Soft budget constraint theories - From centralization to the market

This paper surveys the theoretical literature on the effect of soft budget constraints on economies in transition from centralization to capitalism; i t also reviews our understanding of soft budget constraints in general. It focuses on the conception of the soft budget constraint syndrome as a commi tment 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 int rinsically related. We examine a series of theories (based on the commitmen t-problem approach) that explain shortage, lack of innovation in centralize d economies, devolution, and banking reform in transition economies. Moreov er, we argue that soft budget constraints also have an influence on major i ssues 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.