Soft Budget Constraints, Pecuniary Externality, and the Dual Track System

I put forward a new theoretical framework to analyze the relationship between soft budget constraint syndrome and the economic performances of firms. It differs from the existing theoretical framework, à la Dewatripont and Maskin (1995), in the soft budget constraint literature. In this paper, soft budget constraint syndrome arises when firms that are expected to lose money are financed. The paper highlights a trade-off between hard and soft budget constraints. While soft budget constraints may compromise firms’ incentives to improve performances, an all-out effort to harden budget constraints may put macro stability at risk, especially for economies suffering from allocative inefficiency. Based on this trade-off, the paper shows that a transition from centralized financing to decentralized financing in fact compromises firms’ incentives to improve their performances, whereas a transition from centralized financing to a dual track system enhances efficiency. In the dual track system, budget constraints are soft in the centralized track but the macro stability of the economy is assured as a result. The macro stability enhances the disciplinary effect of hard budget constraints in the decentralized track, which in turn promotes firms’ incentives to improve performances. The paper sheds light on a complementary relation between soft budget constraint syndrome in the state sector (i.e., the centralized track) and the remarkable growth of the non-state sector (i.e., the decentralized track) in China.