Soft Budget Constraint Theories: From Centralization to the Market

Introduction This paper has two purposes. One is to examine the effect of soft budget constraints (SBC) on economies in transition from centralization to capitalism. The other is to survey our understanding of SBC more generally. Of course, this latter aim is also pertinent to the former. Current work on SBC follows in the tradition of the famous debate in the late 1930s and early 1940s on market socialism (Hayek-Mises vs Lange-Lerner). Like that earlier discussion, it is concerned with why some economic institutions work well while others do not. And, although focused particularly on socialist institutions, it also has considerable bearing on our understanding of markets. The 1940s debate was a major inspiration for the theory of mechanism design, while recent contributions have stimulated the study of commitment problems in game theory and contract theory. However, differences between the two literatures are also evident. Lange and Lerner wrote about the potential benefits of socialism at a time of socialist ascendancy, whereas modern studies emphasize its flaws in an era of precipitous decline. The fundamental feature of a centralized economy is the dominance of the state sector. A