In a post a few days ago, (After subverting bank insolvency, our leaders are now about to make a mess of liquidity) , I argued that hard budget constraints were the defining characteristic of a well-functioning market economy. Many/most of the advanced industrial countries were weakening or even undermining the capacity of their financial sectors to intermediate efficiently by permitting a softening of the budget constraints of banks and other financial institutions that were deemed systemically important and/or were too politically connected to fail. I noted that the concept of the soft budget constraint (SBC) came from professor János Kornai, a great economist and a Nobel prize winner (the overlap is by no means perfect – there are type I and type II errors)(CORRECTION: As pointed out in a comment on this post, Professor Kornai has not (yet) won the Nobel prize. My bad, as the teenagers in my family would say. In my defense, he ought to have been awarded the prize already, preferably instead of the large efficient markets cohort that did receive it.)
Professor Kornai’s classic book Economics of Shortage, analyses a fatal internal contradiction in central planning – how soft budget constraints became a defining feature of a centrally planned economy and were central to its astonishing inefficiency and eventual downfall. In a paper co-authored with Eric Maskin and Gerard Roland (“Understanding the Soft Budget Constrained”, published in the Journal of Economic Literature, December 2003, vol. 41(4), pages 1095-1136), Kornai argues the wider applicability of the SBC concept to economies other than centrally planned economies. For those with access to JStor, the paper can be found here.
I am pleased and honoured that this blog can bring you the following short note in which professor Kornai explains the relevance of the SBC to an understanding of the causes and consequences of the financial crisis of 2007-2009.