Kornai on Soft Budget Constraints

In his guest post on Willem Buiter's Maverecon, János Kornai gives an interesting take on the Global Financial Crisis through his research on Soft Budget Constraints (SBCs).

During the communist period in Hungary, firms, despite being given material incentives to be profitable (including profit shares to the owners), they also faced very high rates of rescue by the state when in financial trouble. Kornai argues the real effect of rescues like this is a modification of the budget constraint faced by the firm, to one that is effectively "soft". That is, the short-term spending decisions of a firm will be looser should there be little chance of firm closure.

This argument is subtly different from the Moral Hazard argument. Moral Hazard tells the story of what happens to a firm's taking of risk when it becomes either implicitly or explicitly insured. SBC theory tells us that a firm will not necessarily take more risk, but their spending decisions will generally be brought forward, as their intertemporal budget constraint is perceived as being "soft".

My third year students, who've just covered the Keynes-Ramsey condition in intertemporal consumption choice, will be able to see this as a direct application. If a firm's internal discount rate is greater than the perceived cost of capital (which is decreased, due to the likelihood of rescue), then present expansion of the firm will appear to be a cheaper "option" than waiting later to expand.