Gersovitz Review of Tomz Reputation and Sovereign Debt

7/28/2019 Gersovitz Review of Tomz Reputation and Sovereign Debt

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American Economic Association

A Review of Michael Tomz's "Reputation and International Cooperation: Sovereign Debt acrossThree Centuries"Reputation and International Cooperation: Sovereign Debt across Three Centuries by MichaelTomzReview by: Mark GersovitzJournal of Economic Literature, Vol. 47, No. 2 (Jun., 2009), pp. 475-481Published by: American Economic Association

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Journal ofEconomie Literature 2009, 47:2, 475-481

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

A Review of Michael Tomz s

Reputation and International

Cooperation: Sovereign Debt across

Three Centuries

Mark Gersovitz*

Repudiation and expropriation pose obstacles to the international mobility of capitaland thereby to efficient international allocation of resources. Tomz discusses the deter

minants of lending in theface of the threat of repudiation. Using history, he arguesthat debtor countries have sougfit

a reputation for compliance with loan agreementsto access future loans and thatmilitary or trade sanctions have been unimportant in

sustaining lending. He discusses when and why banks have been more active as lend

ers relative to bondholders. This article situates Tomz s concerns in the broad themesof thought

on obstacles to capital mobility and evaluates his arguments.

Michael

Tomz, apolitical scientist, has

written a useful book on the mecha

nisms that support the international mobil

ityof capital?Reputation and International

Cooperation: Sovereign Debt across Three

Centuries (Princeton University Press, 2007).

Capital mobility has long concerned econo

mists. In 1817, David Ricardo set out the bigthemes for an investigation of international

capital mobility, arguing that the interna

tional movement of capital faces significantobstacles:

The difference in this respect, between a sin

gle country and many, iseasily accounted for,

by considering thedifficulty ith which capital moves from one

country to another, to seek

*Gersovitz: Johns Hopkins University.

a moreprofitable employment, and the activity

with which itinvariably passes from one

province to another in the same

country. (Ricardo

2005, pp. 87-88)

His reason was that

Experience, however, shows that the fancied

or real insecurity of capital, when not under

the immediate control of its owner, togetherwith the natural disinclination which everyman has to quit the country of his birth . . .

check the emigration of capital. These feel

ings. . . induce most men of property to be

satisfied with a low rate of profitsin their own

country, rather than seek a moreadvantageous

employment for their wealth inforeign

nations.

(Ricardo2005, p. 88)

Ricardo must have seen these obstacles

to capital mobility as quite large and quite

immutable because he based his theoryof comparative advantageon them: In the

475







476 Journal ofEconomie Literature, Vol. XLVII (June 2009)

absence of capital mobility, how does trade

substitute for capital mobility and what is itsrole in raisingwelfare?

Maximization of world welfare requiresan international allocation of capital that

establishes a common marginal product

anywhere that capital can be productive.

Although the factor composition of trade

can move the world economy toward such

equalization, capital mobility is probablystill needed to achieve the fully efficient

allocation. But achieving this allocation

encounters Ricardo's presumption that owners of capital who invest abroad fear that

theymay get neither their capital back nor

a reward formaking it available. In particular, lenders to foreign governments may fear

repudiation and direct investors may fear

expropriation?fears sometimes termed

countryor

sovereign risk.

These general considerations lead to the

motives of providers and recipients of capital 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 providers, the implications of the foregoing for the

welfare ofmarket participants, and the role

forpolicy by governments and international

organizations. To develop such a positiveand normative theory of obstacles to capital

mobility and their consequences, it is easiest

towork backward from a breakdown in relations between providers and recipients and

itsdeterminants.

Research over the last thirty years has

emphasized that the willingness to pay of

recipients of capital determines whether

recipients uphold the terms on which theyreceived capital. The idea is that the recipients make a cost-benefit analysis of honor

ing the terms. The cost is the terms of the

contract, such as

paying

a return to the

providers. The benefits are avoiding the penalties that aggrieved providers could impose.

Providers of capital want to maintain a suf

ficient probability that these benefits to therecipient exceed costs so that the providers

get adequate recompense, leading to a strat

egy of credit rationing based on the available

penalties and the attributes of the recipientsof capital.

In the economics literature, the majoralternatives to willingness to pay are sol

vency and liquidity. Solvency is the notion

that a recipient country cannot eversatisfy

the terms of itsagreement with the providersof capital?a cannot-pay-ever approach. An

example would be a country with a presentdiscounted value of national income known

to be less than the present discounted value

of its obligations. But solvency is unlikely to

be operative because, longbefore itcould be,

providers would know that recipients would

not be willing to honor contracts. A liquidity

problem arises if the recipient cannot satisfythe terms of its agreement in the short term

but could(and would) later

on?a cannot

pay-now approach. The major objection to

aliquidity explanation is that the recipient

canusually declare a unilateral moratorium

and wait for problems to abate because by

hypothesis they will. Providers of capitalwould 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

good for later on but without which itwouldbecome insolvent in the future. Perhaps ithas

to finish somelarge investment project that

would otherwise come to permanent grief.Providers of capital may have trouble coor

dinating the provision of the new funds, but

I have not seen this dynamic offered as an

explanation of actual crises between recipients and providers. So thewillingness-to-pay

approach seems firmly in the saddle if one

choosesamong

it,solvency,

andliquidity.The next question in understanding inter

national capital mobility is the nature of







Gersovitz: A Review ofReputation and International Cooperation 477

the penalties that sustain willingness to pay

undersome circumstances?a controversial

topic of much research. The plausible penalties 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 itabroad unless expected returns are at

least equal to their opportunity cost of funds.

Expected returns are determined in part bythe probability of trouble with the recipi

ents of capital, which in turn is determinedinpart by the availability of penalties. Later

1 return to themotivations of providers,an

underexamined topic.The penalties

are indirect for a number

of reasons. Providers cannot get collateral

because thewhole purpose of the provisionof capital from abroad is to put itwithin the

foreign countrywhere capitals product ishigh

by hypothesis butwhere capital isvulnerable

to therecipients

control.Similarly,

courts

will either not render a judgment against a

sovereign government or their judgmentscannot be enforced. This situation leads to a

qualitative contrast with the recourse often

available against private borrowers within a

lenders owncountry.

Tomz s goal is sorting out which of the

conceivable indirect penalties is operativein the case of financial transfers between

providers of capital (banks and bondholders)

and recipients of capital (the governments ofcountries). He argues that the loss of futureaccess to capital from a loss of reputation for

trustworthiness is determinative. Chapter 1

sets the context, chapter 2 provides his con

ceptualization of how reputation sustains an

equilibrium with positive international lend

ing, and chapters 3 to 5 provide evidence for

the approach.Economists will probably find chapter

2 on thetheory

to be the weakestpart

of

the book. Tomz does not present a preciseabstract formulation of the behavior ofmar

ket participants who pursue objectives in the

face of constraints. His presentation couldhave been greatly improved byan

algebraicstatement of the problem he is addressing.Tomz postulates that there are three typesof recipients of capital: stalwarts (who tend

to service debts in good times and bad),/airweathers (who repay in good times but not

bad), and lemons (who regularly default in

bad times and sometimes in good times).Lenders are said to learn about the type of

aspecific borrower as the borrower responds

to good times and bad. As time passes without 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 goodto know why Tomz does not use a model in

which there is only one type of borrower,one who is always willing to contemplate

repudiation under the right circumstances.

Equilibrium of the lender and borrower is

thendetermined by

the need to ensure that

the penalty of exclusion will be applied to

repudiators in such a way that lenders are

prepared to lend given the incentives of bor

rowers to repudiate. In thisway, one avoids

the artificial hypothesis of inherent types as

exogenous to themodel and can instead tryto

infer how characteristics of the equilibrium,such as the amount of lending and the prob

ability of repudiation,are affected by objec

tive circumstances that can be examined

empirically. Thus the concept of reputation is

replaced by a notion of strategic equilibrium.In any case, there is certainly

alarge relevant

literature of formal models both on interna

tional capital mobility and on game theory,

includingwhen there are more than one typeof player with type at least initially known

only to the player. Tomz even cites some of

these contributions and itwould have helpedthe reader if he could have adapted these

models toincorporate

the features he feels

are special to his approach. Instead, there is

no concept of equilibrium, certainlyno proof








of itsexistence, no comparative analysis. Thus

there is littleof substance in this chapter thatjustifies Tomz in repeatedly referring to itas

"mymodel."

There is also almost no substantive dis

cussion of what determines a type. Does it

have something to do with processes that

would seem morepolitical 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 bycreditors that isolate the country may makelittle 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 arguingthat a revolution or country is under siegefrom foreigners and may benefit from beingable to undermine domestic enemies as

foreign agents or appeasers and consolidate

power. If isolation is desirable, then beingcut off is a benefit not a cost.

Althoughthe

countries of this kind that comeimmediately

tomind do not provide the bulk of recorded

breakdowns between lender and borrower,

they include some prominent cases and there

may be less overt instances as well. Tomz

mentions some of these countries but there

is noanalysis of their situation. A parallel

political economy approach might be to look

atwho within the borrower country benefits

economically from isolation consequent on

sanctions and to ask when the political process is such that these people determine pol

icy.Provoking isolation may not be a Pareto

policy but itmay be the best feasible for these

people given the political system. The typesof borrowers inTomz s discussion, however,

largely remain quite abstract.

Tomz next turns to evidence on the costs

of not fulfilling the terms agreed with credi

tors and he has some really quite interesting

things

to

say.

I think that hispredilection

for

informality serves him better inhis empirical

investigation, which benefits from a creative

eclecticism, whereas itservesbadly inhis con

ceptual discussion, which needsmore

rigorous and focused development. Nonetheless,the empirical discussion could have been

helped by a stronger conceptualization that

would have guided which regularities to look

forand how to interpret them.

Chapter 3 presents statistical evidence

from the eighteenth and nineteenth centu

ries on the rates thatborrowers have paid. He

finds that new entrants generally paid higherrates than seasoned borrowers who had hon

ored their obligations and that these ratesfell if the new borrowers in turn honored

their obligations. He relates the interestingcase of a fictional (and fraudulent) sovereignborrower, Poy?is, which first entered the

London market in 1822 paying the same rate

as a number of South American countries

newly independent of Spain. The informationon its true status took almost a year to leak

toLondon with a consequent collapse in the

valueof

itsdebt.

Chapter 4 examines investment advice

from American and British publications on

the purchase of foreign government bonds

between 1919 and 1929. Tomz identified

four comprehensive bibliographies from this

period and drew a random sample of their

references and then coded the principlesof risk assessment thatwere discussed. He

finds that the predominantconcern was with

repayment history. There was some very sec

ondary consideration given tomilitary intervention as a

possible consequence of failingto honor bond payments but virtually

no

mention of trade sanctions. Tomz addresses

the concern that he is examining opinionsrather than actions by emphasizing that these

publications were meant toprovide advice to

actual or potential bondholders so that the

authors themselves had a reputation tomain

tain for relevance.

Chapter5 looks at the

experienceof bor

rowersduring the interwar period. Of partic

ular interest is the second half of this chapter








that looks at three countries thatmaintained

their payments during the 1930s: Australia,Argentina, and Finland. Here and in chapter7 (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

during the 1930s.

Chapter 6 discusses the role of coercion

of recalcitrant borrower states by the states

of lenders. The upshot of Tomz s examination of the nineteenth century, the sup

posed heyday of gunboat diplomacy, is that

there is virtuallyno 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

incolonies through the arrogation of the

monopoly of force and other governmental functions to the m?tropole. Doubtless,India had much easier access to the London

capital market as part of the British Empirethan itwould have had otherwise and so the

international state structure must surelyhave

something to do with themobility of capital.But Tomz s concern is narrower: the coercion

of an otherwise sovereign state in the inter

ests of its foreign creditors.

The way that Tomz gets to his conclusion about the unimportance of interstate

coercion is perhaps ofmoregeneral interest

than the conclusion itself.He begins withsome evidence from the Correlates ofWar

(COW) dataset. These or similar data are

the rawmaterial ofmany studies in politicaleconomy, such as the literature on civilwars,whether as an explanatory or dependent vari

able. Tomz shows that there is a statistically

significantcorrelation between debt defaults

and military disputes (short ofwar) whether

in a bivariate ormultivariate analysis, the lat

ter controlling forvarious factors thatmake

conflict between two countries more likelyregardless of debt problems.

Tomz thenmoves to discredit these infer

ences from the COW data by showing that

the vast majority of the military disputesoccurred in the middle of long default episodes. As he points out, this finding raises the

questions ofwhy creditor nations waited so

long and, most importantly, ended the mili

tary dispute without resolving the default.

Perhaps the correlations aremisleading. He

then develops thehistorical 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

respondence between British officials and

their aggrieved citizens who lent abroad

showing that the officials repeatedly told the

importuning lenders thatmaking risky loanswas

theirown

lookout. Some British officials,however, did urge governments in default to

take account of the consequences for their

reputations as borrowers, precisely the con

siderations thatTomz stresses. Finally, Tomz

argues that citizens of smaller countries, such

as Switzerland, were active lenders to coun

tries that could not possibly be coerced bythe home countries of the lenders. All in all,I found Tomz sdiscussion tobe a veryworth

while consideration of diverse evidence and

much preferable to a mechanical statistical

analysis of the COW data. This chapter provides a valuable model of how to scrutinize

findings from the COW data using a more

historical approach.

Chapter 7 focuses on the role of trade

sanctions in sustaining international capital movements. Here, Tomz's conclusion

is unambiguously negative?he is a strongdetractor of the position that the potentialfor interference with a

country'strade

provides the incentive for it to service itsdebts.

He begins with a detailed examination of








the Argentine experience during the 1930s

when he finds the threat to future borrowing, not to trade, was operative. Iwas most

impressed by two of his observations. First,

Argentina serviced debts to U.K. and U.S.

lenders equally despite the United States

having little tradewith Argentina and there

fore negligible scope for trade retaliation

at the same time that the Argentine debts

to the United States werelarger and at

worse terms than their debts to the United

Kingdom. Second, asalready mentioned, the

debate among Argentine politicians pivotedon the loss of access to future lending not

trade. The remainder of chapter 7 presents a

broader analysis of debtor-creditor relationsas they relate to the importance of bilateral

trade between the two types of countries

during the 1930s. Tomz's evidence suggeststhat countries that had high trade volumes

with the countries of their lenders and presumed vulnerability to trade disruption

were no morelikely

to servicetheir debtsthan otherwise. Finally, Tomz reports on his

examination of "96,000 scrap book pages" of

newspaper articles maintained by the British

Corporation of Foreign Bondholders from

1870 to 1914. There ismention of trade sanc

tions in only two instances; in neither case

werethey applied.

The penultimate chapter discusses

whether and when lenders are better organized as bondholders or banks. Much of the

literature has placed emphasis on the sup

posed greater cohesion of banks in dealingwith recalcitrant lenders and Tomz does

provide an exhaustive list of reasonswhy

this relative cohesion might be expected.He points out, however, that the petrodollar

lending episode of the 1970s and 1980s was

unique in the predominance of banks as

lenders. This fact suggests that banks' cohesion and, hence, their suitability to dealing

with recalcitrant borrowersmay

not be whataccounts for their prominence in the petrodollar period because this factor also should

have applied at other times when banks did

not, however, predominate. Instead, Tomzargues 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 topoint out that, duringthis period, bank lending to foreign govern

ments enjoyed special advantages from U.S.

foreign tax credits. Sovereign borrowers paidinterest to banks as

though itwere net of the

borrower country's taxes, thereby generating

potentially huge tax credits to shelter banks'incomes from other sources from U.S. taxes.

The U.S. tax code subsequently became less

favorable. Tomz also argues that the mone

tary authorities in the countries of the lenders

implicitly guaranteed bank loans.

The favorable climate forbank lending at

this time also included explicit government

guarantees thatTomz does not, however, dis

cuss, for instance from the Export-Import

Bank of theUnited States. This storyof explicitguarantees has yet tobe toldbut hints of itcan

be found in data when acountry's liabilities

are broken out bywhether they are owed to

private or public lenders. Thus one can see

in the case of countries thatwerereported in

thepress as nonpayers that subsequently their

liabilities to private creditors fellwhile thoseto public creditors rose. Such a reallocation

most likelydoes not represent the repaymentof debts by the sovereign borrower toprivatelenders coincidentally offsetby a rise indebtsto public lenders. Instead, therewas a direct

transfer from the public entity in the lender's

country that has guaranteed the debts to the

private lender as the guarantee was invoked

leading to a change in the identity of the

claimant on the borrower without, however,

any direct involvement of the sovereign borrowerwhose liabilitieswere reallocated.

Of course, as I write in the fall of 2008,financial manias and bailouts are

uppermost in everyone's mind, and it raises the

issue much mooted in the 1970s and 1980s








about banks' internal controls and incen

tivesjust prior

to the LDC Debt Crisis of

the 1980s?the problem of themanagementrun financial institution.When outcomes are

realized significantly after loans are made, it

ispossible forbank managers, who benefit via

promotions and bonuses from such activities

as sovereign orsubprime-mortgage lending,

to argue that skeptical commentators (and

responsible regulators, ifany exist) are alarm

ists,that everythingwill be alright, and that in

themeantime themanagers of banks should

be richly rewarded for their perspicacity.Hence, we have Walter Wriston s (in)famous

aphorism that countries do not go bankrupt.

Unfortunately formany people, he did not

follow this statement by themore importantrealization that this fact is not good

news

for lenders because countries can stop, have

stopped, and probably will stop paying even

without going bankrupt. A full explanation of

thisepisode

ofpetrodollar lending

followed

by defaults seems to need attention to the

complexities of the lenders' incentives, more

than ithas 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 themanagerial bank.

In general, I found this book to be schol

arly and insightful,a

probing effort to seek

further understanding. And by theway, the

book has an excellent reference list. I learned

from reading it and I feel others who areinterested in international capital mobility

will aswell.

References

Ricardo, David. 2005.Principles of Political Econ

omy and Taxation. Savage, Md.: Barnes and Noble

Books.

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