ABSTRACT
The soft budget constraint describes a system whereby enterprises receive various forms of subsidies more or less automatically and have any operating profits largely expropriated. Under the soft budget constraint a firm anticipating a bailout, when faced with liquidity constraint not only modifies its production decisions, but also lacks any incentive to do something about the liquidity problem. The soft budget constraint entails an information or agency problem, and the problem of credible commitment on the part of the State. Hardening the budget constraint and squeezing access to public funds may induce enterprises to reduce their costs, but they as well may reduce the quality and quantity of their output. The hardening of firms’ budget constraints will provide incentives for the introduction of new financial instruments. The imposition of a hard budget constraint on enterprises will have implications for monetary conditions in a reforming country, namely demand for precautionary balances will increase.
