Soft budget constraints, transition, and financial systems

This paper surveys a number of contributions that deal with the "soft budget constraint problem," that is, the refinancing of loss-making enterprises. This problem is particularly prevalent in transition economies but is also pervasive in market economies. Following DEWATRIPONT AND MASKIN [1995], the paper looks at soft budget constraints as dynamic commitment problems in the presence of sunk costs. Various ways to harden budget constraints are analyzed: privatization, demonopolization, decentralization of government, decentralization of credit, and banking reform. Finally, the paper looks at the role of budget constraints on risk taking and innovation.