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Understanding Public Sector Debt: Financial Vicious Circle under the Soft Budget Constraint

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Abstract

The article explains why debt of public sector organizations grows beyond the sustainable level by focusing on the principal-agent relationship under the soft budget constraint. Specifically, this article explores the extent to which factors affect the level of public sector debt in the context of quasi-autonomous non-governmental organizations (quangos) in Korea over the past two decades (1993–2012). The findings from the panel data analysis suggest that the level of public sector debt increases as an outcome of the financial vicious circle created by the soft budget constraint: a knock-on effect of the moral hazard of quangos as well as the opportunistic behavior of political principals. Public sector debt is positively associated with agency-specific factors as well as the factors related to the political incentives such as policy preferences and electoral considerations. However, macroeconomic factors made little difference to the general pattern of the evidence.

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Notes

  1. Deficit occurs when expenditure exceeds revenue in a given time, while debt is an accumulation of yearly deficits. Therefore, large deficit results in the rise in public debt.

  2. Since 2011, the Korean government has compiled public debt from the general government as well as public sector debt generated by quangos, corporate debt, and household debt.

  3. Rogoff (1990: 21) argues that a political business cycle is the result of the temporal information asymmetries about the incumbent leader’s “competence” and the biases resulting from attempts at “pre-election signaling,” which increases government consumption expenditure before elections.

  4. A more recent model developed by Moesen and van Cauwenberge (2000: 208) predicts that voters are more reluctant to increase the production of public goods when they know they have to pay the full production costs of those goods. However, such arguments were criticized later for lack of rigor and for being “based upon... somewhat questionable notions” (Alesina and Tabellini 1990: 403).

  5. A bilateral monopoly between bureaucrats and politicians allows us to consider their preferences and incentives separately in the democratic political system (Casas-Pardo and Puchades-Navarro 2001).

  6. Rodden (2007) used the concept to describe the behavior of lower level governments under fiscal federalism relying on fiscal rescue or bailout through intergovernmental grants.

  7. Such stimulative fiscal policies as tax cuts, interest rate cuts, and spending increases are politically popular before elections, but result in serious long-term costs such as inflation (Nordhaus 1975).

  8. A liberal or left-wing government favors default on outstanding debt, while a conservative or right-wing government can take advantage of the deliberate accumulation of debt (Aghion and Bolton 1990).

  9. Although quangos are separated from the government, politicians and public officials are able to control them by keeping their involvement “arms’ length but hands on” (Taylor 1997) through formal and informal connections, such as political patronage (Skelcher 1998).

  10. Bad projects can be financed not only for political reasons but also for economic ones, such as sunk costs and profitability (Dewatripont and Maskin 1995: 542–543). Bad projects may not be terminated if the cost of continuing them is smaller than the cost of starting new projects, which might be worse than the existing ones (Bai and Wang 1998: 42).

  11. President Young-sam Kim (1993–1998) focused on improving/reducing financial/economic regulations, industry promotion, inspection/verification; President Dae-jung Kim (1998–2003) focused on the economy, international relations, privatization, IT, and real estate; President Moo-hyun Roh (2003–2008) prioritized social welfare, labor relations, participation, and decentralization; and the main agendas for President Myoung-bak Lee (2008–2013) were natural resources, construction, energy, environment, science and technology.

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Authors and Affiliations

  1. Department of Public Policy and Administration, School of Public Service, Boise State University, 1910 University Dr. ERB #5139, Boise, ID, 83725, USA

    Sanghee Park

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Correspondence to Sanghee Park.

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This work was supported by the National Research Foundation of Korea Grant funded by the Korean Government (NRF-2013S1A5B5A07045822).

Appendix

Appendix

Appendix 1 Descriptive statistics
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Appendix 2 Pairwise correlations among continuous variables
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Park, S. Understanding Public Sector Debt: Financial Vicious Circle under the Soft Budget Constraint. Public Organiz Rev 18, 71–92 (2018). https://doi.org/10.1007/s11115-016-0358-y

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