Can EU Conditionality Remedy Soft Budget Constraints in Transition Countries?

Soft budget constraints (SBCs) are a persistent feature of transition economies and have been blamed for i.a. a lack of fiscal consolidation and sluggish growth. EU eastward enlargement has - among other things - been conditioned on tackling SBCs. This paper analyzes such outside conditionality theoretically and empirically. First, modelling the SBC problem as a war of attrition between the applicant countries' governments and firms we find that outside conditionality can foster SBC hardening. Yet, toughening the EU stance or reducing the number of enlargement rounds may have ambiguous effects. Second, estimating SBC hardening in a partial adjustment model by measuring the reaction of employment to output changes we find that EU conditionality did indeed help candidates to fight SBCs.