Soft Budget Constraints and Predatory States

1. Introduction

The concept of the soft budget constraint syndrome (SBC) was first proposed by the Hungarian economist Janos Kornai in the context of socialist economies (Kornai 1979, 1980, 1986a). This concept denotes a situation in which a state-owned enterprise can survive persistent losses thanks to the financial aid of a “paternalist” state. Specifically, it refers to a recurrent practice of rescuing firms so that managers come to expect financial bailout in the face of losses. This expectation consequently shapes their behavior.

The SBC describes a microeconomic behavioral regularity of state enterprises in a socialist economy in which bankruptcy does not exist; it is a micro-behavior in the context of a “no-exit economy” (Raiser 1994). In contrast, a competitive market economy is considered the benchmark for the hard budget constraint (HBC), which entails the bankruptcy of insolvent firms. Following from this, the SBC should not be possible in the context of private property and market competition.

Kornai’s explanation of the SBC is based on three critical assumptions: (1) the SBC is a microeconomic empirical regularity; (2) the SBC is a consequence of state paternalism or state ownership in general and not specific interests within the state; and (3) a pure market economy is a benchmark of the HBC and efficiency for measuring the real and nominal inefficiencies resulting from the SBC.

In this paper, I argue against these assumptions. I will show that: (1) the SBC is not a microeconomic but a macroeconomic problem related to specific income redistributions; (2) the SBC is a consequence of specific interests within the state and not necessarily the predominance of state ownership in general; and (3) the state-market dichotomy cannot explain the SBC since it is often an outcome of a particular combination of market and state in which the state operates in the interest of specific groups.

My primary argument is that the SBC results from macroeconomic income redistribution through a predatory state serving the specific interests of dominant social groups. In the so-called socialist economies, the dominant position of bureaucrats and party apparatchiks softened the budget constraint for specific sectors of the economy, leaving households (the majority of salaried social groups) with a very hard budget constraint. Similarly, in the American capitalist economy during the Bush administration, the SBC was based on the control of the state apparatus by Wall Street and regulated sectors such as mining, oil, media, pharmaceuticals, and corporate agriculture.

Borrowing Veblen’s metaphor of the predatory activity of the leisure class (Veblen [1899] 2007), the SBC can be considered the political economy of a predatory state both in the so-called socialist and capitalist economies. The HBC is not related to an ideal competitive market economy but to budget constraint at the household level in both types of economies, particularly on the part of salaried members of the population.

In the first section of this paper I discuss the internal logical contradiction of Kornai’s exogenous (institutional) explanation of the SBC as a microeconomic behavioral regularity in the presence of state paternalism. Next, I demonstrate the importance of controlling or influencing the state apparatus to soften the budget constraint and stress the macroeconomic dimension of income redistribution. In the third section, I examine the major shortcomings of the endogenous (formal) explanation of the SBC, which considers it to be a strategic profit-maximizing behavior in the presence of asymmetrical information and time inconsistency (Dewatripont and Maskin 1995; Maskin 1996). The tension between the exogenous and endogenous explanations of the SBC is also discussed in this section. Finally, I argue against the main assumption underlying both strands of the literature on the SBC: that the HBC related to an ideal competitive market economy is synonymous with efficiency. In light of the recent financial crisis, it will be shown that this assumption is an ideological construction with no practical relevance. The need for state intervention even under Bush’s neoliberal administration refutes the state-market dichotomy, which disguises the predator state’s role in developing a neoliberal capitalist economy in the United States.

2. Kornai’s Theory of Soft Budget Constraint

Budget constraint (BC) is a fundamental concept within standard microeconomics about household behavior. Disregarding the possibility of credit, it simply asserts that a household’s total spending plan cannot exceed its budget constraint (i.e., its total expected monetary revenue). BC has long been thought of as a bookkeeping identity.

We owe the treatment of BC as a “rational postulate” of the household’s “planned” (or intended) behavior to Clower (1965) and Clower and Leijonhufvud (1981). ¹ Clower (1965) uses Say’s Principle (SP) synonymously with BC and tries to clarify the prevalent confusion among economists between SP and Walras’s Law. ² According to Clower, SP only states that “the net value of an individual’s planned trades is identically zero” (Clower and Leijonhufvud 1981: 80). He intentionally does not refer to the “net market value,” since SP only holds that the “expected” or “planned” purchases of a household cannot exceed its planned or expected revenues. “Trades” that Clower refers to are “theoretically admissible” and are not actual market trades. In this respect, prices and quantities are also conceived in the context of “mental experimentation” and hence make an allusion to “expected” purchase prices and “planned” quantities, rather than to quantities actually purchased or prices actually paid (Clower and Due 1972: 64).

Kornai redefines BC as an empirical fact instead of a rational postulate. Although the distinction between hard and soft budget constraints is meaningless in standard microeconomics (Kornai 1979: 806), they describe two different behavioral regularities in Kornai’s theoretical construction. Kornai’s concept of hard budget constraint amounts to what microeconomics holds as a budget constraint. However, 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: 12). This distinction at the microeconomic level suffers from a fundamental shortcoming. While the application of standard microeconomic budget constraint (or Kornai’s HBC) does not require any transfer between individual economic units, the SBC implies macroeconomic income redistribution. It is thus difficult to understand why Kornai classifies his concept within micro theory.

The institutional rationale for this kind of transfer can be found in Polanyi’s (1944, [1957] 1968) “redistribution” pattern of social integration, which should be distinguished from “reciprocity” and “exchange.” The massive redistribution of income has been a key feature of East European socialism. The subsidization of consumption, especially basic food and housing, is a rudimentary form, but more subtle and pervasive redistribution results from “socialization of losses and profits.” This entails the redistribution of profits from winners (i.e., profitable firms) to losers (i.e., non-profitable firms). There are at least three major redistributive mechanisms in modern industrialized economies: (1) fiscal policies; (2) soft credit; and (3) administrative pricing systems. Poland (Schaffer 1990a, 1990b) and Hungary (Kornai and Matits 1987, 1990) are illustrations of redistribution through fiscal policies due to state intervention, while ex-Yugoslavia’s “self-management” system (Vodopivec 1989; Kraft and Vodopivec 1992) provides a salient example of financial redistribution from net creditors to net debtors via the banking system.

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

Although Kornai considers the dichotomy between ex ante and ex post state intervention rigid (Kornai 1998a: 14), it is the “incremental” rather than the “preliminary” softness that he thoroughly analyzes. Kornai’s theory of the ex post SBC is based on state paternalism: “The soft budget constraint is the manifestation of the paternalist role of the modern state” (Kornai 1986a: 8). He considers the SBC to be a social relationship similar to that of parents and children, or firms that hold the state as a general insurance company.

But how does this relationship work? Are parents held captive by their children’s emotional blackmail or are their children obedient? In the former case the children’s capricious behavior would explain the parents’ expenditures, while in the latter case the parents would determine the children’s expenditures without interference. When considering this metaphor in terms of state paternalism and firms’ behavior, the first situation amounts to a “bargaining economy” where lobbying could exact privileges from the state. The latter would resemble a “command economy” that is built on hierarchical vertical relationships.

The general policy of bailouts for Wall Street during the recent subprime crisis is a good example of a “bargaining economy.” Borrowing Kornai’s metaphor, in September 2008, the Bush administration became a “paternalist” state and transformed itself into the country’s largest insurer and mortgage company. As Stiglitz (2008) sarcastically put it, “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.”

This behavior is typical of spoiled children: they want a bailout but resist regulation. They ask for more money, but cannot tolerate parents’ restrictions about how it should be spent. When Henry M. Paulson behaved as a “paternalist” Treasury secretary (October 2008) and decided to use the first installment of a $700 billion bailout to JP Morgan Chase, its CEO, Jamie Dimon, was happy to receive his company’s unrestricted $25 billion bailout. He did not intend to use the money for new loans to help the American economy shun a depression. According to some reliable internal sources, 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 the oligopoly of giant financial institutions.

In other words, the “paternalist” state was “held up” by its spoiled children. In such a relationship, children strategically endeavor to “socialize their losses,” but they will not accept the “socialization of their benefits.” In such cases we must ask why the state behaves so leniently towards its “children’s” whimsical behavior. I will discuss this in more detail in the next section.

In a “command economy,” firms behave more like obedient children. ³ Consequently, parents’ preferences shape their children’s behavior; at a micro level, children’s SBC cannot be considered the primary cause of the way in which parents help children. In other words, the main question in parent-child relationships is not whether parents assist their children, but rather how they assist their children. If parents are too lenient, then the children’s desires determine the way in which the assistance is provided. But, if parents are too severe, the way in which children are helped hinges entirely upon parents’ discretion. In the latter case, the SBC as a micro behavioral regularity of state enterprises does not have a major explanatory role. That is why Kornai’s theory of state paternalism contradicts his theory of SBC as a micro behavioral regularity. In a command economy, the SBC necessarily stems from the state’s macroeconomic redistribution policies.

The SBC as a micro behavioral regularity requires a “bargaining economy” in which “children” could strongly influence “parents’ decisions.” The lack of credible commitment of “parents” to resist children’s desires entices children to adopt a SBC as a profit-maximizing behavior. The SBC is then an optimal strategic behavior at a micro economic level. Contrary to Kornai’s exogenous explanation of the SBC, the SBC is now regarded as a profit-maximizing behavior that agents might follow during the post-socialist transition or even in a capitalist economy. Recent formal models of the SBC illustrate this endogenous explanation of the SBC as a microeconomic behavioral regularity (for detailed surveys, see Maskin 1996; Kornai, Maskin, and Roland 2003; Vahabi 2001, 2005). Although this micro-based explanation removes Kornai’s contradiction, it assumes away any disequilibrium stemming from the SBC. I will examine this alternative endogenous explanation in the third section.

3. Paternalist State: Benevolent or Predatory?

The specific nature of the “paternalist” state was not the object of enquiry in Kornai’s work before the transformation of the socialist system in 1989. Before this historical political upheaval, Kornai’s work was about “economics” and not “political economy.” The Economics of Shortage (1980), in which Kornai thoroughly explores the SBC, does not deal even remotely with politics.

After the collapse of the Soviet bloc, Kornai began writing about politics in The Political Economy of Communism (1992). This explains why Kornai focused on ex post SBC (or incremental SBC) and excluded ex ante SBC (or preliminary SBC). While the specific nature of the “paternalist” state is irrelevant in the former type of SBC, the “benevolent” or “predatory” feature of the state is critical in explaining the latter type of SBC.

Kornai acknowledges preliminary SBC in certain passages without further comments: “The more powerful and prestigious the department or ministry (a typical case is departments in charge of defense), the more intensive is the SBC syndrome” (Kornai 1986a: 24). But he does not examine the difference between strategic and non-strategic state firms with regard to competition over capital goods, and the egregious siphoning effect that it might have on the shortage of such goods.

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 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 harder budget constraints in the private business and household sectors (see Kraft and Vodopivec 1992), as well as significant commercial bank deficits that turned into a public debt of the National Bank of Yugoslavia (see Bole and Gaspari 1991).

Kornai and Matits (1987) also note that the effect of redistribution is much stronger within industry than within agriculture. However, they do not examine whether the SBC in industry is compensated by a harder budget constraint in the agricultural sector. According to Kornai, even in a classical socialist system not all agents are marked by the SBC. While socialist firms have a SBC (Kornai 1980: 515), households are subject to the HBC (Kornai 1980: 514) since they cannot expect to cover their planned expenditures with anything except their expected revenues. The socialist state has a BC, which is neither completely hard nor completely soft. It is not constantly hard since the state budget has to cover the losses of socialist enterprises, nor is it always soft since the current expenditures of state agencies are usually subject to the HBC (Kornai 1980: 528-29). Although Kornai does not quantify the relationship between the state firms’ SBC and the households’ HBC, he argues that there exists a “siphoning effect” between these two sectors with regard to the utilization of input resources. Consequently, the runaway demands of the socialist firms are the source of the shortage. Following Kornai, Qian (1994) developed a model that explains a shortage economy during the post-socialist transition on the basis of the siphoning effect.

Kornai and Matits (1987: 12-13) concede the relevance of chronic favoritism in redistribution, but claim that they can “neither support with adequate force nor refute the hypothesis.” We cannot find further investigations regarding this hypothesis in Kornai’s abundant publications. Focusing on incremental or ex post SBC, Kornai indiscriminately characterizes all state enterprises as prone to the SBC and confines the HBC to the household sector.

After the demise of the Soviet-type regime, Kornai insists (on the role of politics and states) that, “the primary attribute of the socialist system is that a Marxist-Leninist party exercises undivided power” (Kornai 1992: 89). The “paternalist” state as a state party represents the particular interests of the bureaucracy, which is a “hierarchically structured social group” (Kornai 1992: 498). This social group is estimated to comprise ten percent of the population (ibid.). Interestingly, Kornai now refutes “market socialism” on the basis of political arguments.

This change in Kornai’s reasoning is particularly striking if one compares his most critical essay regarding “market socialism” before the collapse of the socialist system (Kornai 1986b) with his Tanner Lectures (Kornai 1993). In “The Hungarian Reform Process: Visions, Hopes and Reality” (Kornai 1986b), “naïve” market socialists are not criticized for their lack of political understanding of the state’s nature in socialism. However, in his Tanner Lectures on “Market Socialism Revisited” (1993), which he delivered on 18 January 1991, Kornai titled a section, “The role of the state and politics.”

In this section, he reproaches the “naïve” authors of the Lange-type model for disregarding the “real” nature of any modern state and particularly that of an exceptionally powerful party-state. “The Walrasian model, along with most of its later variants including the Lange-type model, is a marvelous piece of intellectual machinery placed in a sociopolitical vacuum. It is a construction that lacks a positive theory of politico-socioeconomic order as a foundation” (Kornai 1993: 27). Kornai adds that he uses the word “vacuum” because the Lange model lacks the following attributes (among others): “…understanding of the sociopolitical environment of the actors and the institutions that influence their behavior; incorporation of the state, as an endogenous constituent of the system, in the overall theory of the economy” (Kornai 1993: 28).

Although Kornai labels “market socialism” as a vision or “a normative model of pure theory” “naïve,” he does not consider the prototype blueprint of the reform economists under the socialist system to be naïve: “On the contrary, its axiomatic point of departure is a special form of state, the party-state. It postulates that on the one hand the Communist Party’s political monopoly is to remain, and on the other hand the market will coordinate a substantial proportion of economic processes. Yet these two postulates cannot be satisfied together, because each precludes the realization of the other. That is the biggest flaw in the blueprint” (Kornai 1993: 13).

Kornai insists on the contradictory interests of “the bureaucracy” as a hierarchically structured social group with market coordination. But “market socialism” in China lends credence to an opposite viewpoint. In fact, if the bureaucracy could gradually be transformed into a bourgeois layer, why should such a symbiosis of the bureaucracy and market be excluded?

The modern reformulation of market socialism in light of contract theory and the so-called principal-agent model demonstrates the theoretical possibility of hardening the budget constraint within the state sector. The modern corporation in capitalist economies is marked by the separation of property ownership (shareholders) and effective control or management by the senior executives (Berle and Means [1932] 1968). If this performs well under capitalism, why should it not work under market socialism, although the ownership now belongs to the state?

To refute this possibility, Kornai devotes a section to “Property rights and the soft budget constraint” (1993: 17-20). In this section he tries to demonstrate that the SBC is closely related to the predominance of state property, whereas private property has a natural affinity to HBC. Kornai compares the objectives, instruments, and situations of the agents and principals under capitalism and socialism. He concludes that, “there is no real decentralization without private ownership. This well-known proposition was first emphasized strongly in the works of Mises and later expounded in more detail by the ‘property-rights school’” (1993: 19).

Capitalism is depicted as the counter example of the SBC. Contrary to this naïve vision, the American model of capitalism, with its enduring New Deal institutions, is replete with examples of the SBC. The institutions in question are neither purely private nor wholly public. They are, rather, hybrids, even chameleons: “private economic activities supported, leveraged, guaranteed, and regulated by public power; public institutions aided, abetted, and buttressed by private money. They are elements of an American social welfare state but dressed up, in characteristically American fashion, in the guise of a market system” (Galbraith 2009: 104).

Galbraith estimates that these institutions in health care, higher education, housing, and social security together account for nearly 40 percent of the total consumption of goods and services in the United States. Taking into account the state’s intervention in the military, agriculture, and other sectors, the government is responsible for over half of the state’s economic activity. In other words, the market and the state are intertwined even in the so-called neoliberal model of capitalism. The main issue is how the prevalent SBC in these sectors is run and to what extent the private sector is taking advantage of it.

The neoliberal model of capitalism under the Bush administration demonstrated complete control of the state apparatus by specific business groups in order to guarantee those groups a SBC (Vahabi 2004). “The Predator State is an economic system wherein entire sectors have been built up to feast on public systems built originally for public purposes and largely serving the middle class. The corporate republic simply administers the spoils system. On a day-to-day basis, the business of its leadership is to deliver favors to their clients. These range from coal companies to sweatshop operators to military contractors. (…) Everywhere you look, regulatory functions have been turned over to lobbyists. Everywhere you look, public decisions yield gains to specific private persons. Everywhere you look, the public decision is made by the agent of a private party for the purpose of delivering private gain. This is not an accident: it is a system. In the corporate republic that presides over the Predator State, nothing is done for the common good” (Galbraith 2009: 146-147).

The SBC is not a specific feature of the socialist or the capitalist systems; it is not excluded by the existence of private property. It is the outcome of a symbiosis between the state and the market. Thus, an understanding of the nature of the state and its politics is critical to understanding the sources and consequences of the SBC in terms of income redistributions at a macroeconomic level in both socialist and capitalist systems. A predatory vision of the “paternalist” state in Soviet-type economies is in accordance with the dominant position of the state-party or bureaucracy as a specific, hierarchically-structured social group. In the same vein, the SBC under neoliberal American capitalism is closely related to the rise of a predator state during the Bush administration.

4. Endogenous Theory of Soft Budget Constraint

In the first section, we noted a fundamental contradiction between the assumption of a “paternalist” state and the SBC as a microeconomic behavioral regularity of socialist firms. This contradiction is resolved in game theory models of the SBC, which do not need to postulate a “paternalist” state.

An endogenous explanation of the SBC predicts the softening of budget constraints due to asymmetrical information and time consistency (Dewatripont and Maskin 1995; Maskin 1996). In Dewatripont and Maskin’s model, time inconsistency of the center lies at the heart of the SBC syndrome: if the center were able to credibly commit itself not to subsidize the firm ex post, the firm would make more efficient ex ante decisions. Following this pioneering work, an abundant formal literature has been developed to endogenously explain the SBC due to adverse selection, moral hazard, and rent-seeking (Kornai, Maskin, and Roland 2003). This has integrated the SBC into new microeconomics as a special case of time inconsistency.

With this line of argument, the SBC syndrome pertains whenever a funding source (e.g., a bank or government) finds it impossible to keep an enterprise to a fiscal budget; that is to say, that it occurs when an enterprise can extract a bigger subsidy or loan ex post than would have been considered efficient ex ante. In this sense, the SBC problem is not specific to socialist economies, since the extent to which loss-making firms or projects are terminated or refinanced is also relevant in capitalist economies (both developed and undeveloped). The SBC is accordingly treated as a more general, dynamic commitment problem. It occurs when an agent fails to take efficient action, or undertakes an inefficient action, because said agent knows that the enterprise will receive additional financing.

The credit default swap (CDS) provides a good illustration of how derivatives could benefit from a SBC thanks to taxpayer support. In theory, the hedging benefit of CDS should have made it possible for subprime risk to be located with investors and institutions for whom bearing such risk was the most efficient. However, there are two problems with this simple view. First, because of their built-in leverage, CDS may make it possible for investors to take riskier positions than otherwise possible. As Krugman (2009) aptly notes: “the key promise of securitization – that it would make the financial system more robust by spreading risk more widely – turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.”

Second, the sellers of CDS, including some specialty “monoline” ⁴ insurance companies that primarily insured municipal bonds, as well as the well-known case of AIG, “ultimately did not have the ability to bear the risks they took on, so some of the hedging benefit of CDS turned out to be illusory (or would have turned out that way without taxpayer support)” (Stulz 2010: 78).

The enormous increase in the total market value of CDS’s contracts from 2004 to the end of 2008 (see Table 1 in Stulz 2010: 80) is not surprising because default risks increased for many companies in 2008. Since the state would normally devise detailed financial regulations based on predictions of strategic behavior by derivative holders, how can we explain the absence of such regulations, the lack of incentives for monitoring, and strong resistance even to the partial reform of Wall Street in the Senate in the aftermath of the global financial crisis?

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Table 1.

Ownership forms, coordination mechanisms and types of budget constraint

Property type	Bureaucratic coordination	Market coordination	Selection mechanism	Type of budget constraint
State ownership	Strong linkage	Weak linkage	Political forces (bureaucracy)	Soft budget constraint
Private ownership	Weak linkage	Strong linkage	Economic (market forces)	Hard budget constraint

It is no secret that in April 2010, 1,500 lobbyists from the financial sector backed the votes of 41 Republican senators against President Obama’s partial reforms for Wall Street. The influence of Wall Street on the state apparatus explains the softening of budget constraints for financial investors and banks within a private property market economy. This influence extended even after the end of the Bush administration’s time in office. During Obama’s presidency, the Geithner-Summers plan was an attempt to transfer up to 500 billion U.S. taxpayer dollars to commercial banks by buying toxic assets (particularly collateralized debt obligations or CDO) from the banks at a price far above their market value.

Jeffrey Sachs (2009) correctly reported on 25 March 2009: “It is no surprise that stock market capitalization of the banks has risen about 50 per cent from the lows of two weeks ago. Taxpayers are the losers, even as they stand on the sidelines cheering the rise of the stock market. It is their money fuelling the rally, yet the banks are the beneficiaries.” Some Americans were afraid that the government might temporarily nationalize the banks; even that option would have been preferable to the Geitner plan. In fact, the nationalization option could have hardened the budget constraint. It is worth remembering that in the past, the Federal Deposit Insurance Corporation (F.D.I.C.) had taken control of failing banks, and even nationalized large institutions like Continental Illinois and Washington Mutual. According to Stiglitz (2009), “what the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a ‘partnership’ in which one partner robs the other.”

In fact, the recent financial crisis shows that nationalization can sometimes harden the budget constraint, even though predatory forces in the state scrupulously shun such an option. A major problem with the exogenous and recent endogenous explanations of the SBC is that nationalization is never regarded as a way to harden the budget constraint. The fundamental liberal tenet is what Kornai quotes from von Mises [1920] 1935: there is no real decentralization without private ownership. ⁵ Since it is assumed that the hardening of budget constraint requires decentralization, we find the following causal relationships among “private property,” “decentralization,” and the “hardening of budget constraint:”

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Image 1.

The causal relationships among “state property,” “centralization,” and the “softening of budget constraint” are understood as follows:

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Image 2.

“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 1986a: 26). Accordingly, while state ownership is akin to the SBC, private ownership is correlated with the HBC.

Kornai further substantiates this causal chain in his paper on the affinity between ownership forms and coordination mechanisms (Kornai 1990). He argues that there is a “natural affinity and cohesion between certain types of ownership and certain types of coordination mechanisms” (Kornai 1990: 142). For instance, state ownership has a natural affinity with bureaucratic coordination. Private ownership and market coordination maintain a similar relationship. Conversely, bureaucratic coordination cannot be imposed on private activities, due to the “basic incongruity of this pair.” They have no “natural affinity.” Similarly, market coordination cannot be consistently combined with the predominant state ownership as advocated by the tenets of market socialism. When there is an affinity, the linkage between the ownership form and the coordination mechanism is strong; otherwise it would be weak.

State ownership has a strong linkage with bureaucratic coordination and a weak linkage with market coordination. The SBC prevails because the selection in bureaucratic coordination is through politics and bureaucracies. Conversely, private ownership has a strong linkage with market coordination and a weak linkage with bureaucratic coordination; since the selection in market coordination is left to the market, the HBC dominates. The following table summarizes these relationships.

The “natural affinity” thesis was not demonstrated by Kornai; it is assumed intuitively based on a dichotomous vision of market versus state. In our theoretical framework, however, this dichotomy is fallacious, and thus there is no “natural affinity” between state property and the SBC on the one hand, and private property and the HBC on the other. The budget constraint can be hardened (or softened) through nationalization (or privatization) depending on the particular activity of the private sector and the state’s nature.

Despite having in common the basic causal relationships between the hardening of budget constraint and decentralization, there exists a fundamental difference between the endogenous versions of the SBC and Kornai’s exogenous version of the SBC. In order to understand the difference, it suffices to ask what would happen if, ex ante, the creditor knew with certainty that the firm or investor bank would 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: 84). To put it differently, Kornai and Maskin are not talking about the same thing. While Maskin’s endogenous SBC falls within a profit-maximizing behavior and is consistent with new microeconomics, Kornai’s theory of the SBC is inconsistent with profit-maximizing behavior.

The SBC as ex post bailouts describes the rationale of an economic system in which the profit criterion is not effective, and hence persistent loss-making firms can survive thanks to a redistributive institution. This institution may be a paternalist state or any other hierarchical organization based upon vertical relationships.

5. SBC, Inefficiency, and Disequilibrium

Kornai introduced a pure competitive market as the benchmark of efficiency at a systemic level. ⁶ Because the hard budget constraint was considered a yardstick of efficiency, the SBC was considered synonymous with real and nominal microeconomic inefficiencies commonly referred to as the “Kornai effect” following Kornai and Weibull’s (1983) pioneering paper. ⁷ The SBC literature shed light on the inefficiencies of classic and reformed socialist systems. But the concept gained particular currency within the realm of policy-making during the post-socialist transition in the nineties, since “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: 84).

Subsequently, hardening the budget constraint was not only synonymous with putting an end to the shortage economy; it meant, as Kornai stressed, the restoration of the capitalist market system, privatization, and decentralization (1998b: 538). At the beginning of the post-socialist transition, it was widely held that the “Holy Trinity” of liberalization, privatization, and stabilization would be enough to produce an efficient market. Kornai emphatically argued that the hardening of the budget constraint should be given equal priority to these. Instead of the “Holy Trinity,” he has proposed the “Magic Square” in his recent discussions of the “organic development” of a private market economy: “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 labor productivity” (Kornai 2000: 10).

The Magic Square concept won over the majority of decision-makers in international institutions at first glance. Reports from the World Bank (1999), the EBRD (2001), and other institutions repeatedly referred to “hard budget constraint” and “soft budget constraint.” Unfortunately, they sometimes quoted these expressions without paying any tribute to their author. Hardening budget constraint became a categorical imperative all over the world, including in emerging and developed countries. But how could the efficiency effect of the hardening of the budget constraint be measured? Should it be gauged at a microeconomic level or at a macroeconomic level?

Suppose the SBC of major mortgage insurance companies and investment banks is the source of a massive financial crisis (this is similar to what happened in the recent U.S. subprime crisis). ⁸ Should the Senate and Congress vote for a general policy of state bailouts for large financial institutions like Fannie Mae, Freddie Mac, and AIG? Should it eschew a rescue of Lehman Brothers and adopt a case-by-case bailout policy? Obviously, a general bailout policy softens the budget constraint and undermines the credible commitment of the state pertaining to inefficiencies in the financial sector. But in the presence of systemic risk, the non-intervention of the state (as the insurer of last resort) entails major spillover effects that will likely lead to a liquidity crisis and a severe depression. The interdependence and chain effects of the crisis at a macroeconomic level outweigh the sectoral inefficiencies of state bailout. Accordingly, the hardening of the budget constraint becomes more inefficient than the SBC, from a macroeconomic point of view.

In contradistinction to Kornai’s original meaning of the SBC, new microeconomics grapples with the SBC as a profit-maximizing strategic behavior. Hence, the SBC only implies ex ante inefficiency but does not exclude ex post efficiency. In fact, ex ante, the investment would not have been made by the principal, given that the adverse selection or moral hazard had been shunned. Ex post, however, production is better than non-production, since the principal would not accept a production by agents pertaining to persistent losses.

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

In Kornai’s previous works (Kornai 1979, 1980, 1986a), the SBC was always discussed in relation to the general state of markets, particularly with regard to the invalidity of Walras’s Law. ⁹ Paradoxically, Walras’s Law is irrelevant within the partial equilibrium setup of new microeconomics. Furthermore, any allusion to the invalidity of Walras’s 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 remain silent on macroeconomic implications of the SBC with regard to Walras’s Law in their joint paper (Kornai, Maskin, and Roland 2003).

We once again encounter the problem of clarifying 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 reconsidered as part and parcel of the new microeconomics? In light of the recent synthesis of institutional and formal theories of the SBC, it seems the latter option has been chosen. Still, a question remains: does the SBC as the optimal strategic behavior of rational agents retain its original meaning?

Although it is hard to accept that different strands of the SBC literature share the same meaning of the phenomenon, it is easy to concede that they all attribute the HBC to a competitive decentralized market economy. In the previous section, I argued that such an assumption is not an empirical or analytical result, but rather a liberal dogma. An enquiry into the recent financial crisis demonstrates that under certain conditions nationalization can be an effective means to harden the budget constraint of financial institutions that run a casino economy on securitization.

In my opinion, there is an affinity between HBC and a particular type of socio-economic relationship, namely the wage/salary relationship. It is a stylized fact of both socialist and capitalist economies that a HBC is often applied to household expenditures. This fact is substantiated in Kornai’s works regarding Soviet-type societies, in which he clearly acknowledges that households are subject to the HBC (Kornai 1980: 514).

During the recent financial crisis in capitalist economies, only households were subject to the HBC; households cannot survive recurrent losses, since they will not be rescued. They can lose their homes and “hopes,” but insolvent banks can be bailed out, particularly if they have accumulated colossal debts. Contrary to households, banks are “too big to fail” (Stern and Feldman 2004). Clearly, there is a recurrent practice of rescuing banks while leaving bankrupt households to fail.

Borrowing Kornai’s terminology, bankers will expect a rescue if losses occur, and these expectations will shape their behavior. The SBC is the behavioral regularity of financial institutions and the HBC is the behavioral regularity of wage/salary-earning households. It was household creditworthiness that was threatened, not the banks’. Yet, state intervention bailed out banks and transformed private debts into public debts to be borne by taxpayers. Still, a recovery necessitates mending household balance sheets. The question remains: will public debts allow the revival of the creditworthiness of the American, Greek, Spanish, or “European” families in general?

6. Conclusion

Kornai coined the expression SBC to describe the lack of responsiveness of the socialist enterprise to changing relative prices. The source of this microeconomic behavioral regularity was sought in the paternalistic role of the socialist state. State failure was thus the cause of real and nominal inefficiencies of socialism.

Kornai’s theory of the SBC can be traced back to von Mises’s criticism of socialism in the famous “calculation debate”: The lack of “rational calculation” due to the abolition of private property and market coordination was reformulated in terms of the SBC. Streissler is right when he claims that “Janos Kornai had provided a catchy reformulation of the Mises’ statement and offered it as the reason for the failure of socialism: socialism foundered on its “soft” budget constraint, which implies basically that even the socialist planning office does not believe in its own prices and is willing to abandon them whenever political opportunity suggests so” (Streissler 1990: 197).

The converse of the SBC is the HBC, which was attributed to a competitive market economy as a benchmark of efficiency. Efficient markets, particularly capital markets, were assumed to provide the necessary information and selection processes for rational allocative mechanisms. In the aftermath of the recent financial crisis, it is hard to believe in Eugene Fama’s (1970) vision of the world. It is now a fact of daily life that the SBC also depicts the behavioral regularity of large banks and financial investors in the capitalist economies under “paternalist” (or predatory) states.

This paper identified the main critical assumptions of Kornai’s theory. I also stressed the merits of his institutional theory of the SBC in comparison with the recent formalized branch of the SBC. Contrary to this branch, Kornai’s explanation is not reduced to a profit-maximizing strategy, and the disequilibrium implications of the SBC are not neglected at a macroeconomic level. Kornai rightly observed that the SBC was an unquestionable stylized fact of socialist economies. The same stylized fact holds true for capitalist economies under certain conditions. I regard the SBC to be germane in both economic systems and contend that it results from macroeconomic income redistributions in the presence of a predatory state. The SBC is thus an “efficient” analytical instrument in the toolkit of political economy. As Streissler declared in 1990, the theory of SBC predicted the failure of the socialist system. But does it not also predict the failure of the capitalist system in the presence of a predatory state?

My analysis of the SBC was focused on a binary distinction between state-owned enterprises and privately-owned businesses, since I endeavored to show that soft budget constraints may prevail under both types of ownership in the presence of a predatory state. However, other types of ownership, particularly worker-owned and workers’ self-management, family production or “house holding” (Polanyi 1944), and various types of cooperative ownership should not be ignored in a thorough analysis of the SBC.

Although such alternative forms of ownership might shun a predatory state, the responsiveness of economic agents to varying relative prices will be strongly weakened. In fact, under a genuine cooperative sector and worker-owned enterprises, the price system can be undermined and the SBC might prevail. The question of how to afford an alternative economic calculation will be once again on the table of political economists who advocate a socialist system.