Softbudgetconstrainttheories.pdf

Economics of Transition Volume 9 (1) 2001, 1–27 ? The European Bank for Reconstruction and Development, 2001. Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA. Soft budget constraint theories From centralization to the market 1 Eric Maskin* and Chenggang Xu** *Institute for Advanced Study, Princeton and Department of Economics, Princeton University. Institute for Advanced Study, Einstein Drive, Princeton, NJ 08540, USA. Tel: + 1 609-734- 8309; E-mail: maskin@ias.edu **Department of Economics and CEP, London School of Economics, London WC2A 2AE, UK. Tel: +44 (0)207 955 7526; E-mail: c.xu@lse.ac.uk Abstract This paper surveys the theoretical literature on the effect of soft budget constraints on economies in transition from centralization to capitalism; it also reviews our understanding of soft budget constraints in general. It focuses on the conception of the soft budget constraint syndrome as a commitment problem. We show that the two features of soft budget constraints in centralized economies – ex post renegotiation of firms’ financial plans and a close administrative relationship between firms and the centre – are intrinsically related. We examine a series of theories (based on the commitment-problem approach) that explain shortage, lack of innovation in centralized economies, devolution, and banking reform in transition economies. Moreover, we argue that soft budget constraints also have an influence on major issues in economics, such as the determination of the boundaries and capital structure of a firm. Finally, we show that soft budget constraints theory sheds light on financial crises and economic growth. JEL classification: D2, D8, G2, G3, H7, L2, O3, P2, P3. Keywords: soft budget constraint, renegotiation, theory of the firm, banking and finance, transition, centralized economy. 1 We are grateful to Janos Kornai, Janet Mitchell and Gerard