Explain the concept of hard budget constraint and how it was introduced during the transition.
The definition of a ‘budget’1 is a plan for revenue and expenditure of any economic unit, for example: households, enterprises, government agencies, or non-profit organisations.
During the period of transition, socialist enterprises operated under what Kornai termed ‘soft budget constraints’ (SBC).2 Under the SBC the state-owned enterprises are bailed out by the state when the enterprises’ revenues do not cover their costs. ‘Bailing out’ can happen in a number of ways; the state awards fiscal subsidies to inefficient firms, also, the taxation may be soft (i.e. tax rates may not be uniform), soft credit rules may exist whereby the enterprises have an indefinite time to pay back the loans, or alternatively wage arrears may exist whereby the enterprises delay paying workers their salary. The SBC phenomenon is not limited to the post-socialist countries, and it does exist in the market economies, but it is far more common, far more widespread, and far more damaging in the Soviet economies3. A single instance of government bailout, as was the case during the credit-crunch, will not lead to the formation of the SBC phenomenon4. It will develop only during a constant and prolonged state assistance whereby the managers learn to depend on the state aid, but that is not limited to only the managers of failing firms, the managers of successful and profitable firms, seeing that the government is propping up the failing enterprises, will want to increase even more the profits of their already profitable enterprises whereby leading to the increase of their own bonuses. The governments had several temptations for bailing out state enterprises, from political repercussions of a large firm going bankrupt and laying off hundreds of thousands of jobs, to the negative externalities (e.g. supply problems) caused by a large firm going out of business and cancelling all of its order.
The concept of the HBC is best explained in the terms of the SBC, which accounts for the lengthy discussion above, so in effect HBC is the exact opposite of the SBC5. Overall, under the HBC the state allows the chronic loss making firms to close down, it refuses them subsidies, it cuts them off from soft financing explored above, and the survival of the enterprises depends exclusively on their proceeds from sales.
After looking into both, the SBC and HBC, the question, “what is wrong with firms operating under SBCs?” has to be answered, because in the early days of the capitalism the budget constraints were draconian hard, with the existence of debtors’ prisons, and with the borrowers having to auction off their personal property when their enterprises when bankrupt6 leading the managers to being very risk averse and to not getting involved in research and development projects due to a fear of failure. The first problem with the SBC syndrome is to do with the undermining of trust7 as various enterprises (especially those that have been privatized) do not know whether the firms facing SBC will pay their debts on time, or whether the contracts will be fulfilled, because the SBC enterprises know that they can rely on the state for survival and therefore don’t have to be efficient. This generally leads to awkward delays and provokes strong friction in payment relations. The second problem with firms operating under SBC is that natural selection8 that exists in the market economies fails to occur. This leads firms to operate in much more inefficient ways, and because they know that they will be bailed out by the state they are able to postpone painful restructuring which would likely lead to the dismissal of many employees. Therefore the firm will not look into the ways in which it can meet customers demand, but into the ways in which it can gain favours with the potential rescuers. The third problem with firms operating under the SBC is that it has a negative effect on the credit market9. Such firms become irresponsible in their borrowing because they feel that they will be able to survive even if they act as bad debtors. The banks could also be more likely to lend to such firms because they know that the state will always bail these firms out even if they undertake projects with very low (or even negative) net present value, and the banks will eventually get their money back. This could lead to the misallocation of resources from the potentially value enhancing firms and projects to the value destroying firms and projects.
