UNDERSTANDING THE SOFT BUDGET CONSTRAINT JÁNOS KORNAI, ERIC MASKIN and GÉRARD ROLAND1 1 Kornai: Harvard University and Collegium Budapest; Maskin: Institute for Advanced Study, Princeton, and Princeton University; Roland: UC Berkeley, CEPR and WDI. We express our gratitude to the editor, John McMillan and two anonymous referees for valuable comments and suggestions. Kornai is grateful to János Varga, Brian McLean and Julianna Parti for their devoted research and editorial assistance and to the Hungarian National Science Foundation (OTKA, Project 265 of Hungary's National Scientific Research Fund) for financial support. Maskin thanks the NSF for research support. Roland acknowledges support from ACE grant No P 98-1008-R.2 ABSTRACT. We propose a clarification of the notion of a soft budget constraint, a concept widely used in the analysis of socialist, transitional, and market economies. Our interpretation is broad enough to embrace most existing approaches to soft budget constraint phenomena and provides a classification of their causes and consequences. In light of this interpretation, we then review the theoretical literature on the subject and compare it with those on other dynamic commitment problems in economics.31. Introduction The term “soft budget constraint” (SBC), 2 has become a familiar part of the economics lexicon. Originally formulated by Kornai (1979, 1980 and 1986) to illuminate economic behavior in socialist economies marked by shortage, the concept of SBC is now regularly invoked in the literature on economic transition from socialism to capitalism. Indeed, SBC problems currently constitute a central policy issue in transition economies. But the concept is increasingly acknowledged to be pertinent well beyond the realm of socialist and transition economies. A host of capitalist phenomena, such as the collapse of the banking sector of East Asian economies in the 1990’s, can be usefully thought of in SBC terms. We have two main objectives in this paper. The first is conceptual clarification. Although the intuitive meaning of SBC was reasonably clear from the outset, there is still no consensus on a precise definition. Of course, such ambiguity about a central concept is not uncommon in the social sciences. Interpretations change and develop over time, as experience in applying the concept accumulates. Hence we do not intend to adjudicate the differences of opinion and declare which definition is “correct.” We believe however that the interpretation presented here is comprehensive enough to embrace most research on the subject. The concept of SBC has been invoked by two distinct groups of economists. First, it has been a workhorse for those involved in studying and formulating policy for post-socialist economies. There has hardly been a report on transition—by the World Bank, the EBRD, or other agencies—in the last decade in which the expressions “soft” and “hard budget constraint” have not appeared prominently (see, for instance, World Bank 1997, 1999; EBRD 1998, 1999, 2000, 2001). Second, there is a sizable group of theorists who have attempted to model the SBC phenomenon formally. A large formal literature has developed, much of it evolving from Dewatripont and Maskin (1995). In this paper, we attempt to lay out a conceptual apparatus acceptable in both genres and therefore useful for integrating research programs. In addition to interpreting the SBC 2 HBC correspondingly stands for “hard budget constraint”.4concept, we suggest ways that “softness” might in fact be measured. Conceptual clarification and some discussion of measurement are taken up primarily in section 2. Our other purpose in this paper is to survey the formal theoretical literature on SBC and to show that a rich variety of simple models can be developed that cover the situations discussed in section 2. Rather than being exhaustive, the review in section 3 presents the models that we have found most instructive; we acknowledge that the selection is somewhat arbitrary and reflects our own tastes.3 Also, not all issues discussed in section 2 have yet been the subject of formal models. We conclude, in section 4, with a comparison of the soft budget constraint phenomenon and other important issues of dynamic commitment in economic theory. We also discuss problems that remain to be clarified and research tasks ahead in the SBC research program. The causes and consequences of the SBC-phenomenon and policies for hardening the constraint form the subject of a rich and instructive body of empirical literature, to which we refer in several places. However, we attempt no comprehensive review of this literature here.4 3 Several surveys of formal models have been produced (Maskin 1996; Dewatripont, Maskin and Roland 2000; Berglöf and Roland 1998; Maskin 1999; Maskin and Xu 2001; Mitchell 1998, 2000; Roland 2000). 4 There are several reviews of the empirical literature on the SBC-syndrome and on the efforts to harden the budget constraint in post-socialist transition countries (Djankov and Murrell 2002, Kornai 2001, Schaffer 1998, and World Bank 2002). Special mention should be made of the study by Djankov and Murrell, which applied meta-analysis techniques to 31 econometric studies. For a critique of the Djankov-Murrell approach, see Carlin, Fries, Schaffer and Seabright (2001), which summarizes questionnaire data from 3300 firms. The questionnaire specifically enquired into the effect of hardening budget constraints.52. Clarification of Concepts: The SBC Syndrome The expression “soft budget constraint” is borrowed from the terminology of microeconomics.5 Although its usage here is figurative, the phenomenon it describes is real and specific. The term syndrome customarily denotes a characteristic configuration of symptoms generated by particular circumstances. Thus, to describe the SBC syndrome involves reviewing both the symptoms and the circumstances. Kornai first observed the SBC phenomenon in the Hungarian economy of the 1970’s, a socialist economy experimenting with the introduction of market reforms (Kornai 1979, 1980). Although state-owned enterprises were vested with a moral and financial interest in maximizing their profits, the chronic loss-makers among them were not allowed to fail. They were always bailed out with financial subsidies or other instruments. Firms could count on surviving even after chronic losses, and this