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

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 such as the size of quangos 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.