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Why do soft budget constraints exist and persist? In this paper we argue that the prevalence of soft budget constraints can be best explained by the political desirability of softness. We develop an infinite horizon political economy model where neither democratic nor autocratic politicians can commit to policies that are not ex post optimal. We show that because of the dynamic commitment problem inherent in the soft budget constraint, politicians can in essence commit to make transfers to entrepreneurs which otherwise they would not be able to do. This encourages such entrepreneurs to support them politically. Though the soft budget constraint may induce economic inefficiency, it may be politically rational because it influences the probability of political survival. In consequence, even when information is complete, politicians may fund bad projects which they anticipate they will have to bail out in the future. We show that, maybe somewhat surprisingly, dictators who are less likely to lose power, are more likely to use the soft budget constraint as a strategy to gain political support.

Traditional policy analysis in the tradition of Pigou (1920) and Samuelson (1954) saw policymakers as designing policies to solve market failures, or satisfy normative criteria, subject only to the availability of resources and the nature of preferences and technology. In the 1970s economists began to realize that even well-intentioned planners were subject to other types of constraints. Diamond and Mirrlees (1971) examined the nature of optimal policies without lump-sum taxation, and Gibbard (1973) and Green and Laffont (1979) argued that the incentive compatibility constraints generated by private information had to be respected. Kydland and Prescott (1977) also showed that optimal inter-temporal policies might be time inconsistent, making it difficult for a planner to commit to even a second-best policy. In the 1980s and 1990s economists began to merge such ideas with models where policymakers were self-interested and studied how the interaction between such interests and social welfare led to further deviations from first- or second-best outcomes. These models have brought us much closer to an understanding of the relationship between market failures and political failures. Yet many puzzles remain. A central, and fascinating one, is that of the “soft budget constraint.” Originally introduced by Kornai (1979) in the context of centrally planned economies, the basic notion is that governments and policymakers are unable to impose a “hard” budget constraint on government owned enterprises or government agencies. In consequence such enterprises or agencies have incentives to act in inefficient or profligate ways knowing that they will be bailed out if things go wrong. Gregory and Harrison (2005) provide a detailed discussion of the soft budget constraint in the Soviet planned economy. Since its development, the problem of the soft budget constraint has been recognized to be endemic to most polities, though clearly being worse in developing economies. This recognition emerges from the fact that all scholars note that soft budget constraints in Eastern Europe and the former Soviet Republic proved more long lived that central planning. Maskin and Xu (2001, p. 10) report that “considerable empirical work indicates that the soft budget constraint syndrome continues to play an important role in virtually every transition economy, even those that have already undergone many years of reform”. Why do soft budget constraints exist and persist? The central argument in the literature is that soft budget constraints arise because politicians cannot commit not to refinance bad projects ex post and cannot distinguish bad from good ex ante. Given that a project is launched, it will be refinanced as long as benefits cover costs. Previous costs are sunk. Entrepreneurs know this, and submit bad projects for financing in the first place. This is the key argument in Dewatripont and Maskin (1995), which has become the canonical model of soft budget constraints. This approach follows the literature which built on Kydland and Prescott (1977) where policymakers were thought of as well intentioned and thus downplays any political reason for the existence of soft budget constraints. Such an approach to understanding the soft budget constraint is interesting. But it is also useful to extend such an approach, because the overwhelming amount of evidence strongly suggests the role of political motivations in explaining soft budget constraints. For instance, political scientists who have studied this topic, argue that the main reason for soft budget constraints to persist is that soft budget constraints serve the interests of politicians—this is precisely the reason they are not dismantled. This literature leaves unanswered, however, the question of exactly why the interests of politicians manifest themselves in such a way. In this paper we develop a fully political economy model of the soft budget constraint. Our starting point, following Alesina (1988), Osborne and Slivinski (1996), and Besley and Coate (1997), is that politicians cannot commit to policies that are not ex post optimal. This inability to commit to arbitrary policies hampers the ability of politicians to exchange policies for support, since voters do not necessarily believe political promises (unlike in the basic Downsian model where perfect commitment is assumed). Such a political setting is the natural one if one accepts that the problem of the soft budget constraint is a problem of commitment. Instruments which solve this credibility problem are therefore potentially attractive politically. We argue that the key thing about the soft budget constraint is that, in effect, it is a credible way of transferring income to potential supporters: because a policymaker cannot commit to enforce a hard budget constraint, he can commit to make transfers to citizens. Nevertheless, this in itself does not make a soft budget constraint politically rational. Instruments which allow all politicians to make credible commitments to policy are not necessarily attractive unless they improve the position of one politician relative to another. For example, politicians would like to be able to offer income redistribution to groups to win their support. In order for this offer to change the expected outcome of a political fight, such redistribution has to satisfy two conditions; (1) it must be optimal ex post for politicians to enact, and (2) it must be something that all politicians cannot offer. Such asymmetries arise in many natural ways. Politicians differ in their valuation of welfare of different groups, in their ability to undertake different policies, in their regional attachment, and in their interaction with different groups. For instance, Dixit and Londregan (1996) argue that (p. 1134) “Such differences can arise when each party has its core support groups of constituents whom it understands well. This greater understanding translates into greater efficiency in the allocation of benefits: patronage dollars are spend more efficiently”. Although in reality there may be many reasons for politicians having different costs or benefits in transferring resources to different groups, the exact modelling of these asymmetries is not crucial for our argument. We therefore simply adopt the familiar mechanism of Dixit and Londregan (1996) where politicians have lower net costs of transferring resources to core supporters than to other groups. In this paper we argue that it is the combination of these two things that leads to the prevalence of the soft budget constraint. Politicians are happy to finance projects which are known to be bad in the sense that revenues do not cover costs and which they anticipate that they will find it optimal ex post to “bail out”. This is because such “bail outs” redistribute resources to people or groups to whom they would otherwise find it difficult to redistribute to credibly and to whom other politicians cannot credibly redistribute resources. We refer to such groups as the core supporters of a politician. We show that the key difference between such bad projects and good projects is that all politicians can commit to refinance good projects ex post and thus although they may redistribute resources to potential supporters, they do so symmetrically and therefore do not give any politician a strategic advantage. In many countries where soft budgets constraints are prevalent the quality of democracy is questionable at best or they are pure dictatorships at worst. Thus it is crucial to investigate how the extent of democracy itself influences the attractiveness of the soft budget constraint as a political strategy. Our starting point is the observation by Bueno de Mesquita et al. (2003, p. 28) that to understand the political survival of dictatorships the key is to investigate how they are able to generate sufficient support to cling to power: “Make no mistake about it, no leader rules alone. Even the most oppressive dictators cannot survive the loss of support among their core constituents.” A main difference among democracy and dictatorship, however, is that dictators actively use the state apparatus to ensure that even if they are supported by less than half of the population they remain in power. Thus while the minimum winning coalition under democracy is half of the voters, the minimum winning coalition in a dictatorship may be considerably lower. To be able to study not only democracies, but also autocracies, we include this insight into our modelling. We show that, maybe somewhat surprisingly, dictators who are less likely to lose power, are more likely to use the soft budget constraint as a political strategy to gain political support. The ability of incumbent politicians to launch projects that only they can credibly refinance in the future creates an incumbency bias. Moreover, it introduces an interesting inter-temporal structure to the model. If an incumbent politician launches a project today which only he can refinance tomorrow, this encourages his core supporters to support him because they anticipate that he will bail them out tomorrow, thus increasing their utility. In addition, if such a politician remains in power then he can launch further projects in the next period with payoff in the period after that. This further increases the benefit to core supporters from maintaining the politician in power. A one shot game will not capture these inter-temporal effects, and thus we develop an infinite horizon model. While in Dewatripont and Maskin (1995) the soft budget constraint is something politicians would want to escape if they credibly could, in our model the soft budget constraint may arise as something politicians desire even when information is complete. Many case studies point out that soft budget constraints may serve political purposes. For instance, Gimpelson and Treisman (2002) find that in Russia (p. 172) “regional governments boost public employment by hiring partisans and clients and extract greater federal aid” and that (p. 178) “Central politicians responded with bailouts because they knew, too, that regional voters would, quite rationally, have punished them if they did not”. Kitschelt et al. (1999) discuss the widespread use of clientelistic policies in post-communist countries. One example is Bulgaria where politicians build clientelistic networks (p. 203) “especially in the sectors of state-run enterprises and collectivized agriculture” and where “quasi-private business groups in the BSPs sphere of supporters successfully extracted cheap credits from a compliant government-controlled central bank …… and sold foreign commodities at high world market prices to unavailable, debt-accumulating state-owned companies”. These scholars see the soft budget constraint as arising out of a clientelistic exchange of redistribution for political support. The politics of soft budget constraints and patronage is not, however, unique to eastern European transition economies. A large number of studies emphasize such political strategies are prevalent in African countries. The first European colony in Africa that became independent was Ghana in 1957.1 The Nkrumah government launched a policy of active involvement in the economy, but the economic effects of the policy of patronage was disastrous; massive public investments did not yield any payoff in terms of increased growth. Killick (1978, p. 248) argues that to understand the poor economic development in Ghana one need to ask “why the creation of new state enterprises was allowed to outstrip the resources devoted to project planning, why incompetent managers were tolerated and why interfering politicians were not disciplined”. He goes on to argue that “‘Political interference;’ emerges as a logical result of the use of state enterprises to reward party activists and to extend the area of political control. And inattention to economic efficiency in the planning and operation of enterprises becomes explicable if the creation of such enterprises is accepted as an end in itself and as an ostentatious display to impress the electorate”. Political motivations for the soft budget constraint have previously been proposed by Shleifer and Vishny (1994), Boycko et al. (1996), and Desai and Olofsgård (2006), who assume political benefits of excess labor in public firms that result in soft budget constraints. A difference from these models is that in the present paper these political benefits emerge as a result.2 Our model is related to models where the incumbent chooses policy to bind his own hands in order to influence the outcome of an election (e.g., Milesi-Ferretti, 1995). As in such papers we study a dynamic model of voting and commitment. Although we study different questions, our model also relates to Robinson and Torvik (2005), because as in that paper a key mechanism is that politicians differ in what commitments they can make to different groups of citizens. In contrast to Robinson and Torvik (2005), the present paper develops an infinite horizon model, allowing us to capture dynamic effects. Maybe more important, however, motivated by the case study literature the present paper departs from an assumption of prefect democracy. We study how the degree of democracy affects the political desirability of soft budget constraints. 3 Finally, our model is related to Dixit and Londregan (1995) where agents do not undertake efficient investments because politicians cannot commit not to tax away the future profits by these investments. In our model, by contrast, politicians choose policy today so that they are able to commit to a particular policy in the future.

The conventional wisdom in the economics literature, following the seminal paper by Dewatripont and Maskin (1995), is that the soft budget constraint arises because well-meaning politicians face a dynamic commitment problem—they cannot commit not to bail out bad projects ex post. Interestingly however, the preponderance of case study evidence on the soft budget constraint links it to political incentives—firms or groups are bailed out for political reasons. In this paper we have developed a political economy model to try to link these insights and show how the soft budget constraint may arise as an efficient political strategy. We believe this is critical to understanding why soft budgets are so hard to eradicate. In an environment where politicians cannot commit to arbitrary forms of redistribution the presence of the sort of commitment problem isolated by Dewatripont and Maskin may be politically advantageous because it allows politicians to deliver benefits to potential supporters. While in standard theories of the soft budget constraint politicians would never finance a project known to be poor, in our theory this is exactly the reason it is financed in the first place because it is the only way to deliver redistribution which can influence electoral outcomes. This follows because of linkages between politicians and certain groups, who we call their core constituencies. Such linkages create asymmetries in what politicians can promise to different groups. In particular politicians will only bail out poor projects operated by their own core groups and this heightens the desire of the core group to see them remain in power.