Soft budget constraints may be optimal

In many countries, local governments rely to some degree on the federal government to cover for deficits. This has been regarded as a poor policy, because it leads to severe moral hazard issues, the most serious example probably being Argentina. One such solution is that the central government impose a hard budget constraint (HBC) on local ones: no borrowing allowed. This is also the policy adopted by many US states.

HBC is not uniformly liked, though. As the US shows, recessions lead state governments under such a constraint to suddenly and severely curtail essential services, sometimes to even shut down completely. This obvious solution to accumulate a rainy day fund during good times never happens, mostly due to constant pressures to lower taxes.

It turns out there is another reason why HBC could be less than optimal. Martin Besfamille and Ben Lockwood show that HBC can lead to excessive effort to complete investment projects once started and avoid a bailout, and thus discourage starting projects in the first place. This does not happen with soft budget constraints, as local government are driven there to over-investment and lower effort. Between the two, HBC may lose in terms of efficiency.

Of course, there is also the question whether a government can truly commit to HBC. This article shows, however, that a full commitment to HBC may actually not be optimal.