American Economic Association

A Review of Michael Tomz's "Reputation and International Cooperation: Sovereign Debt across Three Centuries" Reputation and International Cooperation: Sovereign Debt across Three Centuries by Michael Tomz Review by: Mark Gersovitz Journal of Economic Literature, Vol. 47, No. 2 (Jun., 2009), pp. 475-481 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/27739929 . Accessed: 05/06/2013 04:37
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Journal of Economie

Literature

2009,

47:2, 475-481

http:www.aeaweb.org/articles.php?doi=10.1257/jel.47.2.475

Tomz s of Michael and International Reputation across Debt Cooperation: Sovereign Three Centuries A Review
Mark Gersovitz*

and expropriation pose obstacles to the international mobility of capital Repudiation and thereby to efficient international allocation of resources. Tomz discusses the deter minants of lending in theface of the threat of repudiation. Using history, he argues that debtor countries have sougfit a reputation for compliance with loan agreements to access future loans and thatmilitary or trade sanctions have been unimportant in more active as lend sustaining lending. He discusses when and why banks have been ers relative to bondholders. This article situates Tomz s concerns in the broad themes on obstacles to of thought capital mobility and evaluates his arguments.

Tomz, a political scientist, has a useful book on the mecha written Michael nisms that support the international mobil and International ityof capital?Reputation across Three Debt Cooperation: Sovereign Centuries (Princeton University Press, 2007). econo Capital mobility has long concerned mists. In 1817, David Ricardo set out the big themes for an investigation of international capital mobility, arguing that the interna tional movement of capital faces significant obstacles:
The difference gle country tal moves and many, a sin in this respect, between is for, easily accounted country to another, to seek

a more and the activity profitable employment, it with which from one prov invariably passes in the same ince to another (Ricardo country.

2005, pp. 87-88)

reason was

His

that shows that the fancied

not under when capital, the immediate control of its owner, together with the natural disinclination which every . . . man has to quit the country of his birth check the emigration of These feel capital. . . . induce most men to be of property ings in their own satisfied with a low rate of profits a more country, rather than seek advantageous in nations. for their wealth employment foreign

however, Experience, or real of insecurity

with which capi by considering the difficulty

from one

(Ricardo 2005, p. 88)

* Gersovitz:

Johns Hopkins

University.

Ricardo must have seen these obstacles to capital mobility as quite large and quite immutable because he based his theory of comparative advantage on them: In the

475

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476

Journal of Economie

Literature, Vol. XLVII

(June 2009)

of capital mobility, how does trade substitute for capital mobility and what is its role in raising welfare? Maximization of world welfare requires an international allocation of capital that a common establishes marginal product can be anywhere that capital productive. the factor composition of trade Although can move the world economy toward such is probably equalization, capital mobility to achieve the still needed fully efficient But achieving allocation. this allocation encounters Ricardo's presumption that own ers of capital who invest abroad fear that nor they may get neither their capital back a reward for it available. In particu making lar, lenders to foreign governments may fear repudiation and direct investors may fear sometimes termed expropriation?fears absence These general considerations lead to the motives of providers and recipients of capi tal across international boundaries and the constraints they face. In turn, the circum stances of these market participants deter mine the international allocation of capital, the occurrence of hostile acts toward provid ers, the implications of the foregoing for the welfare of market participants, and the role for policy by governments and international such a positive organizations. To develop and normative theory of obstacles to capital it is easiest mobility and their consequences, towork backward from a breakdown in rela tions between providers and recipients and its determinants. over the last Research thirty years has to pay of that the emphasized willingness of determines whether recipients capital on which terms the recipients uphold they received capital. The idea is that the recipi ents make a cost-benefit analysis of honor ing the terms. The cost is the terms of the
contract, such as country or sovereign risk.

Providers of capital want to maintain a suf ficient probability that these benefits to the so that the recipient exceed costs providers get adequate recompense, leading to a strat egy of credit rationing based on the available penalties and the attributes of the recipients of capital. In the economics literature, the major to to pay are sol alternatives willingness is the notion and vency liquidity. Solvency that a recipient country cannot ever satisfy the terms of its agreement with the providers
of

viders. The benefits are avoiding the penal ties that aggrieved providers could impose.

paying

a return

to the pro

providers would know that recipients would not be to honor contracts. A willing liquidity arises if the recipient cannot satisfy problem the terms of its agreement in the short term cannot but could (and would) later on?a The pay-now approach. major objection to a is that the recipient liquidity explanation can a unilateral moratorium declare usually and wait for problems to abate because by hypothesis they will. Providers of capital would then be forced to float the troubled recipient until the temporary lack of funds is past. An exception would be a recipient who needs new additional funds to deal with an immediate problem, ones that itwould be on but without which itwould good for later become insolvent in the future. Perhaps ithas to finish some investment project that large would otherwise come to permanent grief. Providers of capital may have trouble coor new funds, but dinating the provision of the I have not seen this as an dynamic offered crises of actual between explanation recipi ents and providers. So thewillingness-to-pay seems in the saddle if one approach firmly chooses among it, solvency, and liquidity. The next question in understanding inter national capital mobility is the nature of

a a country with present example would be discounted value of national income known to be less than the present discounted value of its obligations. But solvency is unlikely to be operative because, long before it could be,

capital?a

cannot-pay-ever

approach.

An

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Gersovitz:

A Review

of Reputation to pay

and International Cooperation

477

the penalties
under some

circumstances?a

that sustain willingness

controversial

topic of much research. The plausible pen alties are rather indirect and probably often weak in that they do not support the interna tional equalization of the returns to capital. The presumption in the literature has been that rational providers of capital will not send it abroad unless expected returns are at least equal to their opportunity cost of funds. returns are determined in part by Expected the probability of trouble with the recipi ents of capital, which in turn is determined in part by the availability of penalties. Later 1 return to the motivations of providers, an underexamined topic. The penalties are indirect for a number of reasons. Providers cannot get collateral

because the whole purpose of the provision within the of capital from abroad is to put it where capitals product ishigh foreign country is vulnerable where but by hypothesis capital to the recipients control. courts Similarly, will either not render a judgment against a or their sovereign government judgments cannot be enforced. This situation leads to a contrast with the recourse often qualitative available against private borrowers within a
lenders own

Tomz s goal is sorting out which of the is operative conceivable indirect penalties in the case of financial transfers between providers of capital (banks and bondholders) and recipients of capital (the governments of countries). He argues that the loss of future access to a capital from loss of reputation for trustworthiness is determinative. Chapter 1 con sets the context, chapter 2 provides his an sustains how of reputation ceptualization with international lend positive equilibrium ing, and chapters 3 to 5 provide evidence for the approach. Economists will probably find chapter 2 on the theory to be the weakest part of the book. Tomz does not present a precise abstract formulation of the behavior of mar

country.

ket participants who pursue objectives in the face of constraints. His presentation could have been greatly improved by an algebraic statement of the problem he is addressing. are three Tomz types postulates that there of recipients of capital: stalwarts (who tend to service debts in good times and bad),/air weathers (who repay in good times but not lemons (who regularly default in and bad), bad times and sometimes in good times). Lenders are said to learn about the type of a as the borrower responds specific borrower to times As time passes with and bad. good out bad behavior, lenders become more confi dent that they are dealing with a good type. These generalities are about all that the chapter contains, however. Itwould be good to know why Tomz does not use a model in which there is only one type of borrower, one who is to contemplate always willing circumstances. under the repudiation right of the lender and borrower is Equilibrium then determined by the need to ensure that the penalty of exclusion will be applied to in such a way that lenders are repudiators to lend given the incentives of bor prepared rowers to one avoids repudiate. In this way, the artificial hypothesis of inherent types as exogenous to themodel and can instead try to

infer how characteristics of the equilibrium, such as the amount of lending and the prob are affected ability of repudiation, by objec tive circumstances that can be examined is empirically. Thus the concept of reputation a notion of strategic equilibrium. replaced by a In any case, there is certainly large relevant literature of formal models both on interna tional capital mobility and on game theory, are more than one type including when there of player with type at least initially known even cites some of only to the player. Tomz these contributions and it would have helped the reader if he could have adapted these models to incorporate the features he feels are to his special approach. Instead, there is no no of concept proof equilibrium, certainly

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478

Journal of Economie

Literature, Vol. XLVII

(June 2009) it serves

of its existence, no comparative analysis. Thus there is little of substance in this chapter that in to it as justifies Tomz repeatedly referring There is also almost no substantive dis cussion of what determines a type. Does it have something to do with processes that would seem more political than economic? For instance, there may be regimes that value isolation or at least forwhom isolation is an inevitable byproduct of their goals and strategies. For these regimes, sanctions by creditors that isolate the country may make little difference or even be a plus. Regimes in the Soviet Union, Communist China, North Korea, Cuba, Iran, Bolivia, Peru, Venezuela, or Zimbabwe may gain support by arguing that a revolution or country is under siege from foreigners and may benefit from being as enemies domestic able to undermine or consolidate and appeasers foreign agents power. If isolation is desirable, then being cut off is a benefit not a cost. Although the countries of this kind that come immediately tomind do not provide the bulk of recorded breakdowns between lender and borrower, some include prominent cases and there they overt be instances as well. Tomz less may mentions some of these countries but there is no analysis of their situation. A parallel political economy approach might be to look at who within the borrower country benefits from isolation consequent on economically sanctions and to ask when the political pro cess is such that these people determine pol icy. Provoking isolation may not be a Pareto may be the best feasible for these policy but it people given the political system. The types of borrowers in Tomz s discussion, however, largely remain quite abstract.
Tomz next turns to evidence on the costs "my model."

in his con badly more rigor ceptual discussion, which needs ous and focused development. Nonetheless, the empirical discussion could have been a that stronger conceptualization helped by would have guided which regularities to look for and how to interpret them. 3 presents statistical evidence Chapter from the eighteenth and nineteenth centu ries on the rates that borrowers have paid. He finds that new entrants generally paid higher rates than seasoned borrowers who had hon eclecticism, whereas ored their obligations and that these rates fell if the new borrowers in turn honored their obligations. He relates the interesting case of a fictional (and fraudulent) sovereign borrower, Poy?is, which first entered the London market in 1822 paying the same rate as a number of South American countries of The information Spain. newly independent on its true status took almost a year to leak to London with a consequent in the collapse value of itsdebt. 4 examines investment advice Chapter from American and British publications on the purchase of foreign government bonds 1919 and 1929. Tomz between identified four comprehensive bibliographies from this a random and drew period sample of their references and then coded the principles of risk assessment that were discussed. He concern was with finds that the predominant was some very sec There repayment history. to consideration ondary given military inter vention as a possible consequence of failing to honor bond payments but no virtually mention of trade sanctions. Tomz addresses the concern that he is examining opinions rather than actions by emphasizing that these were meant to publications provide advice to so that the actual or potential bondholders authors themselves had a reputation tomain
tain for relevance.

of not fulfilling the terms agreed with credi tors and he has some really quite interesting things to say. I think that his predilection for serves him better in his informality empirical investigation, which benefits from a creative

at the experience of bor Chapter 5 looks rowers interwar the period. Of partic during ular interest is the second half of this chapter

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Gersovitz:

A Review

of Reputation

and International Cooperation ter

479

that looks at three countries thatmaintained their payments during the 1930s: Australia, in Argentina, and Finland. Here and chapter 7 (pp. 175-77), Tomz recounts the intense debate among Argentine politicians who explicitly recognized the benefits of future access to credit from paying under such dif ficult conditions. All three countries were at least able to borrow at lower (nominal) rates 1930s. during the Chapter 6 discusses the role of coercion of recalcitrant borrower states by the states of lenders. The upshot of Tomz s examina tion of the nineteenth century, the sup is that posed heyday of gunboat diplomacy, there is virtually no evidence of this type of enforcement of loan contracts. The rea son is quite simple: the governments of rich countries have a lot of interests and they do not particularly like their agendas upset by imprudent and importuning lenders. Of
course, there was the coercion exercised

tary dispute without resolving the default. are misleading. He Perhaps the correlations then develops the historical narrative of these military disputes, showing that they had little to do with default, including a conflict between Britain and Venezuela often cited as the best example of gunboat debt collection.
Furthermore, he examines an enormous cor

various factors that make controlling for conflict between two countries more likely regardless of debt problems. Tomz then moves to discredit these infer ences from the COW data by showing that the vast majority of the military disputes occurred in the middle of long default epi sodes. As he points out, this finding raises the so questions of why creditor nations waited most the mili long and, importantly, ended

through the arrogation of the of force and other governmen monopoly tal functions to the m?tropole. Doubtless, India had much easier access to the London as part of the British Empire capital market than it would have had otherwise and so the international state structure must surely have to do with the mobility of something capital.
Tomz s concern is narrower: the coercion

in colonies

respondence between British officials and their aggrieved citizens who lent abroad that the officials showing repeatedly told the lenders that importuning making risky loans was their own lookout. Some British officials, however, did urge governments in default to take account of the consequences for their as borrowers, con reputations precisely the siderations that Tomz stresses. Finally, Tomz argues that citizens of smaller countries, such as Switzerland, were active lenders to coun tries that could not possibly be coerced by the home countries of the lenders. All in all, I found Tomz s discussion to be a very worth while consideration of diverse evidence and much preferable to a mechanical statistical of COW the data. This analysis chapter pro vides a valuable model of how to scrutinize a more findings from the COW data using historical approach. on the role of trade Chapter 7 focuses sanctions in sustaining international capi
tal movements. Here, Tomz's conclusion

But

of an otherwise sovereign state in the inter ests of its foreign creditors. The way that Tomz gets to his conclu sion about the unimportance of interstate more coercion is of general interest perhaps than the conclusion itself. He begins with some evidence from the Correlates ofWar (COW) dataset. These or similar data are the raw material of many studies in political economy, such as the literature on civil wars, whether as an explanatory or dependent vari able. Tomz shows that there is a statistically significant correlation between debt defaults and military disputes (short ofwar) whether in a bivariate or multivariate analysis, the lat

is a strong unambiguously negative?he detractor of the position that the potential for interference with a country's trade pro vides the incentive for it to service its debts. He begins with a detailed examination of is

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480

Journal of Economie

Literature, Vol. XLVII

(June 2009)

impressed by two of his observations. First, Argentina serviced debts to U.K. and U.S. lenders equally despite the United States having little trade with Argentina and there fore negligible scope for trade retaliation at the same time that the Argentine debts to the United at States were larger and worse terms than their debts to the United as Kingdom. Second, already mentioned, the debate among Argentine politicians pivoted on the loss of access to future not lending trade. The remainder of chapter 7 presents a broader analysis of debtor-creditor relations as they relate to the importance of bilateral the two types of countries trade between 1930s. the Tomz's evidence suggests during that countries that had high trade volumes with the countries of their lenders and pre to trade sumed vulnerability disruption were no more to service their debts likely than otherwise. Finally, Tomz reports on his examination of "96,000 scrap book pages" of articles maintained the British newspaper by of Bondholders from Corporation Foreign 1870 to 1914. There ismention of trade sanc tions in two instances; in neither case only were they applied. The discusses penultimate chapter whether and when lenders are better orga nized as bondholders or banks. Much of the literature has placed emphasis on the sup posed greater cohesion of banks in dealing with recalcitrant lenders and Tomz does an exhaustive list of reasons provide why this relative cohesion might be expected. He points out, however, that the petrodollar lending episode of the 1970s and 1980s was in the of banks as unique predominance lenders. This fact suggests that banks' cohe sion and, hence, their suitability to dealing with recalcitrant borrowers may not be what accounts for their prominence in the petro dollar period because this factor also should

the Argentine experience during the 1930s when he finds the threat to future borrow was ing, not to trade, operative. I was most

have applied at other times when banks did not, however, predominate. Instead, Tomz argues that lending by banks as opposed to bondholders was uniquely favored by other circumstances in this period. Tomz draws on the writings of Karin Lissakers and others to point out that, during this period, bank lending to foreign govern ments enjoyed special advantages from U.S. tax credits. Sovereign borrowers paid foreign were net of the interest to banks as it though borrower country's taxes, thereby generating potentially huge tax credits to shelter banks'
incomes from other sources from U.S. taxes.

transfer from the public entity in the lender's country that has guaranteed the debts to the as the private lender guarantee was invoked to a leading change in the identity of the claimant on the borrower without, however, any direct involvement of the sovereign bor rower whose liabilities were reallocated. Of course, as I write in the fall of 2008, financial manias and bailouts are upper most in everyone's mind, and it raises the issue much mooted in the 1970s and 1980s

The U.S. tax code subsequently became less favorable. Tomz also argues that the mone tary authorities in the countries of the lend ers implicitly guaranteed bank loans. The favorable climate for bank at lending this time also included explicit government guarantees that Tomz does not, however, dis cuss, for instance from the Export-Import Bank of the United States. This storyof explicit guarantees has yet to be told but hints of itcan be found in data when a country's liabilities are broken out are owed to by whether they or one can see Thus lenders. private public in the case of countries thatwere in reported the press as nonpayers that subsequently their liabilities to private creditors fellwhile those rose. Such a reallocation to public creditors most likely does not represent the repayment of debts by the sovereign borrower to private lenders coincidentally offset by a rise in debts to public lenders. Instead, there was a direct

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Gersovitz: A Review

of Reputation

and International Cooperation

481

be richly rewarded for their perspicacity. Hence, we have Walter Wriston s (in)famous not go aphorism that countries do bankrupt. for many people, he did not Unfortunately follow this statement by the more important realization that this fact is not good news for lenders because countries can stop, have even stopped, and probably will stop paying

about banks' internal controls and incen tives just prior to the LDC Debt Crisis of the 1980s?the problem of the management run financial institution.When outcomes are realized significantly after loans are made, it is possible forbank managers, who benefit via promotions and bonuses from such activities as or sovereign subprime-mortgage lending, to argue that skeptical commentators (and are alarm responsible regulators, ifany exist) ists, that everything will be alright, and that in the meantime the managers of banks should

without going bankrupt. A full explanation of this episode of petrodollar lending followed seems to need attention to the by defaults more complexities of the lenders' incentives, than it has received. Tomz is rare in paying any attention to the lender's calculus, even if he has not covered explicit guarantees or the incentive problems of the managerial bank. In general, I found this book to be schol a to seek arly and insightful, probing effort further understanding. And by the way, the book has an excellent reference list. I learned from reading it and I feel others who are interested in international capital mobility will as well.
References Ricardo, 2005. David. Principles Taxation. Savage, Md.: Econ of Political Barnes and Noble

omy and Books.

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