THE SOFT BUDGET CONSTRAINT PROBLEM IN TRANSITION AND DEVELOPING COUNTRIES

Abstract

The soft budget constraint problem arises in most transition and developing countries during their decentralization process. Indeed, central governments generally transfer responsibilities to lower levels of governments but maintain strong interests in local affairs. The result of such a setting is sub-national governments' expectation to receive additional funds in case of financial crisis. This thesis provides an overview of the literature on this topic, in dealing respectively with facts, models and empirical works. The first part describes the origins of the soft budget constraint in transition and developing countries, as reported in the case study literature. It also illustrates mechanisms to harden subnational budget constraints. The second part aims to display fundamental models developed to explain the bailout phenomenon. Goodspeed (2002) and Wildasin (1997) effectively model interactions between levels of government in a given situation to demonstrate bailout's expectation and its implication. Moreover, related models and recent additional developments complete this technical view of the topic. Finally, the last part introduces empirical studies on the problem in transition and developing countries. Investigations demonstrate worrying results, since authors find evidence of soft budget constraint in their analyses.