DP2715 Soft Budget Constraint Theories: From Centralization to the Market

Author(s): Eric Maskin, Chenggang Xu
Publication Date: March 2001
Keyword(s): Banking and Finance, Centralized Economy, Renegotiation, Soft Budget Constraint, Theory of the Firm, Transition
JEL(s): D20, D80, G20, G30, H70, L20, O30, P20, P30
Programme Areas: Transition Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2715

This Paper surveys the theoretical literature on the effect of soft budget constraints (SBC) on economies in transition from centralization to capitalism; it also reviews our understanding of SBC in general. It focuses on the conception of the SBC syndrome as a commitment problem. We show that the two features of SBC 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 SBC also bear on major issues in economics, such as the determination of the boundaries and capital structure of a firm. Finally, we show that SBC theory sheds light on financial crises and economic growth.