Endogenous Soft Budget Constraints

Date: 2005-08-06
By: James A. Robinson, Harvard University
Ragnar Torvik, Norwegian University of Science and Technology
URL: http://d.repec.org/n?u=RePEc:nst:samfok:5605&r=pol
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 a political economy model where politicians cannot 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 vote for them. Though the soft budget constraint may induce economic inefficiency, it may be politically rational because it influences the outcomes of elections. In consequence, even when information is complete, politicians may fund bad projects which they anticipate they will have to bail out in the future.
Keywords: Political Economy; Investment; Development
JEL: H20 H50 O20