Soft budget constraint

A budget constraint is hard when an organisation must live within its revenues and borrowing on market terms, and fails if it cannot. It is soft when the organisation expects that someone else, typically a paternalistic state, will cover its deficits. Kornai (1986) defined softness by the subjective probability of rescue: the higher it is, the softer the constraint.

Ways of softening a budget constraint include subsidies, tax exemptions or arrears tolerated by the tax office, soft loans from state banks, rollover of bad loans, administered price increases and bail-outs. The effects, Kornai argued, are weaker price responsiveness, lower efficiency and, under some conditions, excess demand and shortage.

Kornai developed the concept for socialist economies but noted that it also appears, to a lesser degree, in mixed economies. Kornai, Maskin and Roland (2003) surveyed formal models. A key insight, developed by Dewatripont and Maskin, is that softness is a commitment problem: once money has been sunk, rescuing a failing project can be the best choice ex post, so a sponsor cannot credibly promise not to rescue, and managers anticipate this. Decentralised finance, with many creditors who cannot coordinate a bail-out, can make constraints harder.

• Socialist enterprises in Hungary, Yugoslavia and China, which Kornai's 1986 paper examined.
• State banks rolling over loans to loss-making state firms during transition.
• Bail-outs of "too big to fail" banks and firms in market economies.
• Sub-national governments that expect central rescue, a recurring issue in fiscal federalism.

The concept can be stretched so far that every public subsidy looks like softness. Some rescues are efficient (for example, preventing a bank run). Critics also note that hard constraints impose social costs, such as sudden unemployment, that a political system may reasonably refuse.

The soft budget constraint is a standard concept in comparative, transition and public economics. The evidence on transition shows that hardening constraints, through bankruptcy, bank privatisation or credible fiscal rules, was associated with enterprise restructuring, while persistent softness was associated with arrears and bad loans.