s, demonstrating its relevance beyond its original context.
Objectives of Study: This paper aims to:
Clarify the SBC concept by providing a comprehensive definition.
Survey the theoretical literature to consolidate various models of SBC.
Present simple models that can be applied to analyze real-world situations.
Compare the SBC phenomenon with dynamic commitment issues commonly discussed in economics.
Discuss unresolved problems and suggest directions for future research.
Empirical Literature: While acknowledging the extensive empirical research on SBC and policies designed to harden budget constraints, a comprehensive review of this literature is beyond the scope of this paper.
Lack of Precise Definition: The intuitive understanding of SBC is generally clear. However, there is a notable absence of a precise, universally accepted definition, which is a common challenge in social sciences. This paper seeks to address this gap.
Scope and Impact: The study offers a comprehensive interpretation of the SBC to encompass most existing research on the subject.
Policy Relevance: The SBC concept is extensively used by economists involved in studying and formulating policy recommendations for post-socialist economies. This is evident in its prominent use in reports by international organizations such as the World Bank and the EBRD.
Theoretical Models: Theorists have developed formal models to explain the SBC phenomenon, with significant contributions from Mathias Dewatripont and Eric Maskin (1995).
Clarification of Concepts: The SBC Syndrome
Figurative Use of Microeconomics: The term "soft budget constraint" originates from microeconomics but is applied figuratively to broader economic phenomena.
Definition of Syndrome: A "syndrome" refers to a typical set of symptoms that arise from specific underlying conditions. Therefore, explaining the SBC syndrome requires identifying both its symptoms and the conditions that cause them.
Origin of Observation: Kornai first identified the SBC syndrome in Hungary's socialist economy during the 1970s, a period marked by market reforms.
Observed Behavior: State-owned companies were expected to maximize profits. However, those that consistently incurred losses were routinely bailed out through subsidies or other forms of support.
Impact on Company Behavior: Companies were aware that they would be rescued even if they consistently lost money, and this expectation influenced their operational and strategic decisions.
Consensus on Inefficiency: There is a broad consensus that the soft budget constraint contributed significantly to the inefficiency of socialist economies.
Applicability Beyond Socialist Economies: The SBC is not limited to socialist economies; it can also occur in fully private economies. This broader applicability was noted by Kornai in his 1980 and 1986 publications.
BC-Organizations and S-Organizations
Definition of BC-Organization: An organization with a budget constraint (BC-organization) must cover its expenses using its initial resources and generated revenue.
Consequences of Deficit: If a BC-organization cannot cover its expenses and faces a deficit, it cannot survive without external support.
Financial Limits: Liquidity, solvency, and debt limitations define the maximum allowable financial deficit that a BC-organization can sustain.
Hard Budget Constraint (HBC): A BC-organization faces a hard budget constraint (HBC) if it receives no external support to cover deficits. In such cases, the organization must reduce its operations or cease functioning altogether if deficits persist.
Soft Budget Constraint (SBC): The SBC arises when supporting organizations (S-organizations) are willing to cover part or all of the deficit of a BC-organization.
Role of State Agencies: State agencies often act as S-organizations, providing support to state-owned enterprises.
Components of SBC: Every instance of the SBC involves a BC-organization facing financial difficulties and a supporting S-organization that provides assistance.
Synonymous Terms: The terms "support," "rescue," and "bailout" are used synonymously to describe actions taken to prevent the financial failure of a BC-organization.
Types of BC-Organization-S-Organization Pairs: Many types of relationships exist in practice:
Corporate Sphere:
State-Owned Enterprises: Early SBC research focused on state-owned enterprises in socialist economies.
Private Firms: Private firms are also sometimes rescued from financial difficulties, particularly during post-socialist transitions.
Methods of Survival: Even after privatization, various mechanisms ensure the survival of firms that continue to lose money.
Capitalist Economies: Capitalist economies also exhibit SBC phenomena through state subsidies to agriculture and assistance to struggling industries.
Banks and Financial Intermediaries:
Large Banks: Large banks in financial distress are rarely allowed to fail; instead, they continue operating, often after being acquired by another bank.
S-Organizations: The government or other financial institutions act as S-organizations in these scenarios.
Nonprofit Organizations:
Bailouts: Bailouts are common for hospitals, schools, and universities that overspend their budgets.
Social Insurance: Social-insurance institutions in transition economies are typically bailed out from the state budget (Kornai and Karen Eggleston 2001).
Local Government Authorities:
Reliance on Central Government: Indebted local governments often depend on rescue from the central government.
International Level:
Financial Assistance: Insolvent national economies facing financial crises seek assistance from international financial agencies or the international financial community (Stanley Fischer 1999).
The Motives
BC-Organization's Perspective: The need for rescue and support is self-evident for BC-organizations, particularly those motivated by profit. Even organizations without a profit incentive may have a strong survival motive.
Leaders' Incentives: Leaders of organizations often view their institutions' work as indispensable, and their positions provide financial benefits, prestige, and power, further driving the desire for survival.
S-Organization's Perspective: The motives of the S-organization are often less clear and are a central focus of much SBC literature. There is no single universal motivation.
Classification of Motives: Motives can be classified based on whether the S-organization's rescue act is voluntary or by necessity.
Forced Rescue: Rescue can be forced when a BC-organization avoids taxes, loan payments, or supplier bills. Enforcing tax obligations and private contracts can be costly, leading the S-organization to temporarily tolerate noncompliance.
Enforcement Capacity: The ability to enforce obligations is essential for hardening budget constraints.
Willing Assistance: Tax authorities or banks may willingly assist BC-organizations by overlooking tax arrears or nonperforming debt.
Government Objectives: In socialist economies undergoing market-oriented reforms, governments may want enterprises to profit for efficiency and revenue reasons. However, they also fear that allowing loss-making enterprises to fail will lead to unemployment, social unrest, and political tension.
Inconsistent Behavior: This conflict results in inconsistent behavior, where one agency demands profitability while another rescues failing enterprises. Inconsistent behavior can also occur sequentially, with initial threats followed by bailouts.
Additional Motivations: Besides the fear of unemployment and political unrest, other motivations for softness include:
Prior Investments: The S-organization (e.g., a bank or investor) may extend credit or invest more in a troubled BC-organization due to prior investments or loans. This is central to Dewatripont and Maskin (1995) and related models, providing a logically parsimonious explanation for the SBC syndrome.
Paternalism: The S-organization may bail out an ailing enterprise due to paternalism, especially if the enterprise is state-owned. This can also be found in large corporate organizations where profitable units help loss-makers.
Political Considerations: Politicians may strive to save jobs by obtaining subsidies for firms in financial difficulty to increase their popularity, political influence, and reelection chances.
Reputation: Leaders may prevent financial failure in multi-level hierarchical control structures to protect their reputation.
Economic Spillover: An S-organization may rescue a BC-organization to avoid economic spillover effects, such as bankruptcies causing mass redundancies and recession (i.e., "Too big to fail").
Corruption: Corrupt influences, such as crony relationships or bribery, may motivate the S-organization.
Distinction from Insurance: Insurance companies are not considered S-organizations because a BC-organization does not purchase rescue from them.
Commitment Problem: The SBC problem arises because the S-organization does not contractually commit to provide support but is incentivized to bail out the BC-organization ex post.
Future Research: Future research should investigate structural factors driving S-organization motivations and the effect of institutional frameworks and the social, economic, and political environment. The empirical literature on post-socialist transition addresses the effect of property relations, asking if state-owned enterprises are more likely to be bailed out than private firms, and if privatization hardens budget constraints.
Empirical Measures: Empirical measures of hardness and softness vary across studies and are not closely grounded in theory.
Temporal Nature of SBC Syndrome and the Ex Ante/Ex Post Distinction
Prolonged Support: Rescues in the SBC syndrome are not entirely unexpected and include prolonged support for organizations with persistent financial problems.
Expectations: The likelihood of continued support is well understood by all parties concerned.
Dynamic Commitments: An S-organization's inability to make dynamic commitments is a key explanation for SBCs.
Initial Prospects: When a BC-enterprise is initially established, its prospects often appear positive. Therefore, the S-organization may declare it will refuse bailouts to incentivize hard work.
Enforcement Difficulties: However, the S-organization cannot enforce that declaration if the enterprise encounters difficulties. The cost of economic and social disruption from the enterprise's collapse could be higher than repeated bailouts.
Anticipated Bailouts: Both parties anticipate a continuing sequence of bailouts if the potential disruption from collapse is significant.
Ex Ante Regret: The S-organization would not have wished to see the enterprise set up had it known that these troubles would occur.
Ineffective Promises: The problem lies with the S-organization's ineffective ex ante promise not to make the bailouts. The enterprise would have been more motivated to reduce the chance of failure if it expected the promise to be kept.
Tragedy of SBC: The higher prospect of failure that comes with lost motivation is the real tragedy of the SBC syndrome.
Ex Ante vs. Ex Post: In this scenario, the ex ante and ex post perspectives of the S-organization are radically different. A large part of SBC-related phenomena can be understood in terms of this distinction.
Alternative Theories: The ex ante/ex post distinction is not the only way to understand the SBC phenomenon. Shleifer and Vishny (1994) offer an alternative theory without the ex ante/ex post distinction.
Means of Softening
Categories of Support: Means of rescue and sustenance fall into fiscal means, credit, and indirect methods of support.
Fiscal Means:
Types of Subsidies: Subsidies from the state budget or tax concessions (remission, reduction, or postponement of tax obligations).
Variations: Forms of fiscal softening vary by country and period. Some places kept the open-subsidy system, while others curbed it and granted tax concessions.
Tax Arrears: Tolerance of tax arrears has been a major instrument of softening.
Credit:
Relaxed Lending: Loans offered to struggling firms that would not normally be eligible using standard lending criteria, or relaxed servicing and repayment terms.
Excessive Credit: Too much credit is extended under the SBC from an economic efficiency standpoint.
State-Owned Banks: State-owned banks favor distressed enterprises when allocating credit and tolerate late payments.
Trade Credit: Buyers postpone payments beyond deadlines in trade credit. Late payment was a main cause of economic problems in Russia in the 1990s.
Indirect Methods:
Trade Restrictions: The state may protect firms suffering from sales difficulties by imposing administrative restrictions on imports or deterrent tariff barriers to ease pressure from foreign competitors.
Observable Events: Actions that soften the budget constraint are often observable events, and indicators of softness can be measured.
Disguised Softening: Softening can be disguised by parallel measures that appear contradictory, such as reducing subsidies in the state budget while relaxing tax collection.
Expectations and the SBC Mentality
Unanticipated Bailouts: If a bailout is entirely unanticipated, there is little point in ascribing the event to an SBC.
Expectation of Rescue: The syndrome is truly at work only if organizations can expect to be rescued from trouble, and those expectations, in turn, affect their behavior.
Collective Experience: Such expectations have much to do with collective experience. The more frequently financial problems elicit support in some part of the economy, the more organizations in that part of the economy will count on getting support themselves.
Ineffective Announcements: S-organizations may announce that they will break with past practice and refrain from making bailouts, but such announcements normally have little effect unless combined with some institutional change that lends credibility to the promises.
Observing Expectations: It is not possible to observe expectations and perceptions directly, but an appropriate questionnaire may garner useful information about these. Managers of BC-organizations could be asked what sort of financial trouble would force it to cease trading, or what chance they would see of a rescue.
SBC Mentality: The SBC mentality is a basic feature of the SBC syndrome. The syndrome embraces not just a characteristic sequence of events and financial transactions but also the perceptions of organization managers that give rise to those events.
Primary Consequences: Survival and Exit
Influence on Organizational Lifecycle: The SBC syndrome heavily influences the life and death of organizations.
Normal Exit: Financial difficulties normally lead to exit for municipalities, towns, districts, and countries. Exit is a normal event for organizations in categories (i)-(iii).
HBC Environment: An HBC environment will not permit survival if an organization makes persistent losses.
Key Measure: A key measure of the SBC syndrome is the degree to which organizations are permitted to fail.
Frequency of Bankruptcies: One can examine the overall frequency of bankruptcies and liquidations as a first approximation.
Accurate Calculations: More accurate conclusions can be drawn by limiting exit proportion calculations to organizations in serious financial difficulty.
Creative Destruction: The SBC idea complements Schumpeter's (1911) theory of creative destruction. Theories of the SBC syndrome help illuminate the role of S-organizations in producing deviations from normal exit rates by weakening or even eliminating the "destructive" aspect of the Schumpeterian process.
Behavioral Effects of the Syndrome
Distorted Behavior: When BC-organizations anticipate being rescued should they get into trouble, their behavior is usually distorted.
Attenuation of Managerial Effort: Perhaps the most important effect is the attenuation of managerial effort to maximize profits or, when there is no profit motive, to reduce costs. There is also a weakening of the drive to innovate and develop new technologies and products. Finally, rather than wooing customers, sellers concentrate more on winning the favor of potential S-organizations, i.e., on rent-seeking (A. Krueger 1974).
Price Responsiveness: The SBC syndrome dulls the price responsiveness of BC-organizations and thereby the effect of price signals.
Increased Input Demand: BC-organizations' ability to buy inputs without footing the bill—costs are borne by S-organizations—can dramatically augment their demand for these inputs. This, in turn, can lead to serious shortages.
Theories of the SBC Syndrome
Lack of Unified Theory: No existing model captures all characteristic features delineated in section 2; therefore, a single designated theory of the SBC does not exist.
Causal Chain: Understanding the SBC syndrome entails bearing in mind a complex chain of causality, which has been depicted in a schematic form in figure 1.
Block 1: Represents the political, social, and economic environment that generates the motives behind the formation of the SBC syndrome.
Block 2: Represents the motives that create the SBC syndrome.
Block 3: Represents the effects that the SBC syndrome brings about.
Focus of Formal Theories: Formal theories focus on blocks (2) and (3), and the effects of block (2) on block (3). The linkage (1)--(2) is usually touched on in these works, but not always with a detailed analysis.
Inspiration for Modelers: Some modelers have been inspired by a particular political-social-economic formation under block (1), such as reform experiments within socialism or the post-socialist transition.
Simplified Approaches: There is a fair amount of work that simply posits the existence of the SBC syndrome and concentrates on the effect (2)->(3).
SBC as a Dynamic Commitment Problem
Key Explanation: An important potential explanation for SBCs is the inability of the S-organization to commit itself not to extend further credit to a BC-organization after providing initial financing.
Bailout Declarations: The S-organization would like to induce the BC-organization to work hard to avoid making a loss; therefore, it declares that it will refrain from making bailouts.
Failure to Abide: Once a loss occurs, however, it fails to abide by this declaration.
Early Model: The first formal model to make the link between SBCs and dynamic commitment was that of Schaffer (1989).
Managerial Effort: The manager of the BC-organization can choose whether or not to expend costly effort. If he expends the effort, then output is high, and if he refrains from doing so, output is zero unless the center bails the enterprise out (in which case, output is again high).
Incentive Mechanisms: To induce effort (which is not directly observable), the center can offer the manager a bonus if output is high.
Commitment Failure: If the center's net profit from the output is positive even after it pays for the bailout and the manager's bonus, then the manager will choose not to expend effort. This outcome can be viewed as a failure of commitment.
Advantage of Commitment: If the center could somehow tie its hands and commit itself not to undertake a bailout, it would fare better because the manager would now choose to exert effort to collect the bonus; otherwise, the center would therefore enjoy high output without a costly bailout.
Unanswered Questions: While Schaffer (1989) connects SBCs to the issue of dynamic commitment, the paper leaves many questions unanswered.
Dewatripont and Maskin (1995) Model of SBC
Key Questions: They present a model that attempts to answer the following questions:
Why does the center have to play this game at all?
Why have socialist and transitional economies seemed to be more vulnerable to SBCs than full-fledged market economies?
Basic Structure: The simplest version of the DM model comprises two periods, a S-organization (center) that serves as a source of financing, and a set of BC-organizations or enterprises, each headed by a manager, that require funding to undertake projects.
Project Types: Projects are of two possible types: good (with probability ) and poor (with probability ).
Asymmetric Information: The type of project is known by the manager but not the center. Thus, there is asymmetric information about the project when the manager decides whether or not to submit it.
Funding Decision: When a project is submitted, the center must decide in period 1 whether or not to fund it, which costs 1 unit.
Good Projects: If funded, a good project yields a verifiable gross monetary return Rg >0 and a private benefit Bg >0 for the enterprise by the beginning of period 2.
Poor Projects: By contrast, a funded poor project yields a zero monetary return by the beginning of period 2.
Liquidation Option: Faced with a poor project, the center could liquidate the enterprise's assets. Then the center obtains a liquidation value RL < 0 and the enterprise gets a net private benefit BL < 0.
Reputation Loss: This represents the manager's loss of reputation after liquidation.
Refinancing Option: The center can refinance the project by injecting additional capital of 1, in which case, the gross return is Rp>0 and the manager's benefit Bp>0.
Mixed Strategies: The decision to liquidate or refinance need not be a pure strategy; the center may choose to refinance with probability and to liquidate with probability . The degree of softness in the enterprise's budget constraint will influence the manager's decision, in this case .
Conditions for Refinancing
Manager's Submission: Assume that all monetary returns go to the center (so that the manager's payoff equals his private benefit); then the manager submits a poor project if and only if \alpha Bp + (1-\alpha)BL > 0.
Submission Condition: The manager can only submit if \alpha > \frac{-BL}{Bp - B_L}.
Relationship with : Therefore, decreases with and increases with .
Government's Perspective: Assume that the S-organization is the government and that it maximizes the overall social welfare from a project. This welfare equals the project's net monetary return, plus the private benefit to enterprises, plus the external effect E of the project on the rest of the economy.
Refinancing Preference: For a poor project, the government will prefer to refinance that poor project, and so if Rp + Bp + Ep - 1 > RL + B_L.
Efficiency: If inequality (1) holds, it does not follow that the project is efficient or that the state would have chosen to go ahead with financing ex ante had it known the project was poor.
Poor Project Efficiency: Indeed, a poor project is efficient only if its benefits (amounting to Rp+Bp+Ep) outweigh its costs (amounting to 2).
Discrepancy: Observe that if (1) and (2) both hold, the government will choose to refinance a poor project even though that project is inefficient and would not have been financed in the first place had its type been known.
Ex Ante vs Ex Post: The discrepancy arises because (2) represents an ex ante criterion; by contrast, (1) is an ex post criterion, one that arises after an investment of 1 has already been sunk in the project.
Commitment and Efficiency: If the government could credibly commit not to bail out poor projects, it would improve efficiency. Without such commitment, the government will end up refinancing poor projects, and so they will indeed be submitted ex ante.
Importance of Ex Ante Uncertainty
Ex Ante Identification: If a project is identified as bad ex ante, it will not be funded.
Center's Choice: When a project is submitted, the center must choose between funding all and funding none; therefore, projects will be funded if . In this soft budget constraint equilibrium, all poor projects are refinanced, despite their inefficiency.
Hardening the Budget: Hardening the budget means creating conditions where the government can credibly commit not to refinance, not by direct choice, but by institutions.
Kornai's Observations: Kornai (1980) states that the effects of the SBC syndrome increase demand and decrease price sensitivity, contributing to shortages.
Consistency: The DM model is consistent with Kornai, as a paternalistic government may give rise to an SBC. SBCs may be particularly likely when the S-organization is paternalistic.
Repeated Bailouts: The model can be interpreted to include repeated bailouts by interpreting the first period as the investment phase and the second period as the production phase with capital already sunk. The cost may be impossible to recoup, but ex post, further production is better than non-production, but ex ante, the investment would not have been made.
Extensions and Adaptations: The DM model has seen many extensions and adaptations, shedding light on a variety of SBC phenomena in socialist settings, transition economies, and competitive environments. The model also examines the special issue of soft budget constraints for banks and offers other ways of formalizing the SBC syndrome.
SBC in Socialist Economies
Economic Models: Economic models describe causes of shortages, innovation, the "ratchet effect", and enterprise autonomy in socialist economies with SBCs.
Shortage
Role of SBC: Kornai (1980) shows that the SBC syndrome plays an important role in explaining how shortages became so prevalent under socialism.
Price Controls: Yingyi Qian (1994) builds on this model, showing why governments had incentive to keep prices low, aggravating shortages as a means to mitigate the effects of SBC.
Mitigation Strategies: These economists show how creating a price cap and consumer rationing can improve the negative effects of the SBC on the economy.
Innovation
Failure to Innovate: The failure to innovate became one of the major causes for the collapse of central planning in the former Soviet Union and other socialist economies. Qian and Xu (1998) argue that this failure was directly related to the SBC syndrome.
Screening R&D Projects: Because of the SBCs, these economies lack the capacity to screen out poor R&D projects ex post; therefore, they have to rely on ex ante screening, which is less effective.
The Ratchet Effect
Definition: Joseph Berliner (1952) coined the term "ratchet effect" in his analysis of management behavior in soviet-style firms.
Target Adjustments: Managers were often rewarded for over-fulfilling production targets but feared next year's target being "ratcheted up" if this year's goal was met.
Broader Applicability: The ratchet effect, like the SBC syndrome, is not confined to socialist economies.
Interrelation: The ratchet effect and the SBC influence each other, as the need for bailing out "weaker" enterprises may increase the temptation to extract more resources from "stronger" enterprises.
Capital Distribution: There may not be enough capital generated from first-period returns to refinance all good projects, as projects in the first period are given more funding. Because of this, managers will refrain from exerting effort because the prospect from refinancing is too low.
Enterprise Autonomy
Rationale: The reforms of socialism attempted to achieve greater enterprise autonomy. The rationale was that the center delegating decision-making authority promotes better decisions, as enterprise managers have better local information.
SBC in Transitional Economies
Central Theme: A recurrent theme in discussions about transforming an economy from socialist to a market is the need to harden the budget constraints of both enterprises and banks because private markets create better resource distribution and efficiency with fewer bailouts.
Devolution
Method for Hardening: Qian and Roland (1998) investigate devolution of government as a method for hardening budget constraints in China.
Decentralization: Private markets were not an option, so fiscal authority was decentralized from Beijing to regional governments. The competition among regional governments to attract foreign capital led to harder budget constraints.
Privatizing Banks
Relationship Transformation: Hardening budget constraints is about changing the relationship between funding and enterprises, and not a direct policy choice.
Objectives: Enterprises are funded and refinanced by a government that cares about not only financial return but also overall social welfare.
Profit Maximization: Turning firms' financing to a private bank means this bank would maximize profit rather than social welfare (betterment for society is no longer a requirement, which helps the budget constraints become harder).
Arrears and Redeployment
Debt Chain Reaction: Arrears and redeployment refer to the chain reaction of debt caused when several firms do not pay each other back.
Insolvency: When those firms do not get paid, they cannot afford to pay others, creating a sort of debt chain reaction. The bank may feel constrained to bail out large numbers of them to avoid generalized insolvency.
The SBC in a Competitive Environment
Benefits of Competition: Models show competition improves economics from different angles, providing more variety and lower prices.
Competition Across Enterprises:
Demonopolization: Demonopolization of an industry may itself help harden budget constraints. If the setup is costly, there will be too many enterprises than the efficient number in a free-entry equilibrium.
Entry of New Projects:
Financial Pressure: New projects compete for the bank's money to continue to grow, making firms with a long credit history possibly ineligible for further help.
Decentralized Banks:
Credit Availability: Having less stake in a particular player from the bank's perspective and also asymmetric information between lenders and borrowers can help increase the credit availability to new players. There may not be enough returns to split in illiquid firms.
SBC in Banks
Focus on Banks: This section focuses on banks as BC-organizations, with the S-organization being another entity (state or central bank).
Three-Tier Interactions: With interactions between 3 tiers of agents, not 2, the bank is a BC-organization for the government but still an S-organization for the firm. The cause of soft budget constraints of firms will now not necessarily be any more the wedge between the ex ante and ex post financial return to the bank.
Bank Passivity and Gambling for Resurrection
Bank Behavior: Mitchell (1998) analyzes the phenomenon of bank passivity, in which a bank fails to liquidate poor projects because it anticipates being bailed out by the government if it gets into difficulty. The bank can either refinance the loan to a poor project or liquidate it.
Downside Insurance: The expected financial return from rolling over is negative, but the possibility of bailout serves as downside insurance. The bank benefits from the upside of such a decision and does not suffer the consequences of the downside.
Monitoring: To prevent such gambling, the government may try to monitor the bank.
Rent Seeking by Banks
Government Subsidies: In the previous subsection, a bank receives a subsidy from the government to keep it solvent. In this subsection, we explore the possibility that the government will subsidize a bank to induce it to refinance poor projects.
Lenders of Last Resort
Market Failure: When there is financial-market failure, it may be desirable for the government to step in and provide liquidity to prevent bank run contagion.
Government Bailouts: Charles Goodhart and Dirk Schoenmaker (1995) show that a high percentage of failing banks have enjoyed government bailouts.
Financial Crisis
Connection to Policies: Various authors have argued informally that certain financial policies, including bailing out firms and banks and providing government guarantees to private investment, had much to do with the East Asian financial crisis that began in 1997. Such policies are intimately connected with SBCs.
Other Conceptions of SBC
Dynamic Commitment: Models conceive of the SBC syndrome as a problem of dynamic commitment.
Political Intervention in Firms
Politician Influence: Boycko, Shleifer, and Vishny (1996) associate the SBC syndrome with the interventions of politicians in firms. Politicians in power pay subsidies to enterprises to induce them to retain excess labor.
SBC as a Control Instrument
Center's Role: Bai and Wang (1996) show that SBCs may be deliberately introduced by a center to control an agent. Because effort is unobservable, the fee must be made contingent on the variables that the center can observe: the total net return, the number of projects launched, and the number of projects terminated after the first period.
Optimal Fee Schedule: The optimal fee schedule will have the agent launch some projects that are bad and that have not been pre-screened.
Concluding Remarks
A Broad Range of Phenomena, a Common Framework of Analysis
Variety: The SBC syndrome embraces a broad range of phenomena from economic life. There are many different ways in which the budget constraint could be softened.
Predictable Patterns: The syndrome gives rise to specific and predictable patterns of behavior among economic agents.
Extensions Beyond Socialism and Post-Socialist Transition
Universality: The SBC should not be thought of as wedded only to the socialist system or to transitional economies, as it can arise in any economic system.
Necessary Elements: All that is needed is the confluence of certain elements: a BC-organization and one or several S-organizations with the incentive to provide financial rescue.
SBC and Other Dynamic Commitment Problems in Economics
Commitment Problems: The soft budget constraint is only one of several important commitment problems that have developed literatures since time consistency was recognized as a significant economic issue. These literatures often highlight how particular institutional solutions can solve serious commitment problems.
Softening and Hardening the Budget Constraint from a Secular Historical Perspective
Intellectual Challenge: Studying the softening and hardening of budget constraints over historical time poses a formidable intellectual challenge and requires a synthetic approach to changes in politics, society, the economy, and the law.
Normative Implications
Positive Nature: The work reviewed in this paper is, for the most part, positive in nature. More normative implications are needed for the work reviewed in this paper.