Reputation and International Cooperation: Sovereign Debt across Three Centuries

By Michael Tomz

How does cooperation emerge in a condition of international anarchy? Michael Tomz sheds new light on this fundamental question through a study of international debt across three centuries. Tomz develops a reputational theory of cooperation between sovereign governments and foreign investors. He explains how governments acquire reputations in the eyes of investors, and argues that concerns about reputation sustain international lending and repayment.


Tomz's theory generates novel predictions about the dynamics of cooperation: how investors treat first-time borrowers, how access to credit evolves as debtors become more seasoned, and how countries ascend and descend the reputational ladder by acting contrary to investors' expectations. Tomz systematically tests his theory and the leading alternatives across three centuries of financial history. His remarkable data, gathered from archives in nine countries, cover all sovereign borrowers. He deftly combines statistical methods, case studies, and content analysis to scrutinize theories from as many angles as possible.


Tomz finds strong support for his reputational theory while challenging prevailing views about sovereign debt. His pathbreaking study shows that, across the centuries, reputations have guided lending and repayment in consistent ways. Moreover, Tomz uncovers surprisingly little evidence of punitive enforcement strategies. Creditors have not compelled borrowers to repay by threatening military retaliation, imposing trade sanctions, or colluding to deprive defaulters of future loans. He concludes by highlighting the implications of his reputational logic for areas beyond sovereign debt, further advancing our understanding of the puzzle of cooperation under anarchy.

• Language: English
• Publisher: Princeton University Press
• Release date: Jan 9, 2012
• ISBN: 9781400842926

Michael Tomz

Michael Tomz is assistant professor of political science at Stanford University.

Book preview

REPUTATION AND INTERNATIONAL COOPERATION

REPUTATION AND INTERNATIONAL COOPERATION

SOVEREIGN DEBT ACROSS

THREE CENTURIES

Michael Tomz

PRINCETON UNIVERSITY PRESS PRINCETON AND OXFORD

Copyright © 2007 by Princeton University Press

Published by Princeton University Press, 41 William Street,

Princeton, New Jersey 08540

In the United Kingdom: Princeton University Press, 3 Market Place,

Woodstock, Oxfordshire OX20 1SY

All Rights Reserved

Library of Congress Cataloging-in-Publication Data

Tomz, Michael.

Reputation and international cooperation : sovereign debt across three centuries / Michael Tomz.

p. cm.

Includes bibliographical references and index.

ISBN-13: 978-0-691-12930-3 (cloth : alk. paper)

ISBN-13: 978-0-691-12469-7 (pbk : alk. paper)

1. Debts, External—History. 2. Debtor and creditor—History. I. Title.

HG3891.5.T66 2007

336.3′43509——dc22        2007005573

British Library Cataloging-in-Publication Data is available

This book has been composed in Sabon

Printed on acid-free paper. ∞

press.princeton.edu

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

To Julie, Emily, Anna, and David

Contents

Tables

Figures

Preface

MY INTEREST in reputation and international cooperation began years ago, at Oxford, where I was studying for a master’s degree in political philosophy. There, on the idyllic grounds of Magdalen College, I read Thomas Hobbes’s Leviathan cover-to-cover for the first time. In a passage I found particularly intriguing, Hobbes argues that it is rational to keep promises even when there is no external enforcement. The argument unfolds in response to a character called the Fool, who challenges Hobbes to explain why one could not benefit by violating agreements in the state of nature, where no common power exists.

Hobbes’s answer to the Fool emphasizes the reputational consequences of reneging. According to Hobbes, no one can defend himself from destruction without the help of confederates. A person who breaks covenants, he warns, can expect no other means of safety than what can be had from his own single power. He … cannot be received into any society that unite themselves for peace and defense but by the error of them that receive him; nor when he is received, be retained in it without seeing the danger of their error.

Hobbes’s reply to the Fool stimulated me to reflect on many fascinating questions about reputation. How, exactly, do people form beliefs about the reliability of others, and under what conditions can people violate agreements at little or no reputational cost? Do concerns about reputation really sustain cooperation in the absence of a Leviathan? If so, need anarchy imply a solitary, poor, nasty, brutish, and short existence, as suggested by Hobbes in the most famous line of the book? How does the logic of reputation, which Hobbes applied to individuals in the state of nature, influence behavior in another anarchical setting, international relations? And what practical lessons can one draw to increase the likelihood of international cooperation?

In the years since I first encountered Leviathan, many other great books—and great scholars—have shaped my thinking about reputation and international cooperation. Two early and important influences were Robert Axelrod’s Evolution of Cooperation and Robert Keohane’s After Hegemony. Axelrod’s book taught me how repeated interaction could contribute to cooperation under anarchy; Keohane’s research demonstrated how much one can learn about international relations by focusing on problems of incomplete information. My theory of reputation, which involves ongoing interaction with informational asymmetries, builds upon the fundamental insights of these scholars and the vast literatures they spawned.

Jeff Frieden inspired me to study the issue of international debt, and to view it as a vehicle for understanding cooperation more generally. Through seminars and discussions when I was a Ph.D. student at Harvard, Jeff introduced me to the puzzle of international lending under anarchy. He exposed me to classic and cutting-edge research about debt by economists, historians, and political scientists. His own work, his enthusiasm for international finance, and his faith in the potential for scientific discovery were inspirations for this book.

The book is organized in nine chapters. In chapter 1, I lay out the core puzzle: without a global Leviathan to enforce contracts, why do private investors ever lend money abroad, and why do foreign governments ever repay? Chapter 2 then proposes a solution, a reputational theory of cooperation between sovereign debtors and foreign creditors. I test my theory and the leading alternatives in chapters 3–8, using newly collected data that cover all sovereign debtors over the last three centuries. Having found strong support for the reputational theory, I conclude in chapter 9 by summarizing the findings and discussing their implications, not only for debt, but also for the wider problem of cooperation under anarchy.

As I researched the subject of international debt, I incurred many international debts of my own. Data for this book came from archives and libraries in nine countries on three continents. It is my pleasure to acknowledge the many colleagues around the world who helped make this book possible. If I have failed to mention anyone who deserves thanks, I hope he or she will recognize the oversight as unintentional and not give me a reputation as an ungrateful type!

In Argentina, special thanks go to Mariano Tommasi for hosting me at the Universidad de San Andrés; to Marta Gutierrez for helping me at Biblioteca Tornquist; to Wenceslao Bunge for sharing his home; and to Luis Lavagna, Roberto Lavagna, and Gisela Sin for their advice and friendship. Robert Barros, Alejandro Catterberg, Isidoro Cheresky, Roberto Cortés Conde, Gerardo della Paolera, Carlos Fara, Roy Hora, and other academics in Argentina contributed their keen insights to this project. I met Alan Taylor during one of my research trips to Buenos Aires and have learned much from him over the years.

Many professionals in the United Kingdom assisted my research. I am especially grateful to Henry Gillett at the Bank of England Archives, and to the staff at Guildhall Library for providing access to the records of the Corporation of Foreign Bondholders. Specialists at the British Newspaper Library in Colindale, the National Archive in Kew, and the University of Glasgow were indispensable for my research. Finally, warm gratitude goes to Graham Ingham for arranging accommodations during one of my visits and—when the archives were closed—joining me on the tennis courts.

In Belgium, I could not have asked for a more generous colleague than Frans Buelens at the StudieCentrum voor Onderneming en Beurs, Universiteit Antwerpen. Frans pointed me to all the essential sources, and he shared unpublished data about foreign bonds on the Brussels stock exchange. Many Belgian librarians kindly and efficiently assisted with my research, especially Rudi De Groot at Katholieke Universiteit Leuven, Anke Jacobs at Universiteit Antwerpen, and Anne Lefèvre at Université Libre de Bruxelles.

For insight into French foreign investments, I owe the most to Marc Flandreau at the Institut d’Études Politiques de Paris. Marc shared his working papers and data, and he indicated where to find key pieces of information. I thank Robin Kraft and Leï Lacoste for their persistence in tracking down a complete collection of the Cours authentique at the Archive historique de la Bourse de Paris auprès de Euronext de Paris, and for sending the digital images I needed to construct an inventory of sovereign bonds on the Paris stock exchange.

Data from Germany were obtained through the good graces of numerous archivists, including Frank Berger at the Historisches Museum Frankfurt a.M.; Susanne Brockfeld at the Geheimes Staatsarchiv Preußischer Kulturbesitz in Berlin; Iris Erdmann at the Universitätsbibliothek Gießen; and Sylvia Goldhammer and Sigrid Kämpfer at the Institut für Stadtgeschichte Frankfurt a.M. Using the Stanford Overseas Studies Center in Germany as a base, Adele Faure and Danielle Lostaunau made many trips on my behalf to the Staatsbibliothek zu Berlin and the Zentral- und Landesbibliothek Berlin. I thank them all for their assistance in documenting the role Germany played in international finance before World War I.

Immense gratitude goes to Joost Jonker and Nico van Horn of Utrecht University in the Netherlands. Joost and Nico scoured the Dutch archives to compile the inventory of eighteenth-century loans analyzed in chapter 3. Guy Monod de Froideville sent stacks of stock market price sheets from the library of the Universiteit van Amsterdam. Additional data about Dutch finance came from a seemingly unlikely source, Spain. I thank José María Burrieza Mateos at the Archivo General de Simancas for his help with Spanish diplomatic reports about Dutch finance in the eighteenth century.

The analysis in chapter 6 would not have been possible without the help of many archivists in Switzerland. There, as in Germany, data were scattered across many financial centers. For their help in assembling a relatively complete picture of Swiss lending before World War I, I thank Blandine Blukacz-Louisfert at the Bibliothèque de l’Office des Nations Unies in Geneva; Ulrike Brill at the Bibliothek für Betriebswirtschaft / Zentrale für Wirtschaftsdokumentation, Universität Zürich; Barbara Plaschy at the Schweizerische Landesbibliothek in Bern; Alexis Rivier at the Bibliothèque de Genève; and Matthias Wiesmann at the Schweizerisches Wirtschaftsarchiv, Universität Basel. Halfway around the globe, in New Zealand, Lyndon Moore at Victoria University of Wellington introduced me to the Zürich Kursblatt and provided digital samples from his private collection.

This book also draws extensively on archival and library collections from the United States. Although I cannot list all who helped, I want to single out Joe Puccio and Ronald Roaché at the Library of Congress for putting hundreds of books on advance reserve for my research trips to Washington, DC. I am equally grateful to John Petty and Richard Dine for granting access to the manuscripts of the Foreign Bondholders Protective Council. At the time, the trove was stored in an unheated, barely-lit warehouse in Flatbush, New York. Stanford Library curator Tony Angiletta took pity and relocated the files to Palo Alto. Today, the manuscripts reside in the special collections at Stanford, where they are available to any scholar with a passion for international economic history.

Other librarians at Stanford went above and beyond the call of duty to make this project possible. Stanford, founded only in 1891, did not have all the books and journals I needed for a project about sovereign debt since the 1700s. Interlibrary borrowing specialist Mary Munill solved my problem. Mary efficiently filled hundreds of requests for texts from around the globe. For my most audacious interlibrary needs, such as complete runs of Der Aktionär, the Frankfurter Zeitung, L’Economiste français, and Saling’s Börsen-Jahrbuch, I turned to Rose Harrington, who always found ways to bring the material to Stanford.

The Stanford library generously purchased historical material for this project. Sarah Sussman acquired copies of key texts from Bibliothèque nationale de France, and Tony Angiletta added to the Stanford collection a microfilm edition of the Newspaper Cuttings Files of the Corporation of Foreign Bondholders. Tony also purchased the Corporation’s annual reports from a used bookseller in London, stripped the bindings, and digitized the pages, making them full-text searchable on the Internet for me and other scholars.

For their unmatched skill in locating foreign documents, and for accommodating my numerous requests, I thank Stanford librarians Chuck Eckman, Eric Heath, and Joan Loftus. I am also grateful for the assistance of Assunta Pisani and Ben Stone at Stanford’s Green Library, Steven Mandeville-Gamble in Special Collections, and Peter Latusek and Paul Reist in the library at the Graduate School of Business. I maintain a digital archive of all documents—primary and secondary—related to my research. The material cited in this book is, therefore, available to me at the click of a mouse. For advice about how to build this research archive, I am especially grateful to Steve Chapman, Preservation Librarian for Digital Initiatives at Harvard, and Stu Snydman, Manager of Digital Production Services at the Stanford Libraries.

Several scholars graciously shared data from their own research projects. Peter Lindert sent computer and paper records from his seminal work with Peter Morton; Barry Eichengreen supplied unpublished appendices from his articles with Richard Portes; Nathan Sussman and Yishay Yafeh granted permission to use their dataset of Japanese bond yields; and William Goetzmann and K. Geert Rouwenhorst made available electronic copies of the Investor’s Monthly Manual. Scott Bennett unearthed a box of notecards containing bibliographic citations for the Correlates of War Militarized Interstate Disputes. The citations were an essential starting point for the research in chapter 6. Mario Boone and Jerry Raymond kindly provided digital images of historical government bonds, some of which appear on the cover of the book. Finally, Richard Gregg sent a full-size color photocopy of the infamous Poyaisian bond of 1822. Issued by Scottish con-man Gregor MacGregor on behalf of the fictitious Latin American country of Poyais, the bond hangs on my office wall as a testament to the lemons problem in nineteenth-century international finance.

An extraordinary group of Stanford Ph.D. students contributed to data collection and analysis for this project. I thank Catherine Duggan for working with me to compile a database of loans, debt defaults, and settlements between 1820 and 1914. Catherine reconciled seemingly contradictory pieces of evidence and helped me see important patterns in the data. This project owes much to her intelligence, diligence, and efficiency. My research on Germany would not have been possible without the aid of Carlos Starmanns and Thomas Brambor, who located and analyzed key German sources, many in Gothic script. Kimuli Kasara, Jeongah Kim, Moonhawk Kim, Maggie Peters, Julia Tobias, and Jessica Weeks made significant contributions as well.

I also want to acknowledge the talented Stanford undergraduates who logged countless hours exploring the topics of reputation and debt with me. Over three summers, a team of researchers read and hand-coded more than 96,000 pages from the Newspaper Cuttings Files of the Corporation of Foreign Bondholders. Participants in this prodigious effort included Kasey Alderete, Parilee Edison, Adele Faure, Emily Fenner, Victoria Gevlin, Eugenie Kim, John Kryzwicki, Jeff Lee, Brendan Marten, Milessa Muchmore, Carly Schuster, Sok Tea, and Lauren Young. For superb assistance with other aspects of this project, I thank Nicole Bonoff, Mallory Bounds, Jason Chen, Chris Couvelier, Jozefina Cutura, Summer Jackson, Gaby Kohan, Michelle Leeds, Christopher Lin, Jennifer Martínez, Julia Martínez, Oriana Mastro, Justin Mates, Theo Milonopoulos, Allison Reid, and Christina Riechers.

Finally, I acknowledge the highly competent and professional department administrators who have helped with this project: Hilary Anderson, Sarah Holmes, Angelita Mireles, Marie Toney, Eliana Vásquez, and my good friend Jackie Sargent.

Many mentors, colleagues, and friends commented on early drafts of the manuscript. This project began at Harvard, where I could not have asked for a better set of doctoral advisors. Jeff Frieden challenged and encouraged me at every step in the research process. His analytical rigor and encyclopedic knowledge contributed greatly to my analysis. Jorge Domínguez provided incisive criticisms and offered professional and personal advice when I needed it most. Gary King taught me much of what I know about political methodology and showed me how scientific research should be done. Lisa Martin constantly compelled me to deepen and clarify my ideas, especially about strategic interaction in world politics.

Colleagues in the Department of Political Science at Stanford generously donated their time and talent to this project. Nearly all assisted in some way. I especially want to thank Jim Fearon, Steve Haber, Simon Jackman, Steve Krasner, David Laitin, Isabela Mares, Scott Sagan, Ken Schultz, Jonathan Wand, and Barry Weingast. Judy Goldstein has been a fabulous mentor and collaborator throughout my time at Stanford. Finally, Paul Sniderman has set an unparalleled standard for collegiality. Although working in a different field of political science, Paul commented on many chapters and provided wise counsel during the review and publication process. I count him among my closest colleagues, and I view his career of scientific discovery as worthy of emulation.

I have also learned a great deal from faculty in other parts of the university. Current and former members of the Department of Economics and the Graduate School of Business helped me think about the theoretical and empirical issues raised in this book. Above all, I thank Mark Wright for numerous conversations about sovereign debt. By providing astute comments at a moment’s notice, sharing insights from his own research, and collaborating with me on related projects, Mark greatly influenced this book. I am also grateful to Stanford economists Jeremy Bulow, Avner Greif, Peter Henry, Nick Hope, Jon Levin, Ron McKinnon, Steve Tadelis, and Gavin Wright, and to Stanford historian Zephyr Frank. I had the good fortune of meeting Ken Kletzer when he was a visiting professor at Stanford, and I appreciate all he taught me during his time in residence.

I am a bit awed by the number of people beyond Stanford who discussed this research with me or took the time to answer my email queries. I sincerely thank, among others, Jeremy Adelman, Vinnie Aggarwal, Leslie Elliot Armijo, Christina Arellano, Andrew Bailey, Michael Bailey, David Bearce, Bill Bernhard, Luis Bértola, Michael Bordo, Ted Brader, Lee Buchheit, Josh Busby, Marc Busch, Forrest Capie, Luis Catão, Kanchan Chandra, Bill Clark, John Coatsworth, Christina Davis, Sarah Dix, Jorge Domínguez, Jonathan Eaton, Barry Eichengreen, Drew Erdmann, Rui Esteves, Carolyn Evans, Niall Ferguson, Martha Finnemore, Marc Flandreau, Caroline Fohlin, Page Fortna, John Freeman, Jeff Frieden, Márcio Garcia, Kristian Gleditsch, Jeff Glueck, Erica Gould, Joanne Gowa, Richard Grossman, Andrew Guzman, Galina Hale, Jude Hayes, Mike Hiscox, Mala Htun, Jacques Hymans, Nate Jensen, Bob Jervis, Joost Jonker, Miles Kahler, Devesh Kapur, Trish Kelly, Barbara Keys, Gary King, Ken Kletzer, Peter Koudijs, Pedro Lains, David Lake, David Leblang, Peter Lindert, Charles Lipson, Aaron Lobel, Carlos Marichal, Lisa Martin, Noel Mauer, Paolo Mauro, Sylvia Maxfield, Chris Meissner, Jon Mercer, Helen Milner, Diego Miranda, Ron Mitchell, Kris Mitchener, Ashoka Mody, Andy Moravcsik, Layna Mosley, Aldo Musacchio, Mark Nagel, Larry Neal, Vikram Nehru, John Oneal, Kathleen O’Neill, Barry O’Neill, Ken Oye, Şule Özler, Manuel Pastor, Lou Pauly, Pablo Pinto, Alejandro Poire, Daryl Press, Dennis Quinn, Eric Rasmusen, Rose Razaghian, Eric Reinhardt, James Riley, Albrecht Ritschl, Hugh Rockoff, Ron Rogowski, Andrew Rose, Peter Rosendorff, Bruce Russett, Sebastian Saiegh, Dick Salvucci, Javier Santiso, Anne Sartori, Shanker Satyanath, Ken Scheve, Gene Sessions, Beth Simmons, Alastair Smith, Duncan Snidal, Jack Snyder, David Stasavage, Randy Stone, Bill Summerhill, Nathan Sussman, Richard Sylla, Alan Taylor, Dan Treisman, Josh Tucker, Rob Van Houweling, Catalina Vizcarra, Jim Vreeland, Jessica Seddon Wallack, John Wallis, Barbara Walter, Marc Weidenmier, Tom Willett, Jason Wittenberg, Yishay Yafeh, and Jeromin Zettelmeyer. For detailed and helpful comments on the penultimate draft of the book, I am grateful to Tim Büthe, Lawrence Broz, and Bob Keohane. Bob also suggested the title of the book.

Parts of this book were presented at seminars and conventions across the country, and at the Stanford conference on Sovereign Debt and Latin America, funded through the generosity of Steve Haber and the Social Science History Institute. Paolo Mauro invited me to convey the key findings in a seminar at the International Monetary Fund, and then sponsored me as a visitor in the IMF Research Department. Mark Wright hosted me at the Federal Reserve Bank of Minneapolis, where I discussed my work with many fine economists. I am grateful for the comments I received from audience members at all these forums.

As this project was coming to a conclusion in fall 2006, several students at Stanford read and commented on the entire manuscript. I am especially grateful to Jessica Weeks for reviewing multiple drafts. Her brilliant analytical and writing skills improved every page of the book. Just when I thought the manuscript was done, Maggie Peters’s comments led me to rewrite chapter 2, and Bethany Lacina’s advice led me to remake several tables and figures. Ed Bruera, Luke Condra, Adele Faure, Laurel Harbridge, Brendan Marten, and Lauren Young also scrutinized the manuscript and assisted with the revisions. It is humbling and rewarding to learn so much from one’s own students, even at the seemingly final stages of a research project.

Many institutions invested in my research. For financial support as a Ph.D. student at Harvard, I thank the David Rockefeller Center for Latin American Studies; the Harvard Business School; the MacArthur Foundation; the Mellon Foundation; the National Science Foundation; the Institute for the Study of World Politics; the Social Science Research Council; the Tinker Foundation; and the Weatherhead Center for International Affairs. As an assistant professor at Stanford, I received generous grants from the Freeman Spogli Institute for International Studies; the National Science Foundation (CAREER Grant SES-0548285); the Office of Technology Licensing; the Social Science History Institute; the Stanford Center for International Development; the Stanford Center for Latin American Studies; the Stanford Institute for the Quantitative Study of Society; and the Vice Provost for Undergraduate Education.

This book was completed during the 2006–7 academic year, when I was a Fellow at the Center for Advanced Study in the Behavioral Sciences. For funding that stimulating and productive year, I thank not only CASBS but also the Freeman Spogli Institute for International Studies, the Howard Foundation, and the Stanford Institute for Research in the Social Sciences. All these organizations helped bring this book to fruition.

It has been a pleasure to work with Chuck Myers and his colleagues at Princeton University Press. Chuck’s suggestions greatly improved the manuscript, and his enthusiasm propelled the project to completion. Richard Isomaki copyedited the book, Tobiah Waldron helped prepare the index, and Mark Bellis and Meera Vaidyanathan professionally superintended the production process.

I am grateful to my parents, Robert and Jane Tomz, for supporting my interest in international affairs. They encouraged me to participate in high school debate and foreign extemporaneous speaking, through which I first learned about world politics and gained research skills that serve me today. At family gatherings, they often asked about my work, leading me to search for ways to communicate my hypotheses and findings to nonspecialists. They have my heartfelt thanks for so much encouragement and love.

This book is dedicated to my wife and our three young children. Julie has been by my side throughout the project, which required many late nights and trips away from home. I am eternally grateful for her patience, support, good humor, and love. Emily, Anna, and David became part of our family during this project, and they have brought excitement and joy to our lives every day. I hope they will grow to appreciate research and discovery as much as I do. And I hope someday, when they are old enough to read the book, they will think it has contributed to a better understanding of cooperation in our world.

REPUTATION AND INTERNATIONAL COOPERATION

Part I

THEORY

Chapter 1

The Puzzle of Cooperation in International Debt

EVERY DAY, LEADERS make promises to foreign governments and nonstate actors. They pledge to repay debts, supply foreign aid, curtail pollution, and limit their military arsenals. Leaders vow to lower barriers to international trade and capital, respect human rights at home, and promote democracy abroad. In principle, these commitments—some formal, some not—regulate how governments behave in world affairs.

Without a world government to enforce commitments, though, why should anyone take foreign leaders at their word? The answer is far from obvious. Some international agreements so clearly serve the interests of participants that defection would be unthinkable. Often, however, cheating would give the transgressor an immediate economic windfall, a military advantage, or a firmer grip on power at home. Moreover, the anarchical nature of world politics makes third-party enforcement of commitments unlikely. In this context, neither scholars nor political leaders can take international promise-keeping for granted.

This book examines one of the oldest and most pervasive types of international promises: debt contracts between sovereign governments and private foreign lenders. For centuries, bondholders and banks have lent money to foreign governments for a variety of objectives, including economic development, military procurement, and domestic consumption. The practice continues to this day. Private bondholders and banks now advance more than $100 billion per year to foreign governments around the world.¹

International debt contracts raise serious problems of credibility. When a government borrows money on world capital markets, it pledges to repay the principal plus interest and fees according to a schedule in the loan agreement. After creditors disburse the funds, though, the government may be tempted to break its promise by refusing to make full and punctual installments. The government can suspend interest payments, slow the rate of amortization, or—even worse—repudiate the debt, thereby denouncing the obligation as illegitimate.

History abounds with examples of default on international loans. In January 2002 the Argentine administration stopped servicing roughly $100 billion in foreign bonds, triggering the largest default of all time. Its decision, though unprecedented in magnitude, represents only one entry in a litany of defaults by governments over the past few centuries. In a typical year, approximately 10 percent of governments fail to meet contractual obligations to foreign bondholders and commercial banks, and during systemic crises such as the Great Depression, nearly half the countries in the world have been in arrears on their international debts.²

Considering the inherent problem of credibility in world affairs, and given numerous cases of default throughout history, what gives bondholders and banks the confidence to lend money to foreign governments? Furthermore, why do governments ever repay their debts to private lenders in distant countries? There is, of course, a deep puzzle here—arguably one of the deepest in the study of politics: how does cooperation emerge in a condition of anarchy? The remainder of the book addresses this question in the context of international debt.

The Puzzle

The literature on international relations offers two major perspectives about how credibility and cooperation can be sustained in an anarchical world. The first is repeat play, in which leaders cooperate today to ensure good relations in the future. The second is issue linkage, the process of connecting behavior in one area to the threat of sanctions in another. Both provide substantial insights into world politics, but neither—without amendment—adequately accounts for historical patterns of behavior in international finance. After noting the strengths and weaknesses of these approaches as applied to international debt, I propose a reputational theory that builds on models of repeat play but modifies them by conjoining two key features: incomplete information and political change. I then show, using three centuries of data from international capital markets, that this reputational theory offers new insight into relations between debtors and creditors.

Repeat Play

One of the most fertile lines of research in international relations concerns the effects of repeat play. Using game theory, political scientists and economists have demonstrated that cooperation can arise from the threat of retaliation in ongoing relationships.³ If two parties interact repeatedly with one another, each could retaliate tomorrow in response to uncooperative behavior today. The most severe retaliatory strategy is the grim trigger: Cross me once and I will never cooperate with you again. A more forgiving strategy, tit-for-tat, requires players to mimic their opponents by matching each act of cooperation with cooperation and punishing each instance of defection by striking back once. Many other strategies could achieve the same objective of punishing cheaters in the future.

When the threat of retaliation is sufficiently plausible and severe, it can support cooperation even in the absence of third-party enforcement. As Robert Axelrod explains, the future can cast a shadow back upon the present and thereby affect the current strategic situation.⁴ Leaders who care enough about the future will calculate that the costs of forgoing cooperation tomorrow outweigh the immediate gains from behaving selfishly today.

It is easy to see how this logic could motivate governments to repay and give investors the confidence to lend. Most countries need to borrow not once but repeatedly to meet ongoing demands for economic development, national defense, and domestic consumption. Investors could, therefore, adopt a history-contingent strategy: penalize countries that default by barring them from new loans or by charging higher interest rates in subsequent years. Faced with this retributive strategy, credit-hungry governments would have powerful incentives to honor their debts, and investors could advance money with reasonable assurance of being repaid.⁵

Does existing research support the repeat-play theory? Surprisingly, the answer appears to be no. In their study of sovereign debt since the 1850s, Peter Lindert and Peter Morton conclude that investors seem to pay little attention to the past repayment record of the borrowing governments. … [T]hey do not punish governments with a prior default history, undercutting the belief in a penalty that compels faithful repayment.⁶ Other scholars, focusing on different time periods, have reached similar conclusions. Cardoso and Dornbusch, Eichengreen and Portes, and Jorgensen and Sachs note, for example, that countries that fell into arrears during the Great Depression did not subsequently receive worse terms of credit than countries that had paid in full.⁷ One major study by Özler finds that countries with histories of repayment difficulties were charged higher interest rates during the period 1968–81, but even then the default premiums were remarkably small.⁸ The prevailing interpretation of history, it seems, is that international creditors ignore history!

How have scholars explained investors’ apparent inattention to history? Some cite ignorance. Vinod Aggarwal opens his massive study of debt rescheduling by contending that almost without exception, modern bankers have made mistakes as a result of their unfamiliarity with the turbulent history of international lending. Few lenders in the 1970s, for example, knew that sovereign countries had frequently defaulted on their debt payments in the past.⁹ Others blame irrational exuberance: investors have been drawn into speculative manias and, without systematically weighing the consequences, have lent even to countries with records of default.¹⁰ Whatever the reason, the received wisdom casts serious doubt on the use of history-contingent strategies to enforce debt contracts.

The repeat-play argument seems problematic not only in practice but also in theory. To bar a defaulter from capital markets or force it to pay higher interest rates, an aggrieved creditor would need the cooperation of most—if not all—current and future lenders around the world. Why, though, would profit-seeking bondholders and banks collaborate in punishing a government for defaulting on someone else’s loans? The notion of retribution seems especially problematic because, for most of financial history, loans came from tens of thousands of scattered investors who probably could not have coalesced into a punishment cartel. Without extensive cooperation among creditors, the threat of punishment may not be credible. Ironically, the repeat-play argument may solve one credibility problem by creating another.¹¹

We are, therefore, left with a puzzle. If existing research is correct in concluding that creditors ignore history, and if even retribution-minded creditors would face severe problems in organizing collective punishment, why do sovereign governments ever repay their debts? Perhaps even more troublesome, what inspires investors to lend billions of dollars to governments each year, if not the ability to withhold credit in an ongoing lending relationship? A second possibility is issue linkage.

Issue Linkage

In a complex and interdependent world, countries and nonstate actors can enforce agreements by linking issues, that is, by threatening to retaliate in one area of world affairs if foreigners behave selfishly in another.¹² Actors might, for example, sever economic relations with countries that violate arms control agreements or apply military pressure against parties that fail to respect human rights. Provided the links between issues are credible, leaders will think twice before crossing foreigners, since the gain from cheating on one issue may be outweighed by the loss of cooperation on another.

This insight, so central to international relations theory, may explain how debt contracts have been enforced for centuries. On their own or with help from their home government, banks and bondholders could impose nonfinancial penalties on countries that default. Charles Lipson usefully refers to this kind of retaliation as an extrinsic sanction because it involves punishment on an issue distinct from the one that sparked the dispute.¹³ In contrast, the repeat-play strategy of withholding access to capital is an intrinsic sanction because creditors strike back in the same issue area in which the borrower cheated in the first place.

Creditors could impose various extrinsic sanctions on defaulters. One option is military intervention. The idea