• exogenous and endogenous SBC;
  • income redistribution;
  • soft and hard budget constraints;
  • Walras’ Law;
  • D21;
  • E12;
  • P2;
  • P5


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This paper demonstrates that Kornai's original concept of the soft budget constraint (SBC) as a theoretical innovation in micro-theory disguises income redistributions that are essentially macroeconomic relationships. The SBC also postulates a competitive market economy as the benchmark of hard budget constraint (HBC) and efficiency. A recent formal theory explains the SBC as a component of profit-maximizing strategic behaviour. From this perspective, the SBC can be integrated into the new microeconomics, but it loses its specific institutional connotation and its macroeconomic dimension. The SBC is thus included in ubiquitous market-type relationships, particularly complete (optimal) contractual arrangements.


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The soft budget constraint (SBC) is Janos Kornai's theoretical innovation in the field of microeconomics. It was initially conceptualized to explain the micro foundations of the economics of shortage as the normal state of a socialist system (Kornai, 1979, 1980, 1986). The concept refers to ex post bailouts of loss-making firms by a paternalistic state as a recurrent practice. In contrast, a competitive market economy is characterized as a benchmark for the hard budget constraint (HBC) that entails bankruptcy of insolvent firms. This definition has both theoretical and practical implications.

From a theoretical point of view, Kornai's search for ‘micro foundations of macroeconomic processes’ in socialism fitted well into the neoclassical synthesis, and contributed extensively to intellectual dialogue among advocates of non-Walrasian and disequilibrium schools during the late 1970s and 1980s (Barro and Grossman, 1974; Portes and Winter, 1978; Kemme and Winiecki, 1985; Davis and Charemza, 1989; Brabant, 1990).1 Although the SBC has never been acknowledged as a valid construct either by standard microeconomics or eminent representatives of the disequilibrium school such as Robert Clower and Axel Leijonhufvud, it brought Eastern and Western economists closer by focusing on concrete problems in socialist systems with reference to the market economy. In his earlier works, Anti-Equilibrium (1971) and Rush versus Harmonic Growth (1972), Kornai had already addressed the roots of pervasive shortages in socialist systems, which he dubbed the ‘suction economy’.2

In Anti-Equilibrium, Kornai's main explanatory factor for the cause of suction was the macroeconomic policy of the socialist state and not the microeconomic behaviour of socialist firms. Rush versus Harmonic Growth includes several references to Tinbergen's works, Turnpike theorem, and post-Keynesian models proposed by Harrod and Domar, who argued that the macroeconomic policy of ‘rush’ was the major source of shortage. Kornai's line of reasoning changed radically in his seminal paper Resource-Constrained versus Demand-Constrained Systems (1979), in which he introduced the concept of soft and hard budget constraints. From this point on, he favoured the microeconomic explanation over the macroeconomic one, because the former was more in keeping with dominant economic trends in the late 1970s and 1980s.

Apart from the paradigmatic change since the late 1970s, one might retrospectively ask which one of these two lines of reasoning is theoretically more coherent? Can the SBC be considered a microeconomic concept or should it be considered a macroeconomic redistributive policy to ensure job and wage security?

This question becomes even more important in light of recent developments in soft budget constraint literature. While the concept was never accepted in standard microeconomics, it has been integrated in the new microeconomics of dynamic (credible) commitment since the mid-1990s. Dewatripont and Maskin's game theoretical model of time inconsistency (Dewatripont and Maskin, 1995) was the first formal study of the soft budget constraint (for detailed surveys see Maskin, 1996; Kornai et al., 2003; Vahabi, 2001, 2005). If Kornai's exogenous theory of the SBC is incongruous with standard microeconomics, the endogenous formal models of the SBC provide a unified and consistent explanation in terms of the new microeconomics. ‘Endogenous explanations’ refers here to analyses of the SBC as an outcome of the internal interests of the softening institution (whether it is the state or other organizations playing the role of Principal).

From this perspective, the degree of budget constraint is a matter of rational choice by maximizing agents. But when the SBC is reformulated in terms of new microeconomics, what remains of non-Walrasian or disequilibrium macroeconomics? In Kornai's previous works, the SBC was always discussed in relation to the general state of markets, particularly with the invalidity of Walras’ Law (Kornai, 1979, 1980, 1986). Paradoxically, Walras’ Law is irrelevant within the partial equilibrium setup of the new microeconomics. Furthermore, any allusion to the invalidity of Walras’ Law or to any kind of disequilibrium is meaningless in the context of complete (optimal) contractual framework.

This explains why the eminent representatives of the exogenous (institutional) and endogenous (formal) theories of the SBC remained silent on the macroeconomic implications of the SBC with regard to Walras’ Law in their joint paper (Kornai et al., 2003). This again brings up the issue of the place of the SBC in economic theory. Does it belong to microeconomics or macroeconomics? Should it be regarded as the micro foundation of non-Walrasian or disequilibrium macroeconomics? Or should it be severed from macroeconomics so that it can be considered as part of the new microeconomics? In light of recent syntheses of institutional and formal theories about the SBC, it seems that the last option is the most popular, but a question remains unanswered: does the SBC retain its original meaning as an optimal strategic behaviour of rational agents?

The policy-making or practical implications of the SBC concept are as important as its theoretical relevance. After the collapse of the Soviet system, the policy implications of the SBC were so widespread and significant that they drew the prompt attention of mathematical economists. With the hard budget constraint (HBC) as a yardstick of efficiency, the SBC was synonymous with real and nominal microeconomic inefficiencies, usually referred to as the ‘Kornai effect’ based on Kornai and Weibull's (1983) pioneering paper.3 The SBC literature clarified the inefficiencies of classic and reformed socialist systems, but the concept was used extensively in policy-making during the post-socialist transition in the 1990s, because ‘policy-makers are often encouraged to “harden the budget constraint” of chronic loss-making firms by letting them close down, refusing them subsidies’ (Schaffer, 1998, p. 84).

Subsequently, hardening the budget constraint was not only synonymous with putting an end to the shortage economy; it meant, as Kornai stressed, restoring the capitalist market system, privatizing, and decentralizing (1998b, p. 538). At the beginning of the post-socialist transition, it was widely held that the ‘holy trinity’ of liberalization, privatization and stabilization would be sufficient to produce an efficient market. Kornai emphatically argued that it is equally important to harden the budget constraint. His recent works on the ‘organic development’ of a private market economy stress a ‘magic square’ instead of a ‘holy trinity’: ‘There is close causal relations between healthy development of private sector, hardening of the budget constraint, forceful restructuring of production, and as the ultimate result, the growth of labour productivity’ (Kornai, 2000, p. 10).

The concept was almost immediately accepted by the majority of decision-makers at international institutions. Reports from the World Bank (1997, 1999), the European Bank for Reconstruction and Development (EBRD, 1998, 1999, 2000, 2001), and other institutions repeatedly referred to ‘hard budget constraint’ and ‘soft budget constraint’, sometimes using these expressions without citing the author. Hardening of the budget constraint became a categorical imperative worldwide, including emerging and developed countries. But how should the efficiency of hardening a budget constraint be measured? Should it be gauged at a microeconomic level or at a macroeconomic level?

Suppose that the SBC of major mortgage insurance companies and investment banks is the source of a gigantic financial crisis.4 This is very similar to what is happening in the recent subprime crisis in the USA. Should the Senate and Congress vote for a general policy of state bailouts of big financial institutions like Fannie-Mae, Freddie-Mac, and AIG or should it refuse to rescue the Lehman Brothers and adopt a policy of case-by-case bailout? Obviously, a general bailout policy softens the budget constraint and undermines the credible commitment of the state pertaining to inefficiencies in the financial sector.

In the presence of systemic risk, non-intervention of the state as the insurer of last resort causes major spill-over effects leading to liquidity crises and severe depression. The interdependence and chain-like effects of the crisis at a macroeconomic level outweigh the sectoral inefficiencies of state bailout. Accordingly, hardening of a budget constraint becomes more inefficient than the SBC from a macroeconomic point of view. How then are the inefficiencies of the SBC assessed and measured in the existing SBC literature? This is the second major question that will be addressed in this paper.

This paper will investigate both the place of the SBC in economic theory and its efficiency implications. The second section will discuss the micro and macro dimensions of the SBC according to its creator. The third section will be devoted to the relationship between state paternalism and the SBC. The fourth will provide a concrete example of the empirical and historical importance of the SBC in both macro and micro dimensions from a political economy perspective. The fifth section will critically assess the SBC in the new microeconomics and how its meaning has changed. The sixth will compare the (in)efficiency implications of the HBC and SBC according to exogenous and endogenous approaches to the SBC. The final section will provide conclusions.


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Budget constraint (BC) is a fundamental concept in standard microeconomics5 of household behaviour. Disregarding the possibility of credit, it simply asserts that a household's total spending plan cannot exceed its budget constraint, namely the total expected monetary revenue at its disposal. For a long time, the budget constraint has been considered a bookkeeping identity. BC was first treated as a ‘rational postulate’ of a household's ‘planned’ (intended) behaviour by Clower (1965) and Clower and Leijonhufvud (1981).6 Clower (1965) applied Say's Principle (SP) as synonymous with BC and tried to clarify the prevalent confusion among economists between SP and Walras’ Law.7

According to Clower, Say's Principle (SP) only states that ‘ … the net value of an individual's planned trades is identically zero’ (Clower and Leijonhufvud, 1981, p. 80). He intentionally did not refer to the ‘net market value’, because SP only states that a household's ‘expected’ or ‘planned’ purchases cannot exceed its ‘expected’ or ‘planned’ revenues. Trades considered by Clower to be ‘theoretically admissible’ are not actual market trades. In this respect, prices and quantities are also included in the context of ‘mental experimentation’ and refer to ‘expected’ purchase prices and ‘planned’ quantities and not to quantities actually purchased or prices actually paid (Clower and Due, 1972, p. 64).

Kornai redefined budget constraint (BC) as an empirical fact instead of a rational postulate. While the distinction between hard and soft budget constraints is meaningless in standard microeconomics (Kornai 1979, p. 806), it describes two different behavioural regularities in Kornai's theoretical construction. Kornai's HBC amounts to what microeconomics consider a budget constraint. But this is only empirically held under a ‘pure’ competitive capitalist economy. Conversely, the BC is soft under a socialist system where ‘socialist firms are bailed out persistently by state agencies when revenues do not cover costs’ (Kornai, 1998a, p. 12).

This distinction at the microeconomic level suffers from a fundamental shortcoming. While the application of the standard microeconomic budget constraint (or Kornai's HBC) does not require any transfer between individual economic units, the SBC implies macroeconomic income redistribution. This makes it difficult to understand why Kornai classifies his concept within micro theory.

The institutional rationale for this kind of transfer appears in Polanyi's (1944, [1957] 1968) ‘redistribution’ pattern of social integration, which should be distinguished from ‘reciprocity’, and ‘exchange’. Massive redistribution of income has been a key feature of East European socialism. Subsidization of consumption, especially basic food and housing, is a rudimentary form; more subtle and pervasive redistribution results from the ‘socialisation of losses and profits’. This entails the redistribution of profits from winners (or profitable firms) to losers (or unprofitable ones).

Despite the shift from government to bank financing of state-owned enterprises, the SBC remains an important problem in economies undergoing post-socialist transition, albeit to varying degrees. Kornai (1999) underlined five main groups of instruments leading to the SBC during a post-socialist transition: 1) fiscal subsidy; 2) soft taxation; 3) soft bank credit (non-performing loans); 4) soft trade credit (the accumulation of trade arrears between firms); and 5) wage arrears. The SBC was particularly pressing in Romania, the Russian Federation, China, Albania, Azerbaijan, Tajikistan, Belarus, etc. during the 1990s (Kornai, 1999, p. 3a; Berglof and Roland, 1998, p. 19; Li, 1998). The survival of the SBC was especially critical in the Russian case, to the point that Pinto et al. (1999) dubbed Russian society as a ‘non-payment society’. In this case, enterprises did not pay their suppliers, employers did not pay their employees, or debtors their lenders. The executive and judiciary system also tolerated the situation.

The SBC is also not unknown in developing countries. The considerable degree of government intervention in many of these countries, along with the particular importance of parastatals in industrial production and the lack of numerous fully fledged market institutions can generate situations involving the SBC (Raiser, 1994). Anderson (1995) stressed the importance of personal relationships in the politics of certain Middle Eastern countries and argued that many of their leaders repeatedly obtained easy (soft) international credits due to their political significance.

Corporate finance literature has identified a number of sources and channels of transmission (or propagation) of SBCs not only in transition economies (Berglof and Roland, 1998) but also in developed capitalist economies (Dewatripont and Maskin, 1995; Maskin, 1996). The relationship between loss-making or insolvent firms and commercial banks on the one hand, and the relationship between insolvent commercial banks and the central bank on the other, is also relevant in capitalist countries. The extent to which these firms or banks are subjected to ‘financial discipline’ and bankruptcy procedures under a fully developed market economy constitutes a crucial problem in the general process of Schumpeterian ‘destructive creation’. Furthermore, the SBC may appear in different branches of a multinational firm, or in the relationships between central and local governments (Qian, 1994). Dewtripont and Maskin (1995) applied the concept to explain differences between Anglo-Saxon (USA and UK) and German-Japanese corporate finance.

Aizenman (1993) underlined the relevance of the SBC for all economies with limited control of decision-making processes. For example, the concept may be used to clarify the consequences of a separation between a central bank and a treasury or among ministers or local governments with regard to fiscal resources. The importance of this issue has been documented in recent macro and development literature with a focus on coordination failure caused by multiple competing decision-makers (Dewatripont and Tirole, 1996; Daver and Panunzi, 1997). The concept can also be used to analyse the research and development (R&D) investment under different institutions in developed countries (Bös and Lülfesmann, 1996; Huang and Xu, 1998).

Modern industrialized economies have at least five major redistributive mechanisms: (1) fiscal policies; (2) soft credit; (3) administrative price system; (4) state's industrial policy; and (5) selective tariff protection of different industries and products.8 Situations in Poland (Schaffer 1990a, 1990b) and Hungary (Kornai and Matits 1987, 1990) exemplify redistribution through fiscal policies due to state paternalism; in contrast, the former Yugoslavia's ‘self-management’ system (Vodopivec, 1989; Kraft and Vodopivec, 1992) is a good example of financial redistribution from net creditors to net debtors through the banking system.

The presence of the SBC among a certain group of enterprises implies a harder budget constraint for other enterprises in terms of income redistribution. In the case of the former Yugoslavia, the quantification of redistribution flows during the 1970s and 1980s demonstrates that while the manufacturing sector was a net beneficiary of redistribution, its SBC was compensated by a harder budget constraint in the private business sector and the household sector (see Kraft and Vodopivec, 1992) as well as significant deficits of commercial banks that turned into a public debt of the National Bank of Yugoslavia (see Bole and Gaspari, 1991).

Kornai and Matits (1987) also noted that the effect of redistribution is much stronger within industry than within agriculture. However, they did not examine whether a harder budget constraint in the agricultural sector compensates for SBC in industry. According to Kornai, even in a classical socialist system not all agents are marked by a SBC. While socialist firms have a SBC (Kornai, 1980, p. 515), households are subject to a HBC (Kornai, 1980, p. 514) because they cannot expect to cover their planned expenditures by anything other than their expected revenues.

A socialist state has a BC that is neither completely hard nor completely soft. It is not hard because the state budget must cover losses of socialist enterprises. It is not always soft, because the current expenditures of state agencies are usually subject to a HBC (Kornai, 1980, pp. 528–29). Kornai did not quantify the relationship between state firms’ SBC and household HBC, but he argued that a ‘siphoning effect’ appears between these two sectors with regard to the use of input resources. Consequently, the runaway demand of the socialist firms is the source of shortage. Following Kornai, Qian (1994) developed a model that explains shortage economy during the post-socialist transition on the basis of the siphoning effect.

Kornai's treatment of the SBC at a microeconomic instead of macroeconomic level leads to some serious theoretical problems. Notwithstanding major differences among ex-socialist East European economies, they all shared a macroeconomic reality, that is, job and wage security. Considering this macroeconomic relationship, and contrary to what Kornai claims, a household budget constraint in a socialist system is soft and not hard, although in appearance the expected income should cover the expected expenditures. According to the marginal theory of value,9 guaranteeing full employment at every level of labour supply regardless of the marginal rate of substitution between capital and labour means a redistribution of added value from profit to wage. It implies a level of wage superior to the marginal productivity of labour (w > FL) at every scale of labour supply and a level of interest rate inferior to the marginal productivity of capital (r < FK). Accordingly, an individual's budget constraint is soft, since his/her purchasing power is superior to the amount of her/his labour input.10

By the same token, given an interest rate level, capital investment would decline if investment was dependent on the level of private saving. However, under a socialist regime, state investment is an autonomous function. Investment finances are not allocated selectively according to the rate of profit: they are rationed and distributed in accordance with the state's preferences at sub-equilibrium interest rates. Strategic sectors would be privileged compared to non-strategic sectors. State industrial policy would decide which industries or state firms would have a preferential access to the capital goods.

This discussion ties in with the fourth major mechanism of the SBC: state industrial policy. This policy involves choosing winners (or losers) and defining a pecking order of subsidized industries (enterprises) according to ex ante government preferences. These policies have appeared in former socialist economies as well as Western market economies; they have recently re-emerged to address the current global financial crisis, particularly with regard to the car industry.

Kornai's definition of the SBC particularly highlights ex post bailouts or ex post state intervention, but from a macroeconomic perspective an ex ante state intervention may also lead to a SBC. If an economic unit obtains subsidies, tax reliefs, preferential loans, etc. before the start of the financial period, its BC is soft in a preliminary sense. This observation brought Szabó (1988) to distinguish between a preliminary (ex ante) and an incremental (ex post) softness of budget constraint.

Kornai considers the dichotomy between ex ante/ex post state intervention to be rigid (Kornai, 1998a, p. 14), but he has focused on ‘incremental’ rather than ‘preliminary’ softness. He acknowledged preliminary SBC in certain passages without further comment: ‘The more powerful and prestigious the department or ministry (a typical case is departments in charge of defence), the more intensive is the SBC syndrome’ (Kornai, 1986, p. 24). He did not examine differences between strategic and non-strategic state firms with regard to competition over capital goods and the egregious siphoning effect that this might have on the shortage of such goods. Focusing on incremental or ex post SBC, Kornai indiscriminately characterizes all state enterprises as SBC and confines the HBC to the household sector.

Narrowing macroeconomic income redistribution to the SBC at a microeconomic level disguises the nature of budget constraint at least in two respects. First, it obscures the softening of household budget constraints in the socialist system due to the redistribution of added value from profit to wage. Second, it fails to embrace preliminary SBC stemming from a state's industrial policy or ‘preferred branch and enterprises’ such as the military sector.11


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Another justification for the SBC as a microeconomic concept is that it describes a behavioural regularity of socialist managers. ‘The expectation of the decision-maker as to whether the firm will receive help in time of trouble or not is an essential component of the SBC syndrome. A single instance of occasional assistance to an enterprise will not produce the SBC phenomenon. The expectation will develop only if such bail-outs recur with a certain frequency so that managers learn to depend on them’ (Kornai, 1998a, p. 14). Thus, this behaviour does not originate in individual firms, and it is not a norm set through the interactions of a population of enterprises. It is the outcome of state preferences.

In fact, Kornai's exogenous theory of the SBC is based on state paternalism: ‘The soft budget constraint is the manifestation of the paternalistic role of the modern state’ (Kornai, 1986, p. 8). He considers the SBC to be a social relationship similar to that between parents and children, or firms and state, as general insurance. But in which direction does this relationship work? Are parents subject to children's emotional blackmail or are children obedient? In the former, the capricious behaviour of children is the explanatory factor of parental expenditures; in the latter, children's expenditures are strongly based on parental preferences. Translating this metaphor into terms of state paternalism and firms’ behaviour, the former case amounts to a ‘bargaining economy’ in which lobbying activity could exact extra privileges from the state; the latter one describes a ‘command economy’, which is built upon hierarchical vertical relationships.

A ‘bargaining economy’ is exemplified by the general policy of bailouts for Wall Street during the recent subprime crisis. After September 2008, the Bush administration became a paternalistic state and transformed itself into the largest insurer and the largest mortgage company. Stiglitz noted: ‘Talk about socialism, we have it! It's an irony the biggest increase in the role of government in the economy would happen this way …  This is a pattern we've seen over and over again. Financial markets always want a bailout and always resist regulation. We had bailouts in '89, '94, '97, '98. Financial markets frequently get bailouts, then lecture poor people about self-reliance’ (2008, p. xx).

This is typical behaviour of capricious children: they want a bailout but resist regulation; they ask for more money but cannot tolerate parental restriction about how it should be spent. When Henry M. Paulson acted as a paternalistic Treasury Secretary on 17 October 2008 and decided to give the first instalment of the $700bn bailout to JP Morgan Chase, Chief Executive Jamie Dimon was happy not to be restricted in how to use his $25bn. Certainly, he did not intend to use the money for new loans to help the American economy avoid a depression; reliable internal sources reported that he preferred to use it for new acquisitions and mergers (Nocera, 2008). Thence, the Treasury's bailout bill was used to turn the banking system into an oligopoly of giant financial institutions.

In other words, the paternalistic state is held hostage to spoiled children. In this type of relationship, children strategically endeavour to ‘socialise their losses’, but do not accept the ‘socialisation of their benefits’. The question is, why does the state behave so leniently toward this capricious behaviour? Within the context of a ‘bargaining’ or contractual setup, we can apply an endogenous explanation of state behaviour in terms of credible commitment. While this endogenous explanation falls within the scope of the new microeconomics, it has nothing to do with an exogenous explanation of the SBC, which assumes hierarchical relationships between the state and socialist firms. Such hierarchical relationships were dominant in ex-socialist countries, and Kornai's SBC micro theory described the behavioural regularity of socialist firms.

In a ‘command economy’, firms behave more like obedient children.12 Consequently, parental preferences shape children's behaviour, so children's SBC at a micro level could not be considered the primary cause of the way parents help children. In other words, the main issue in parent–children relationships is not whether children are assisted by parents, but how they are helped. If parents are too lenient, they help children in ways that depend on the children's desires. If parents are too severe, they help children in ways that depend entirely on their own discretion. In the latter case, the SBC does not have a major explanatory role. In this way, Kornai's theory of state paternalism contradicts his own theory of SBC. This contradiction is particularly striking in the context of a shortage economy.


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Where should the main cause of pervasive shortage be sought: in a state's macroeconomic policy or in the SBC of enterprises at a microeconomic level? As discussed above, Kornai's first answer involved the macroeconomic policy of ‘suction’ (Kornai, 1971, 1972). The preference of the socialist state for accelerated growth or ‘rush’ rationalized ‘sucking’ resources and resultant shortages of input and consumption goods. This line of reasoning, which appeared in Kornai's work before the late 1970s, may be called Kornai 1. After the late 1970s, Kornai identified socialist firms’ behaviour as the major source of shortage, and preferred a microeconomic explanation of shortage in terms of SBC. This new line of reasoning may be named Kornai 2.

Kornai acknowledged this radical change: ‘I have described here the same phenomenon as I did in the book, but causal analysis differs from the previous one at several important points. The explanatory factors that I considered the main cause of suction in Anti-Equilibrium stayed a role also in the present analysis, but only secondarily. ‘Weighting’ of the causes has been rearranged. I consider now the main cause of suction the institutional background, concretely: softness of the budget constraint’ (Kornai, 1979, p. 817). However, SBC is not an ‘institutional background’; it is solely a ‘behavioural regularity’ at the microeconomic level, as Kornai stated repeatedly. Accordingly, Kornai's new line of reasoning boils down to a microeconomic explanation of shortage.13

According to Kornai 2, a SBC generates a firm's ‘investment hunger’ (Kornai, 1979, 1980, 1983, 1986, 1998a, 1998b), a situation where ‘every firm without exception wants to grow … ’ (1979, p. 813). This unconstrained ‘investment hunger’ or runaway demand plays a major explanatory role for shortages in the socialist system.

However, hunger or desire for growth does not provide a motive for investment. In fact, financing of investment budgets, both sectorally and globally, is a function of a state's own preference for ‘rush’ or fast growth. In contrast to investment production, creation and allocation of investment finances to investors (incumbent or new) are decided by the state. Both the entry and expansion of incumbent firms hinge upon the state's autonomous investment function. However, financial assistance is granted to firms only when they are state favourites or no other option exists. This makes it difficult to understand how ‘investment hunger’ caused by a SBC actually results in shortages: state paternalism and consequent macroeconomic policy, especially that of ‘rush’ is a better candidate for pervasive shortages.

Bajt argued that the endemic shortage of consumer durables (apartments, cars, washing machines) is not caused by a SBC in this sector: it stems from a rush policy in manufacturing producer goods and arms production. In a sense, Bajt was reiterating the same line of reasoning as Kornai 1 when he criticized Kornai 2: ‘The two basic characteristics of socialist growth that illustrate the irrelevance of the soft budget constraint, and also of the investment motives given by Kornai, for generation of shortage are the “predominant growth of the first department” (capital goods production), promoted to “‘the first basic law of socialist development”, and investment cycles’ (1991, p. 11).

This line of reasoning is theoretically consistent with state paternalism. However, it contradicts how Kornai 2 explains shortage: if state paternalism is the source of firms’ SBC and investment hunger, then why aren't pervasive shortages explained by state paternalism instead of firms’ SBC? Borrowing Kornai's metaphor of parents and children, the only solution to this contradiction is to assume lenient parents and capricious children.

The metaphor would not apply if we assume authoritative parents and obedient children, as suggested in Kornai 2. In other words, the nature of the relationship should not be hierarchical or authoritative, and children can take advantage of parental help without following their rules and regulations. Consequently, the state ought to be depicted as a micro unit and be treated in the same way as other micro units, such as enterprises and households. Of course, theoretical discussions will no longer include the macroeconomic policy of the state, but rather microeconomics of maximizing agents in a ‘bargaining’ market-type economy. This consistent line of reasoning has recently been developed in game theory models of the SBC.

Before introducing the game-theory line of reasoning, more discussion is required about the shift from Kornai 1 to Kornai 2, or a macro-oriented to a micro-oriented explanation of the SBC. From a historical point of view, during the first period of ‘socialist construction’ (or what Kornai, 1992 called ‘Classical Socialism’), voluntarism of development strategies and macroeconomic redistribution was the basis of selective SBC for strategic sectors of the economy (e.g., industry versus agriculture; sector I versus sector II, etc.).

Until the end of the 1970s, state preferences shaped redistributive policies in favour of strategic sectors. The preference for accelerated industrialization softened the budget constraint of these sectors. Borrowing the distinction between ex ante versus ex post SBC, it could be said that the ex ante SBC was the result of state preference. The emergence of strategic sectors led to a new power structure in the context of a command economy. By the beginning of the 1980s, the considerable increases in external debt in open reformed socialist economies such as that of Hungary radically changed the general context.

The pressure of external debt required redefining internal policies to restructure the economy and generate a more efficient export-oriented sector. This new orientation was a prerequisite for earning convertible currencies and entailed a HBC for economic units. However, the strong bargaining power of strategic sectors impeded the implementation of these new policies. The bulk of resources in the command economy were allocated to traditionally favoured sectors that maintained asymmetrical power (and not just asymmetrical information, as suggested by Berliner's 1952 ‘ratchet effect’).

The autonomy of these political and economic elite weakened the decision-making power of the central authority within the command economy. In a sense, the failure to reform was caused by SBC behaviour of strategic sectors at a micro level. Macro-induced SBC provided the conditions for a micro-induced SBC. This coherent explanation of the SBC involves the historical evolution of both macro and micro aspects of the SBC within a political economic perspective in which the asymmetrical power structure of strategic sectors occupied the prime place (for a political economy perspective of the SBC, see Vahabi, 2012).


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Dewatripont and Maskin (1995) pioneered an endogenous explanation of SBC. They argued that the SBC syndrome occurs whenever a funding source (e.g., a bank or government) finds it impossible to keep an enterprise to a fiscal budget (i.e., whenever the enterprise can extract ex post a bigger subsidy or loan than would have been considered efficient ex ante). In this sense, the SBC problem is not specific to socialist economies, because the extent to which loss-making firms or projects are terminated or refinanced is also very relevant in capitalist (both developed or undeveloped) economies.

According to Dewatripont and Maskin, time inconsistency of the Centre lies at the heart of the SBC syndrome: if the Centre were able to credibly commit not to subsidize a firm ex post, the firm would make more efficient ex ante decisions. The SBC is accordingly treated as a more general dynamic commitment problem in which an agent can fail to take an efficient action, or can undertake an inefficient action, because he knows that he will receive additional financing. Hardening of budget constraint then means creating conditions for a credible commitment not to refinance an agent. This model describes a situation in which a superior organization (e.g., a bank) is deciding whether to finance investment projects of certain enterprises.

There are two kinds of projects: fast and slow. Fast projects are ‘good’ investments and can be completed in one period. Slow projects are ‘bad’ investments, because their completion will be delayed and cost more than ‘good’ ones. Banks cannot distinguish between the two different types of projects, but managers can. Managers may hide information about the quality of projects and banks may approve some bad projects that are ex ante unprofitable. However, banks have all the bargaining power when negotiating financing and may propose take-it-or-leave-it offers. Dewatripont and Maskin's model bases the SBC on creditors’ adverse selection and lack of commitment not to refinance bad projects.

They argue that it is worthwhile and feasible for large creditors to refinance a project after the initial investment is sunk, because the marginal benefit of refinancing may exceed the marginal cost, even though the total sum invested may end up being higher than its proceeds. Small creditors would not have the liquidity to continue these projects and would be more likely to terminate them. This model shows that the decentralization of credit results in several small creditors who cannot afford to refinance bad projects and thus may commit themselves to refuse refinancing. Decentralization can thus contribute to the hardening of a budget constraint.

Since this pioneering work, an abundant body of formal literature has explained the SBC endogenously through adverse selection, moral hazard and rent-seeking (for detailed surveys, see Maskin, 1996; Kornai et al., 2003; Vahabi, 2001, 2005). The SBC is thus integrated into the new microeconomics as a special case of time inconsistency. Nonetheless, these endogenous versions of the SBC and Kornai's exogenous version of the SBC still differ fundamentally as the ex post bailouts of loser firms by a paternalistic state. To clarify the difference, we can simply ask what would happen if, ex ante, the creditor knows with certainty that the firm will be a loss-maker.

In all endogenous models of the SBC, ‘if a creditor learns ex ante that the firm is definitely a “bad” firm, it will refuse to finance it since to do so would be throwing money away. This is in sharp contrast to a model of ex post bailouts due to paternalism because in such a model the likelihood of obtaining financing is unaffected by ex ante revelation to the creditors that the firm is expected to be loss-making. If the firm is loss-making ex post, it is subsidized as a result of its situation and, consequently, the firm has a soft budget constraint’ (Schaffer, 1998, p. 84). In other words, Kornai and Maskin are not talking about the same thing.

While Maskin's endogenous SBC fits within profit-maximizing behaviour and is consistent with the new microeconomics, Kornai's theory of the SBC is inconsistent with profit-maximizing behaviour. ‘In describing the behaviour of the firm, we want to have a more general framework than the usual profit-maximizing pattern … In addition, we apply – following Simon (1959) – the satisficing model of decision-making. This approach seems to be more general and realistic, and in the present model profit maximizing appears as a special case of the more general pattern’ (Kornai and Weibull 1983, p. 166).

Why is ‘profit-maximizing behaviour’ excluded from Kornai's definition? The reason is that there is no need for the SBC as income redistribution to be regarded as ‘profit-maximizing’; it must simply meet the survival condition. In fact, if the profit-maximizing condition is satisfied, there will be no need for income redistribution. In Kornai's original theory, the SBC describes the logic of income redistribution within ‘bureaucratic coordination’ (Kornai's term for Polanyi's ‘redistribution’). It can be better understood as a macroeconomic relationship within a particular institutional setting. However, in endogenous explanations of the SBC, the concept does not apply to income redistribution; it defines strategic profit-maximizing behaviour at microeconomic level within a market-type economy.


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There is no solid positive justification to consider Kornai's exogenous explanation of the SBC as part of micro theory. However, a normative justification cannot be dismissed outright. By focusing on the opposition of SBC versus HBC, it may be possible to provide a unified theoretical framework to compare the reality of an inefficient socialist system with an ideal model of efficient competitive market economy. HBC can be used as a benchmark of efficiency in an ideal competitive market economy, and through comparison it can be used to measure inefficiency in an existing socialist system.

To place the SBC in the context of economic theory, Kornai drew upon Schumpeter's destructive creation: ‘The concept of the SBC focuses on the destruction side. Will an organization live forever? If it is to die, will it die a natural death or will it be sustained artificially for some period of time by state support through the SBC’ (Kornai, 1998a, p. 15). Inefficiency of a SBC is related to the failure of the evolutionary market selection. Socialism is characterized by SBC because it does not allow effective bankruptcy, whereas the efficiency of an ideal competitive market economy is ensured by market natural selection.

Kornai assumed that the HBC is related to an ideal market economy, meaning markets in the Walrasian General Equilibrium. However, bankruptcy does not exist in such an ideal state, because in equilibrium enterprises do not experience profit or loss, and their total expected revenue is equal to their total expenditure. In other words, there is no ‘natural market selection’ in an ideal state of competitive market economy.

In reality, however, bankruptcy does not exclude SBC in a capitalist economy. Akerlof and Romer (1993) found that a SBC in the capitalist system is generated by ‘bankruptcy for profit’, which is a major source of looting. Their model describes the circumstances surrounding the financial crisis in Chile and the thrift crisis in Dallas during the 1980s. Although a capitalist system does not guarantee the survival of enterprises, firms’ debt obligations are guaranteed in various ways. For example, the state guarantees deposit insurance, the pension obligations of private firms, almost all the obligations of large banks, student loans, mortgage finance of subsidized housing, and the general obligations of large or influential firms. In such circumstances, ‘bankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values’ (Akerlof and Romer, 1993, p. 2).

Given the possibility of bankruptcy for profit, it is not valid to characterize market economies as involving an HBC. Actually, at a microeconomic level, the HBC (or Say's Principle) is simply a rational postulate that is related neither to socialism nor to capitalism. At a macroeconomic level, the HBC can be regarded as an empirical fact pertaining to a redistributive policy where it is the reverse of the SBC. This holds true both in capitalist and socialist economies. However, Kornai considers the HBC to be an efficient micro behavioural regularity in an ideal competitive market economy.

In this sense, the SBC was from its inception an extremely policy-oriented concept. Kornai never overtly extolled capitalism during his academic career until the late 1980s, but his theory of SBC opened the door for explicit discussion of the inefficiencies in socialism compared with a competitive market economy. Politically as well as ideologically,14 it was hazardous during that time to criticize macroeconomic policies, whereas critical appraisal of microeconomic inefficiencies was not problematic. The SBC as a micro theory was thus well tailored; practical interests of the SBC compensated for its theoretical inaccuracies.

In the same vein, shortage has been explained in terms of microeconomic allocative inefficiencies. Kornai argued that micro behavioural regularity was system-specific and that the normal state of every economic system was characterized by its specific disequilibrium.15 According to Kornai (1971), a non-Walrasian general equilibrium could provide this kind of general framework. Hence, he not only focused on the partial equilibrium consequences of the SBC, but also on its implications within a general equilibrium framework. He argued that if the HBC or Say's Principle (in Clower's terminology) was a necessary condition for the validity of Walras’ Law, then a softening of budget constraints in a socialist system invalidated Walras’ Law (Kornai, 1980).

In contrast to a classical socialist economy, the HBC or Say's Principle applies to a competitive market economy. Does this mean that Walras’ Law is valid in such an economy? Kornai's answer was affirmative: ‘In the capitalist system the firm has a hard budget constraint … in a socialist economy in contrast the firm's budget constraint is soft … It follows from this that in the former system Walras’ Law prevails. In the latter system, however, Walras’ Law is not effective, at least within the firm sector’ (1980, p. 558). In other words, Walras’ Law holds in a competitive market economy because Say's Principle is valid. However, Clower and Leijonhufvud (1981) demonstrated that the validity of Say's Principle does not exclude unemployment and is thus insufficient to validate Walras’ Law (Clower, 1965, p. 116).

Although Kornai conceded the distinction Clower (1965) made between Say's Principle and Walras’ Law in case of a socialist economy, he blurs this distinction with regard to a competitive market economy. In fact, he introduces a pure competitive market as the benchmark of efficiency at a systemic level.16 While the SBC as a positive theory is incongruous with standard microeconomics, its normative implication is entirely in line with standard microeconomics, because the SBC implies that a competitive market economy is obversely a yardstick of HBC efficiency.

According to Kornai, the SBC is synonymous with inefficiencies both at partial and general equilibrium levels. Different aspects of real and nominal micro-inefficiencies (including lack of price responsiveness, runaway demand, and investment hunger) have been substantiated at a partial equilibrium level and are known as the Kornai effect (Prell, 1996). At a general equilibrium level, the SBC is regarded as the source of invalidity of Walras’ Law. In fact, for Kornai, the SBC is always equivalent to inefficiency at a macroeconomic level, though policy-makers may not apply the HBC rigorously due to equity or ethical-political considerations. A dilemma appears between efficiency and equity with regard to hardening of the SBC (Kornai, 1986, pp. 26–27).

The theory of an SBC as an ex post bailout describes the rationale of an economic system in which the profit criterion is not effective, so persistent loss-making firms can survive thanks to a redistributive institution. This institution may be a paternalistic state or any other hierarchical organization based upon vertical relationships. ‘The softening of the budget constraint is an indicator of the fact that many basic allocative and selective processes are not left to the market, but are highly influenced or taken over by bureaucracies and by political forces’ (Kornai, 1986, p. 26). Accordingly, private enterprises and horizontal market relationships have no natural affinity with the SBC. While state ownership is akin to the SBC, private ownership is prone to the HBC.

In contrast to Kornai's original definition of the SBC, the new microeconomics defines the SBC as a profit-maximizing strategic behaviour. Hence, the SBC only implies ex ante inefficiency but it does not exclude ex post efficiency. In fact, ex ante, the investment would not have been made by the Principal had the adverse selection or moral hazard been shunned. Ex post, however, production is better than non-production; otherwise the Principal would not accept production by Agents with persistent losses.

Because the SBC comes within the scope of profit-maximizing behaviour, it is not limited to the state or any other hierarchical institutions. It is now completely cut off from any redistributive rationale and is part and parcel of competitive profit-maximizing market behaviour. Consequently, the SBC as a profit-maximizing strategic behaviour has been completely integrated in microeconomics and has nothing to do with macroeconomic income redistribution.

This new microeconomics approach to the SBC is based on a partial equilibrium framework and is not concerned with Walras’ Law. The SBC is no longer a source of macroeconomic disequilibrium and satisfies the efficiency conditions of an ex post SBC equilibrium.


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This paper demonstrated that Kornai's original definition of the SBC is a source of confusion as a theoretical innovation in micro theory. It disguises income redistributions, which are quintessentially macroeconomic relationships. Moreover, the SBC postulates a competitive market economy as the benchmark of HBC and efficiency.

The SBC must therefore be redefined either as an integral part of macroeconomic income redistribution or as part and parcel of the new microeconomics. The former explains the rationale behind a particular form of social integration, which Polanyi called ‘redistribution’ and Kornai called ‘bureaucratic coordination’. This institutional arrangement defines macroeconomic principles and preferences, which in turn shape microeconomic regularities and individual preferences. In this line of reasoning, the pervasive shortages in Soviet-type economies can be explained by macroeconomic policies, as has been suggested by Kornai (1971, 1972) and other disequilibrium schools.

In the alternative definition of the SBC as a profit-maximizing strategic behaviour, the SBC loses its specific institutional connotation and its macroeconomic dimension. It fits into ubiquitous market-type relationships, particularly a complete (optimal) contractual arrangement. Clearly, Kornai 1 is incompatible with the new microeconomics. However, the Kornai 2 micro approach is not necessarily equivalent to the reinterpretation of SBC as an optimizing strategic behaviour of rational agents from a political economic perspective.

Table 1 presents the major differences between Kornai's exogenous theory and game-theory models of endogenous SBC.

Table 1. Comparison between exogenous and endogenous explanations of the SBC
 Soft budget constraints:types of explanation
Pioneering author/sKornai (1979, 1980, 1986)Dewatripont and Maskin (1995), Maskin (1996)
Fundamental behavioural assumptionSurvival (satisficing)Profit-maximization
Analytical frameworkPartial and general equilibriumPartial equilibrium
Institutional relevanceRedistribution (bureaucratic coordination)Ubiquitous market-type relationships
Efficiency criterionInefficientEx ante inefficiency and ex post efficiency
Sectoral relevance (state versus private)State sectorState and private sector
Dynamic equilibrium and disequilibriumDisequilibriumDynamic equilibrium

Kornai, Maskin and Roland, the leading representatives of exogenous and endogenous SBC, devoted a very short section in their synthesizing paper to ‘normative implications’ of the SBC. They concluded that ‘a major shortcoming of the literature on the SBC is the absence of a systematic exploration of normative implications’ (2003, p. 1132). Could they have arrived at identical conclusions with respect to normative implications when their starting positive explanations of the SBC are so strikingly different? Presumably, the price of integrating the SBC in microeconomic theory is a total reconsideration of both its positive and normative implications.

  1. 1

    For a detailed survey and critical appraisal of this discussion see Vahabi, 1993, Chapter XXI.

  2. 2

    Kornai (1971) coined two expressions (‘suction’ versus ‘pressure’ economies) to describe what were previously known as ‘resource constrained’ and ‘demand constrained’ economies. He abandoned these terms in his later works (Kornai, 1979, 1980).

  3. 3

    The Kornai effect was later extensively formalized by Goldfeld and Quandt (1988, 1992, 1993); Ambrus-Lakatos and Csaba (1990); Scott (1990); Magee and Quandt (1994); Pun (1995); and Prell (1996). For a detailed survey, see Vahabi (2001, 2005).

  4. 4

    Huang and Xu (1998, 1999) tried to explain the miracles and bubbles in Korea and Taiwan on the basis of the SBC. Alexeev and Kim (2008) found a positive correlation between the Korean financial crisis and the SBC by applying Altman's z-score.

  5. 5

    Walras intimated the ‘rationality’ version of the budget constraint by imposing a restriction of ‘zero value of (planned) trade’ for the individual trader, but this was quid pro quo (Say's Principle), not income constrained utility maximization (see Jaffé, 1954, p. 165). According to Jaffé, Walras considered his equations of exchange to be ‘budget constraints’ as part of the requirements for justice in exchange. This interpretation was contested by Walker (1996, pp. 47–48), who denied any normative implication for budget constraints in Walras. The budget constraint is implicitly present in Walras, but not explicitly, as shown by Costa (1998, p. 137). Vilfredo Pareto appears to have been the first to formulate the concept ([1909/1927] 1971). Hicks acknowledged primarily Pareto, and Slutsky [1915] 1952, and all later users of the budget constraint concept apparently drew on the same source (see, e.g., Kornai, 1980). The budget equation in Hicks (1939, p. 305) bears a close resemblance to Pareto's ‘budget of the individual’ ([1909/1927] 1971, p. 160; 1911, p. 90) and Costa (1998, p. 137) conjectures that constrained utility maximization entered standard price theory via Pareto. The modern version of the concept was first developed by Hicks (1939) and Samuelson (1948); it was then introduced by Arrow and Debreu (1954), Debreu (1959), and Arrow and Hahn (1971) in the general equilibrium theory. Patinkin (1956) integrated it into his monetary theory of general equilibrium.

  6. 6

    In these articles, Clower and Leijonhufvud demonstrate that the neo-classical price theory may be regarded as a special case of Keynesian economics, and is valid only under conditions of full employment.

  7. 7

    ‘Say's Principle’ or ‘Say's Law’ is an old subject of controversy among economists. Schumpeter (1954, Vol. 3, Ch. 6) and Sowell (1972) summarized Say's Law in six propositions. Baumol (1977) quoted Say at length, arguing that at least eight different ‘laws’ or formulations can be derived from Say's works. Lange (1942, p. 64) argued that application of Say's Law to a barter economy is a particular case of Walras’ Law that applies to a money economy. This argument has been criticized by Clower and Leijonhufvud (1981, pp. 97–98). Finally, Wood and Kates (2000) published five edited volumes regarding different critical assessments of Say's Principle by specialist economists; these are invaluable references. Here, what really matters is not the historical clarification between different versions of Say's Principle or Say's Law, but whether SP (as an equivalent of BC) describes a bookkeeping identity or a rational postulate of an individual transactor's behaviour. In this perspective, the distinction between Walras’ Law and SP becomes crucial.

  8. 8

    Selective tariff protection results in a high level of effective (different from nominal) protection. This strategy is even more widely implemented in market than planned economies. This type of SBC is ignored in Kornai's work. As one of the reviewers correctly notes, this shortcoming of Kornai's analysis is related to the fact that his whole approach is basically restricted to a closed (to foreign trade) economy.

  9. 9

    The marginal theory of value is a theoretical underpinning of Kornai's economic reasoning. Kornai rejected the Marxist theory of labour in his 1956 doctoral dissertation (see Vahabi, 1995).

  10. 10

    The reality of ex-socialist countries is actually much more complicated. First, the privileges of party members and state managers must be considered in how income and consumer products were discriminately distributed. In contrast to the simplified model of Kornai (which is theoretically justified), prices were not always sticky and inflation was sometimes important. In Poland in the late 1970s, purchasing power was reduced substantially due to inflationary pressure and the afore-mentioned equation could not be verified.

  11. 11

    Kornai and Matits conceded the pertinence of chronic favouritism in redistribution, but they stated that they could ‘neither support with adequate force nor refute the hypothesis’ (1987, pp. 12–13). No other references to this hypothesis appear in Kornai's abundant publications.

  12. 12

    This is not to deny the relative autonomy of socialist managers. Asymmetrical information between different levels of hierarchy or principals and agents allows socialist managers to bargain with their superiors. Joseph Berliner used the term ‘ratchet effect’ (1952) to describe management behaviour in socialist firms: despite a host of inducements to over-fulfil their production plans, managers are not particularly eager to exceed the quotas because they fear their superiors will be more demanding in setting future targets. Kornai also acknowledged the relative autonomy of socialist managers, but he builds on the assumption of a ‘command economy’ rather than a ‘bargaining economy’ (see Szamuely and Csaba, 1998, p. 185).

  13. 13

    Discussion of Kornai's view of ‘institutional background’ requires two important caveats. First, Kornai's conception of institutionalism is usually limited to behaviouralism (see Vahabi, 1993, 2001, 2005) and in this sense SBC could be regarded as an ‘institutional background’. If this is what is really meant, then ‘institutional background’ is simply a term for microeconomic behaviouralism. Second, Kornai regards state paternalism as the ‘institutional background’ of SBC, characterized as a microeconomic behavioural regularity (1980, 1986, 1992, 1998a, 1998b). State paternalism is unquestionably an ‘institutional background,’ but if this is emphasized instead of SBC, it leads back to Kornai 1.

  14. 14

    In the preface to his masterpiece, Kornai (1980) explicitly excluded a discussion of the political system and ideological principles of communist regimes, as well as their international relationships within the COMECON bloc. However, he did tackle these questions after the collapse of the Soviet system (Kornai, 1992).

  15. 15

    For a discussion of Alfred Marshall's normality concept and its effect on Shackle and Kornai, see Vahabi 1998.

  16. 16

    A different line of reasoning appears in The Economics of Shortage (1980). The author argues that every economic system is characterized by its specific disequilibrium, and that chronic unemployment is the specific disequilibrium of a competitive capitalist system.


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