Soft Budget Constraints: Why Bailouts Breed Bad Behavior
Seen in: Decline of the Ottoman Empire , USSR Collapse
What this model means
A soft budget constraint exists when an organization—a company, bank, or state enterprise—expects to be bailed out if it fails. Because failure won’t really be punished, incentives shift: there’s less reason to cut costs, improve efficiency, or avoid risky bets.
The opposite is a hard budget constraint: if you lose money, you go bankrupt and disappear. Hard constraints force discipline. Soft constraints let problems accumulate.
The term comes from Hungarian economist János Kornai, who used it to explain why socialist economies were chronically inefficient. But the model applies far beyond socialism.
Why it matters
Soft budget constraints explain a lot of puzzling behavior: banks that take insane risks, state enterprises that never improve, companies that lose money forever but never die.
Whenever someone else will cover your losses, your incentives change. You focus on lobbying for better treatment, not on actually fixing your operations. The expected bailout becomes priced into every decision.
Examples
1. Soviet state enterprises (1950s–1991)
In the USSR, state factories almost never went bankrupt. If a factory missed its targets or ran deficits, it got more subsidies, extra inputs, or easier targets next time. Managers learned to lobby planners for better terms rather than restructure. Waste accumulated for decades because there was no hard stop that forced real change. Read more in USSR Collapse.
2. The Ottoman Empire’s debt spiral (1850s–1881)
After the Crimean War, European banks offered the Ottomans easy credit. Instead of making hard choices—raising taxes, cutting spending—the government borrowed to cover gaps. Each deficit was papered over with another bond issue. In 1875, the empire defaulted. The “bailout” came from the Ottoman Public Debt Administration, a foreign-run agency that took control of key tax revenues. The soft budget constraint had delayed pain but made the crash far worse. Read more in Decline of the Ottoman Empire.
3. “Too Big to Fail” banks (2008)
Before and during the financial crisis, large banks operated under an implicit government guarantee: if they blew up, the government would probably rescue them. This expectation encouraged larger bets. When the crisis hit, the bailouts happened—validating the assumption and raising questions about whether the lesson would stick.
4. Zombie companies and easy credit
In low-interest-rate environments, weak companies that would normally fail can keep refinancing cheap debt. Banks extend and pretend. The result: “zombie” companies that limp along, tying up resources that could go to healthier firms. Japan’s “lost decade” featured many such zombies.
5. State-backed airlines
National flag carriers often lose money year after year but receive repeated government capital injections. Airlines that should shrink or disappear stay alive for political reasons. The soft budget constraint prevents the competitive pressure that would force efficiency or consolidation.
How to use it / common failure mode
When evaluating any organization’s incentives, ask: What happens if they fail?
- If failure means real consequences (bankruptcy, job loss, shutdown), incentives point toward discipline.
- If failure means rescue (subsidy, bailout, “too important to fail”), expect risk-taking, cost bloat, and weak governance.
This applies to companies, divisions within companies, government programs, and even personal decisions (if someone always covers your overdraft, you’ll manage money differently).
Failure mode: Assuming hard budget constraints are always good. In some cases—systemic banks, critical infrastructure—letting failure cascade is genuinely too costly. The trick is to design systems where rescue is possible but the expectation of rescue doesn’t warp behavior. That’s hard but not impossible.
In one line: Soft budget constraints mean expected bailouts breed bad behavior—because if you know you’ll be rescued, you take risks you otherwise wouldn’t.
This article was produced with AI assistance and human editing. Last updated Dec 14, 2025.