A Theory of the Soft-Budget Constraint

This paper studies the soft budget constraint problem in a principal-agent model. The agent screens projects of and makes initial investment in the projects that have passed the screening. He then finds the types of the funded projects and decides to close some of the ex post inefficient ones among them. Closing projects sends an unfavorable signal about the agent's screening effort. Under the ex ante efficient contract, the agent has incentive to refinance some of the ex post inefficient projects.