A Political Economy Theory of the Soft Budget Constraint (Preliminary-comments appreciated)

Department of Government, Cam-bridge MA02138, Harvard University, Littauer


Why do soft budget constraints exist and persist? The central ar-gument in the literature is that soft budget constraints arise because politicians cannot recognize bad projects ex ante, and cannot com-mit not to refinance them ex post. In this paper we argue that the prevalence of the soft budget constraint phenomenon can be best ex-plained by the political desirability of softness. We develop a political economy model of the soft budget constraint where politicians can-not commit to policies that are not ex post optimal. We show that because of the dynamic commitment problem inherent in the soft bud-get constraint, politicians can in essence commit to make transfers to entrepreneurs which other wise they would not be able to do. This en-courages such entrepreneurs to vote for them. Though the soft budget constraint may induce economic inefficiency, it may be politically ra-tional because it influences the outcomes of elections. In consequence, even when information is complete, politicians may fund bad projects which they anticipate they will have to bail out in the future.

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    ABSTRACT: This paper explores the relevance of soft budget constraints (SBC) to development studies by examining the parastatal sector. The political ingredient of the SBC is discussed by focusing on two examples: 1) religious and military foundations in Iran; and 2) Fannie Mae and Freddie Mac. It presents two main findings. First, the SBC of the parastatal sector can be understood as the political economy of a predator state or state’s rent-seeking activity. Second, the state sector is more prone to the SBC compared with a decentralized competitive market, but it might be subject to a harder budget constraint in comparison with the parastatal sector.
    Full-text · Article · Jan 2011