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The Soft Budget Constraint and Transition Economies
JOURNAL OF COMPARATIVE ECONOMICS ARTICLE NO.
26, 9–10 (1998)
JE971504
INTRODUCTION The Soft Budget Constraint and Transition Economies Since Kornai’s seminal work, the soft budget constraint (SBC) has been widely recognized as one of the most fundamental problems in socialist planned economies. During this period, most of the formerly socialist planned economies have undergone various degrees of market-oriented transition. However, the interest in the SBC in academic research and policy discussions remains very strong. This symposium grew out of a session devoted to the SBC organized by the Association for Comparative Economic Studies at the 1997 Allied Social Science Associations meetings, but it also includes some papers that were not presented at the session. Kornai’s note is based on his comments on Thomas Rawski’s presentation at the session. It provides clarification on some issues concerning the concept of the SBC, especially its relationship to other areas of economic theory. In particular, the theory is about the persistent bail-out of loss-making firms and the effect on the decision maker’s behavior of this expectation of bail-out. The incentive effect of bail-out is the central theme of all three theoretical papers in the symposium. Berglof and Roland use a unified framework to discuss several theoretical models of SBCs in enterprises financed by banks in transition economies. These models share the common feature that bail-out is optimal ex post for the decision maker, i.e., the bank or the government depending on the context, and therefore it is not credible for the decision maker to commit to no bailout ex ante. The prospect of bail-out reduces the incentive for the enterprises to avoid financial troubles. The budget constraints can be hardened by altering the decision-makers’ environment so that bail-out becomes suboptimal for them. Measures that serve this purpose include decentralizing credit, promoting entry of good firms, and ex ante capitalization. The Huang and Xu paper shares the aforementioned common feature but proposes a different means of hardening the budget constraint. They argue that, if the decision-making right is given ex post to two parties who may have conflicting interests and asymmetric information, they may not be able to reach an agreement to continue the project even if it is socially optimal to do so ex post. In other words, decentralization of decision-making rights can 9
AID
JCE 1504
/ 6w13$$$241
0147-5967/98 $25.00 Copyright q 1998 by Academic Press All rights of reproduction in any form reserved.
04-15-98 17:17:44
cea
10
INTRODUCTION
serve as a commitment device to avoid continuation of ex post efficient but ex ante inefficient projects. Deviating from this class of models, Bai and Wang explain why projects are continued even when the decision maker does not find them ex post efficient. Using China’s experience, they argue that, by setting up institutions that limit the bureaucrat’s freedom to close ex post inefficient projects, the bureaucrat is forced to suffer the consequence of ex ante mistakes in project selection. This gives the bureaucrat more incentive to avoid these mistakes. Therefore, the SBC is an optimal institutional response to the hierarchical nature of socialist and transition economies. The need for such institutions diminishes if by privatization, for example, either the bureaucrat’s role is made less important or monitoring the bureaucrat’s effort is made easier. The remaining two papers in the symposium consider some empirical evidence of SBCs. Schaffer examines whether enterprises receive net injections of cash or subsidies, i.e., whether ex post inefficient projects are refinanced, in some Central and Eastern European economies and former Soviet republics. He finds that interenterprise arrears are no worse than in Western economies, that Hungarian banks generally do not provide net financing to net money losers, and that tax arrears have become a major source of subsidy to moneylosing firms. Li and Liang use data about China’s state-owned enterprises to evaluate three sources of financial losses: overemployment, poor project selection and insider rent seeking. They find that each source contributes significantly to financial losses. Moreover, financial losses do not lead to reductions in employment, in investment, or in excessive bonus to insiders. In particular, poor returns to previous investments do not have a negative effect on future investments. Li and Liang do not provide direct evidence on whether investment is ex post efficient. However, they provide support for the view that firms can count on future subsidies regardless of their past poor performance. These papers cover a broad spectrum of views providing reasons of, and cures for, the SBC and they offer several different approaches to the empirical measurement of SBCs. I believe that both academic and policy-oriented readers will find them useful. On behalf of all contributors to the symposium, I thank John Bonin for the enormous amount of time and energy he devoted to the symposium. His effort goes well beyond what is expected from an editor. Chong-en Bai, Guest Editor Boston College Chestnut Hill, Massachusetts 02167
AID
JCE 1504
/ 6w13$$$241
04-15-98 17:17:44
cea
26, 9–10 (1998)
JE971504
INTRODUCTION The Soft Budget Constraint and Transition Economies Since Kornai’s seminal work, the soft budget constraint (SBC) has been widely recognized as one of the most fundamental problems in socialist planned economies. During this period, most of the formerly socialist planned economies have undergone various degrees of market-oriented transition. However, the interest in the SBC in academic research and policy discussions remains very strong. This symposium grew out of a session devoted to the SBC organized by the Association for Comparative Economic Studies at the 1997 Allied Social Science Associations meetings, but it also includes some papers that were not presented at the session. Kornai’s note is based on his comments on Thomas Rawski’s presentation at the session. It provides clarification on some issues concerning the concept of the SBC, especially its relationship to other areas of economic theory. In particular, the theory is about the persistent bail-out of loss-making firms and the effect on the decision maker’s behavior of this expectation of bail-out. The incentive effect of bail-out is the central theme of all three theoretical papers in the symposium. Berglof and Roland use a unified framework to discuss several theoretical models of SBCs in enterprises financed by banks in transition economies. These models share the common feature that bail-out is optimal ex post for the decision maker, i.e., the bank or the government depending on the context, and therefore it is not credible for the decision maker to commit to no bailout ex ante. The prospect of bail-out reduces the incentive for the enterprises to avoid financial troubles. The budget constraints can be hardened by altering the decision-makers’ environment so that bail-out becomes suboptimal for them. Measures that serve this purpose include decentralizing credit, promoting entry of good firms, and ex ante capitalization. The Huang and Xu paper shares the aforementioned common feature but proposes a different means of hardening the budget constraint. They argue that, if the decision-making right is given ex post to two parties who may have conflicting interests and asymmetric information, they may not be able to reach an agreement to continue the project even if it is socially optimal to do so ex post. In other words, decentralization of decision-making rights can 9
AID
JCE 1504
/ 6w13$$$241
0147-5967/98 $25.00 Copyright q 1998 by Academic Press All rights of reproduction in any form reserved.
04-15-98 17:17:44
cea
10
INTRODUCTION
serve as a commitment device to avoid continuation of ex post efficient but ex ante inefficient projects. Deviating from this class of models, Bai and Wang explain why projects are continued even when the decision maker does not find them ex post efficient. Using China’s experience, they argue that, by setting up institutions that limit the bureaucrat’s freedom to close ex post inefficient projects, the bureaucrat is forced to suffer the consequence of ex ante mistakes in project selection. This gives the bureaucrat more incentive to avoid these mistakes. Therefore, the SBC is an optimal institutional response to the hierarchical nature of socialist and transition economies. The need for such institutions diminishes if by privatization, for example, either the bureaucrat’s role is made less important or monitoring the bureaucrat’s effort is made easier. The remaining two papers in the symposium consider some empirical evidence of SBCs. Schaffer examines whether enterprises receive net injections of cash or subsidies, i.e., whether ex post inefficient projects are refinanced, in some Central and Eastern European economies and former Soviet republics. He finds that interenterprise arrears are no worse than in Western economies, that Hungarian banks generally do not provide net financing to net money losers, and that tax arrears have become a major source of subsidy to moneylosing firms. Li and Liang use data about China’s state-owned enterprises to evaluate three sources of financial losses: overemployment, poor project selection and insider rent seeking. They find that each source contributes significantly to financial losses. Moreover, financial losses do not lead to reductions in employment, in investment, or in excessive bonus to insiders. In particular, poor returns to previous investments do not have a negative effect on future investments. Li and Liang do not provide direct evidence on whether investment is ex post efficient. However, they provide support for the view that firms can count on future subsidies regardless of their past poor performance. These papers cover a broad spectrum of views providing reasons of, and cures for, the SBC and they offer several different approaches to the empirical measurement of SBCs. I believe that both academic and policy-oriented readers will find them useful. On behalf of all contributors to the symposium, I thank John Bonin for the enormous amount of time and energy he devoted to the symposium. His effort goes well beyond what is expected from an editor. Chong-en Bai, Guest Editor Boston College Chestnut Hill, Massachusetts 02167
AID
JCE 1504
/ 6w13$$$241
04-15-98 17:17:44
cea