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“Screening and Sanctioning in International Finance”

Chapter 1 of Sovereign Debt and International Cooperation:

Reputational Reasons for Lending and Repayment

Michael Tomz Stanford University

I am grateful for comments from Kanchan Chandra, Jorge Domínguez, Drew Erdmann, Jeffry Frieden, Barbara Keys, Gary King, Lisa Martin, Kathleen O'Neill, Ken Scheve, and Josh Tucker. This research was supported by grants from the Social Science Research Council and the Weatherhead Center for International Affairs at Harvard.

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Chapter One Screening and Sanctioning in International Finance

This chapter challenges standard views about how cooperation emerges between sovereign debtors and foreign creditors. According to the conventional wisdom, governments honor their debts to avoid retaliation by creditors and third parties. This process of sanctioning suffers from a credibility deficit, however: profit-seeking bondholders and banks would prefer not to carry out their retaliatory threats. As an alternative, I suggest that cooperation arises through screening: governments service their debts to build a reputation for reliability, which will help them attract future loans. I propose a model of screening and show how it overcomes problems of credibility that are endemic to sanctioning models. I also identify more than a dozen ways in which the models yield distinctive patterns of behavior, thereby setting the stage for a battery of empirical tests that will occupy the next two chapters. The chapter, which represents approximately one-fourth of the book manuscript, has the following structure. 1. Cooperation through Screening

1.1 Bayesian Learning 1.2 Learning across Administrations 1.3 Learning across Space 1.4 Effects on the Incentives of Investors 1.5 Effects on the Incentives of Governments 1.6 An Alternative Theory of Reputation

2. Cooperation through Sanctioning

2.1 How Sanctioning Differs from Screening 2.2 The Credibility of a Credit Embargo

2.2.1 Would Other Lenders Participate? 2.2.2 Would the Original Lender Impose an Embargo?

2.3 The Credibility of Trade Sanctions and Other Linkages 2.4 Implications for Sanctioning and Screening

3. Competing Hypotheses 4. Works Cited

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How do nations cooperate without the aid of a central government that penalizes parties for breaking promises and engaging in other selfish behavior? Two mechanisms seem plausible. The first mechanism is screening, a process of learning about the unobserved characteristics of governments and sorting them according to perceptions of reliability. In this process, a government that breaks its commitments may signal that it cannot be trusted and acquire the reputation of a "lemon”: an administration that apparently lacks the resolve or competence to uphold its promises to foreigners. Provided that leaders care enough about the future, the fear of being labeled as lemon and screened-out of international agreements can foster cooperation, even in the absence of a central authority. The second mechanism is sanctioning, in which actors enforce cooperation among themselves by threatening to retaliate against parties that behave opportunistically. If the threat of retaliation is credible and severe enough, it could deter governments from exploiting others, thereby sustaining cooperation in a decentralized world.

Under both mechanisms a government incurs costs for refusing to cooperate, but the costs

arise for fundamentally different reasons. Screening-minded policymakers are prospective: in the context of incomplete information, they use the compliance record of a foreign government to draw conclusions about resolve, competence, and other characteristics that would be difficult to measure directly. Based on this information, they forecast how the government might behave in the future and decide whether a cooperative overture would be profitable or foolhardy. In contrast, sanction-minded decision makers are retrospective: with relatively complete information about their partners, they simply retaliate against any breach of contract. History clearly plays a different role in these two stories. With screening, history serves as a source of data about the debtor; under sanctioning, it is a trigger for actors to carry out their retaliatory threats. This chapter specifies how these two mechanisms operate and indicates when one dominates the other.

Through an analysis of debtor-creditor relations, I argue that cooperation emerges mainly

through screening, rather than sanctioning. My argument proceeds in three steps. First, I propose a model of screening, in which debtors and creditors interact under conditions of incomplete information. My model explains how governments acquire reputations in the eyes of international lenders, and it suggests how reputation-building can account for patterns of repayment and default. Second, I show that existing models of the sanctioning process suffer from a credibility deficit: profit-seeking bondholders and banks generally would not collaborate in punishing a government for defaulting on someone else’s loans, and even the original lender would prefer not to carry out its threats. My screening model overcomes this deficit, since neither third parties nor the original creditor has incentives to offer new loans to a reputed lemon. Third, I indicate that the two approaches are observationally distinct, thereby setting the stage for a battery of empirical tests that will occupy the rest of the book.

1. Cooperation through Screening

My analysis of the screening model begins by considering international finance from the perspective of private bondholders and commercial banks that lend money to foreign governments. These investors attempt to lend in ways that enhance their expected welfare, or utility, which depends on the return that they anticipate receiving and the risk that they might

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incur. For nearly all investors, the ideal loan would carry a large expected return and involve relatively little risk. It is easy to justify these assumptions on theoretical and empirical grounds. Most people would agree that more money is better than less, so investments with large projected returns will seem more attractive than loans with comparatively lower yields. Moreover, each extra dollar of income tends to improve welfare by progressively smaller amounts, a phenomenon known as diminishing marginal utility. Mathematically, these assumptions imply an increasing but concave utility function, which means that investors are risk-averse. The revealed behavior of investors seems highly consistent with this view: people tend to pay lower prices for risky assets than for safer ones with otherwise similar characteristics.

The concept of risk plays an important role in the screening model and therefore deserves some elaboration. Risk is best defined as the uncertainty surrounding the cash flow or percentage-rate return that investors expect to receive. By the concavity of the utility function, investors dislike uncertainty in general, and they particularly despise the kind of uncertainty that could lead to a massive loss.1 It may be useful to illustrate these assumptions using basic probability theory. Suppose that we could sketch a probability distribution summarizing the cash flow of an investment under all possible states of the world. For any given mean or expected cash flow, investors would prefer a distribution with a smaller variance and less negative skewness. The screening model assumes that investors demand compensation for risk, particularly when the risk includes some possib ility of a sizable loss. If the risk is excessive, investors may prefer to avoid it entirely, a point I revisit later in this chapter.

In international lending, the greatest source of risk and threat to returns is the possibility

of default. When a government arranges to borrow money from foreign bondholders or international banks, it promises to repay the principal, plus interest and fees, according to a schedule specified in the loan contract. After creditors disburse the funds, however, the government may feel tempted or compelled to break its promise by refusing to make full and punctual installments. For instance, the government might suspend interest payments, slow the rate of amortization, or extend the original maturity date. Even worse, political leaders might decide to repudiate both interest and principal, thereby asserting that the entire debt is illegitimate and will not be recognized at any point in the future. Technically, any deviation from the original agreement can be classified as a default, regardless of whether the violation arose from unilateral action or mutual renegotiation. I adopt this technical definition but acknowledge that certain kinds of default are more serious than others.

As they contemplate lending to a foreign government, investors must estimate the probability that the government will default and predict the amount of money that could be recovered in the event of a contractual breach. These kinds of calculations are extremely difficult, particularly under conditions of limited information that prevail in international relations, but they are essential for evaluating the attractiveness of a potential loan. Investors cannot assume that all sovereigns carry the same probability of default or that estimation errors 1 Countless psychological studies, surveyed by Rabin (1998), have shown that people perceive the devastation of a financial loss as greater than the benefit of an equal-sized financial gain. The human aversion to loss is so extensive that it may arise from kinks as well as concavity in the utility function. Researchers have found that people measure their personal welfare with respect to a reference point, usually their current endowment, and would suffer a sharp decline in happiness if their assets dropped below the reference point. These results reinforce my assumption that investors strongly dislike any loan that carries some possibility of a negative return.

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would be identical regardless of the borrower. Governments differ in their ability and willingness to repay, and investors must consider this variation when deciding how to allocate capital. Some bondholders and banks use mathematical models, whereas others rely on judgement and qualitative techniques, but all investors employ some method of learning about the likelihood of default.

1.1 Bayesian Learning

I argue that, either consciously or subconsciously, most investors learn according to Bayesian principles: they update their beliefs about the likelihood of default in response to new information. At each stage in the learning process, investors develop a posterior belief that represents a compromise between their pre-existing views and the newly arriving data. If the incoming data corroborate what investors already thought, beliefs will remain roughly the same. In this case, the confirmatory data will give investors greater confidence in their estimates but should not lead them to modify the estimates themselves. If, on the other hand, the data challenge existing perceptions about the debtor’s propensity to meet financial commitments, investors will adjust their beliefs by taking a weighted average of their prior views and the new data. The greater the reliability of recent evidence, relative to historical information summarized in prior opinions, the more investors will disregard their preconceptions and assign a heavy weight to breaking news.

My argument does not require that all people possess identical cognitive abilities or apply

Bayesian precepts to all spheres of daily life. After all, psychologists have identified a conservative bias in human learning: once people form a first impression, they often downplay dissonant evidence and give undue weight to their initial view. 2 The proper question is not whether people think like Bayesians in all circumstances, but under what conditions their reasoning most nearly approximates the Bayesian ideal. For two reasons, the approximation should be close when people act in their capacity as international investors. First, investors -- and the rating agencies that advise them -- have a strong profit motive to update their beliefs in response to new information, instead of clinging to outmoded views that could lead to financial ruin. Moreover, investors generally do not have an ideological stake in defending views about the creditworthiness of a foreign government, whereas they might respond defensively to data that challenged their religious convictions. Thus, I argue that most international investors behave as intuitive Bayesians, even though they may not know the precise mathematical formulation of Bayes's rule.

When learning about the likelihood of default, investors and rating agencies can use Bayesian logic to analyze many sources of information. For instance, they can study data on economic and political conditions affecting the borrower and the territory it governs. Some variables, such as the endowment of natural resources and the incidence of wars and revolutions, have been available to investors for hundreds of years. Other indicators, including national income, were only developed in the early 1900s and collected systematically after the Second World War. These sources of information can help investors update their beliefs about a

2 A clear discussion of this phenomenon appears in Nisbett and Ross (1980, ch. 8). Most psychologists rely on laboratory experiments with undergraduates, but Tetlock (1999) has found a similar conservative bias in studies of “expert” decisionmakers.

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particular borrower, but they may not provide a complete picture of the risks and potential returns. To improve their forecasts of repayment, investors must also consider the borrower’s history of behavior, particula rly its record of compliance with international debt contracts. Credit histories, carefully recorded by investors and institutions for centuries, can shed light on political and economic characteristics that would be difficult or impossible to measure directly.

The screening model focuses on the lessons that investors learn from observing the

behavior of debtors, which is the key to understanding why governments repay their foreign debts. In the next few pages I explain how investors use Bayesian princip les to analyze the credit history of a government and sort debtors into categories, depending on the perceived risk of default.

Investors understand that defaults can arise due to circumstances beyond the debtor's

control. Most countries are small in relation to global markets, and therefore wield little influence over the real international interest rate and the prices of tradable goods. These exogenous factors directly affect a sovereign's ability to obtain the foreign exchange for servicing international debts. Countries are also powerless to prevent droughts, floods, hurricanes and earthquakes from destroying crops and manufacturing facilities. Through their effect on the domestic economy, natural disasters can reduce government revenues and divert resources from debt servicing to immediate domestic needs. Other things equal, a government is more likely to interrupt payments when suffering from rising interest rates, declining terms of trade, and natural disasters than when external conditions are relatively favorable. Investors take such contingencies into account when negotiating international loan contracts.3 This explains why, on average, governments that are vulnerable to external shocks must pay higher interest premia and accept smaller loans than countries that are better insulated from adverse developments.

Investors also understand that governments respond differently to similar exogenous

shocks. Some governments pay their debts under virtually any conditions. When the price of their exports falls or the supply of international capital dries up, these “stalwarts” tighten their belts, thereby leaving enough public revenue and foreign exchange to uphold their contractual obligations to foreigners. Other governments are “fair-weather payers” who remain faithful during auspicious years but default when external conditions deteriorate. Still other governments are “lemons” that tend to break their contracts, regardless of the external situation. If these lemons could attract foreign capital, they would fall into arrears or even repudiate their debts because of domestic political pressure or incompetence in managing economic affairs. The screening model focuses on three ideal types of debtors: stalwarts, fair–weather payers, and lemons. In practice, some governments may fall between these stylized categories, but a simple model with three types will generate many interesting predictions and provide a basis for empirical work. Adding more types would complicate the analysis without yielding additional insights.

3 Some have argued that debt contracts are implicit ly state-contingent. See, e.g., (Aizenman and Borensztein, 1989), (Alesina, 1988), (Calvo, 1989); (Carlson, Husain et al., 1997), (Grossman and Van Huyck, 1988), and (Obstfeld and Rogoff, 1996, p. 360-61).

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Credit histories can help investors discern the type of debtor they are confronting. In practice, bondholders and banks cannot directly observe the resolve and competence of a foreign government, but they do have beliefs about whether they are dealing with a stalwart, a fair-weather payer, or a lemon. These beliefs constitute the image or reputation of the debtor in the eyes of international investors. As with all beliefs, assessments of the hidden characteristics of a foreign debtor may prove erroneous, but they represent the best guesses that investors can make with the information at their disposal. One important source of information is the record of government responses to exogenous shocks. Investors can easily observe whether a government paid its foreign debts, and they have good records of national disasters, changes in global interest rates, and fluctuations in commodity prices that might have compelled a government to break its contracts. By considering these two pieces of information – exogenous shocks and actual payments – investors can draw inferences about the resolve and competence of the government. Thus, credit histories can provide data on characteristics of the debtor that would be difficult or impossible to measure directly.

I contend that a government can change its image by acting contrary to its perceived type,

given widely recognized circumstances beyond its control. A few examples should illustrate this prediction, which follows Bayesian rules of inference. Suppose that a government is widely perceived as a fair-weather payer. If this government defies expectations by servicing its debts under austere conditions, it will improve its standing in the eyes of investors by exhibiting greater resolve and competence than previously anticipated. By the same logic, a decision to default under favorable circumstances will cause the government's reputation to sink. But a putative fair-weather payer that meets expectations by defaulting under duress and paying when the yoke is light will experience no change in reputation. In these cases, the payment history conveys no new information about the government’s reverence for international obligations or its proficiency as an economic manager. Thus, governments that are perceived as fair-weather payers should not suffer much reputational loss by defaulting during moments of external crisis such as a world war or a global economic contraction.

A parallel prediction applies to other types of debtors. Consider a putative stalwart, a

government that is widely believed to honor its obligations during good times and bad. Any default by this government would seem surprising and lead investors to assign lower credit ratings, reflecting news that the government was not always willing or able to service its international debts. Given their preeminent reputations, alleged stalwarts must run if they hope to stand still: preserving a class-A rating requires paying under nearly all circumstances. At the opposite extreme, governments with lemon-like ratings have many opportunities to enhance their reputations. By offering an adequate settlement on defaulted debt and servicing any loans it manages to receive, a reputed lemon can elevate its standing and regain fuller access to international capital markets. In all these examples the lesson is the same: investors change their beliefs about type when a government acts in surprising ways. A summary of these predictions appears below.

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Reputations Change when Governments Act Contrary to their Perceived Type (Arrows indicate the direction of change in reputation. X’s indicate no change)

My argument has an important corollary: a government can improve its reputation by paying when external conditions are favorable.4 The potential existence of lemons makes this improvement possible. Investors know that stalwarts and fair-weather payers honor their debts under auspicious conditions, whereas lemons tend to default even during relatively favorable periods. Thus, a government that pays during good times can distinguish itself from a lemon. Whether this behavior has any effect on reputation depends on prior beliefs about the government. If investors knew the government was not a lemon, the behavior would simply confirm expectations and cause no change in reputation. If, on the other hand, investors thought the government might have been a lemon, payment would count as contrary evidence and cause a reputational gain. This process will exhibit diminishing marginal returns, with each additional payment enhancing reputation by a smaller amount. At some point, when investors become highly certain that the government is not a lemon, paying during a good situation will only preserve – not improve – the government’s reputation.

My argument can be expressed as a general claim about the way reputations change in international affairs. When dealing with foreign governments, both state and non-state actors must form beliefs about resolve, competence, and other hard-to-measure factors that would affect the government’s propensity to keep its promises. Those beliefs constitute the government’s reputation in the eyes of international observers. According to my theory, a government alters its reputation by defying expectations: by acting contrary to its perceived type in a variety of situations. Likewise, a government preserves its reputation by behaving as anticipated, thereby validating beliefs that observers already held about the government’s characteristics. Thus, the behavior of a government can affect its reputation, but only under certain conditions. 1.2 Learning across Administrations

I have argued that investors learn about the resolve and competence of a government by studying its behavior in response to exogenous shocks. Investors use their findings, along with other information about economic and political conditions, to forecast whether the government will break its promise and how much it will pay in the event of default. Put more generally, investors use the previous behavior of a government to help predict what it will do in the future.

4 Diamond (1989) develops a similar argument about the dynamics of reputation in debt markets, but his model does not allow for exogenous shocks, and it presumes that lenders can foreclose on the assets of defaulters, which is unlikely in an international setting. See also Eaton (1996).

Favorable Adverse Favorable Adverse Favorable Adverseconditions conditions conditions conditions conditions conditions

Repay x x x

Default x x x

Reputed LemonReputed FairweatherReputed Stalwart

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The forecasting problem becomes considerably more complicated when governments

change over time. At least in theory, the political resolve and technical competence of leaders can vary from one administration to the next, causing fluctuations in the probability of default and the salvage value of international loans. Thus, when considering the lessons of history, investors must decide what past events teach them about the disposition of the government in office today and the likely characteristics of its successors. In short, investors must assess the correlation of government type over time. If this correlation is high, investors will consider distant history as well as recent behavior when forming beliefs about the borrower, but if the correlation is low, they will pay more attention to recent signals than dated ones and prior beliefs will have a short half- life. To complete the screening model, we need a principled way of gauging how far investors look into the past.

I claim that investors use available information to estimate the correlation of government

type over time.5 It would be foolhardy to assume that each incoming administration bears no relation to its predecessors and retreat to a position of agnosticism with every change in personnel. Governments come and go, but the preferences and capabilities of political leaders remain somewhat consistent over time. This consistency arises partly from the rigidity of political institutions such as constitutions, parties, electoral laws, and bureaucracies that affect which people rise to power and what policy options they are able to pursue. The regularity also stems from slow-moving socioeconomic features, including national culture and industrial structure, that shape the preferences of the individuals and groups that select political leaders. Notwithstanding this potential for continuity, the characteristics of governments can change in ways that affect the probability of default. Instead of assuming that they are dealing with a long succession of identical twins, or taking the opposite view that each new government is a total stranger, investors attempt to learn how closely governments resemble each other.

Investors learn about the correlation of type by watching for institutional and

socioeconomic upheavals. Dramatic events convey the clearest signals. When a country redrafts its constitution, switches from authoritarianism to democracy, or redraws its national boundaries to accommodate new territory, investors can safely conclude that political power is shifting. These extreme changes cast doubt on the past as a predictor of future performance. Socioeconomic upheaval should have an analogous effect. Investors have long understood that economic modernization and social revolutions can alter the preferences and capabilities of leaders, sometimes in radical ways. The weight that investors attach to the behavior of previous administrations should be inversely proportional to the degree of socioeconomic change that has taken place in the interim. By examining these and other indicators of domestic upheaval, investors can make sensible judgements about the pertinence of historical information, and thereby engage in Bayesian learning not only within but also across political administrations.

The previous argument needs one qualification: if a country maintains a consistent record

of compliance across a variety of institutional and socioeconomic settings, investors may conclude that the continuity stems from deeply rooted characteristics of the country and its leaders. Hence, a new round of upheaval would not prompt investors to discount the past. This

5 Cole, Dow and English (1995) also consider variation in government type, but they assume that the correlation of type is known and stationary over time, rather than estimated by investors.

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qualification derives directly from my theory of learning. In the previous section, I contended that a government could acquire an exemplary rating by paying its debts regardless of external shocks; by a parallel logic, a country can earn the esteem of investors by honoring its debts despite domestic disturbances. The inferential process that investors employ in both these cases resembles John Stuart Mill’s “method of difference” and is a common technique in the toolbox of social scientists. By observing uniform behavior under fundamentally different conditions, investors can gain confidence that the conduct did not arise by chance alone, but was causally related to characteristics of the debtor that transcend changes in domestic and international affairs.

Investors are most interested in estimating the correlation of government type when the

current administration is an unproven borrower, one with little or no record of attracting and repaying foreign loans. For this kind of government, investors lack firsthand information about political resolve and technical competence, so they must glean insights from the behavior of predecessors. As the government becomes more seasoned in dealing with international capital markets, investors can base their opinions on direct experience with the government and reduce their reliance on long-term records. Thus, reputational legacies should fade as the government earns a name of its own. In Bayesian terminology, the weight of historical information will decline as investors collect more reliable and precise data about the current administration.

The seasoning process allows a new government to distinguish itself from its

predecessors by behaving in surprising ways. To see how this process might work, consider a government that enters office carrying the reputational baggage of its predecessors, who were widely regarded as lemons. By acknowledging debts contracted under previous administrations and settling any existing defaults, the new government can display higher resolve and competence than expected. After a probationary period, investors might become convinced that a better rating would be appropriate and upgrade the government to fair-weather status. Of course, the process could also work in the opposite direction. A government that inherits a class-A rating could squander its patrimony by defaulting on its foreign debts. Thus, the dynamics of reputation are similar, both within and across political administrations. A government changes its image by paying more or less than expected, given circumstances beyond its control.

As it becomes more seasoned, a government can differentiate itself from previous

administrations, but it may not eliminate all reputational residue. History continues to cast a shadow because the maturity dates of international loans can exceed the expected life of a single government. When setting the price of long-term credit, investors must consider not only the reputation of leaders in office at the moment of issue, but also the characteristics of likely successors. If investors perceive the current administration as a historical aberration, they will use the behavior of predecessors to predict what might happen when the administration leaves office. Thus, sovereign borrowers can become prisoners of the future as well as the past. To separate cleanly from its predecessors, a government may need to take office in the context of a major institutional or social upheaval, one that suggests to investors that the country is embarking on a new political trajectory. In this case, the behavior of the current administration would provide the best available guide to the future.

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From my analysis of learning across political administrations, we can derive two generic insights about reputations in world affairs. First, each government inherits some images that were associated with it s predecessors, but the reputational heritage will vary, depending on the circumstances that brought the new administration to power. The greater the degree of institutional and social upheaval separating previous administrations from the new one, the more observers will discount the past and allow the government to enter with a relatively clean slate. The only exception to this logic arises when a country has a long history of consistent behavior despite domestic upheavals, in which case observers will attach a heavy weight to their prior views. The second insight concerns the dynamics of the legacy bequeathed by previous administrations. I argue that, over time, a government can shed its reputational inheritance by becoming a seasoned actor on the world stage, one that observers will begin to judge on its own record. 1.3 Learning across Space

Reputations can spread not only through time but also across political and economic space. The previous section explained how one government, through its record of compliance with debt contracts, can affect beliefs about the creditworthiness of its successors. Old governments, I argued, can impose reputational externalities on new ones. By a similar logic, the behavior of a government can have ripple effects on the reputations of its contemporaries. How a sovereign treats its debts may shape opinions about local governments and private corporations within the sovereign’s jurisdiction, and it could color the way investors think about borrowers in neighboring and distant lands. These ripple effects arise when investors use data about some actors to draw conclusions about other actors that are assumed to possess similar characteristics or face analogous situations. A fully developed screening model should explain when investors are most likely to generalize about many debtors, based on the behavior of just a few.6

Above all, investors will monitor the sovereign for clues about the creditworthiness of

companies and governments within the sovereign’s jurisdiction. For centuries, firms have relied on foreign banks and supplier networks to obtain short-term commercial credit, which is the life-blood of international trade. Firms have also turned to foreigners for working capital to finance inventories and current expenses, and they have sought longer-term loans to purchase equipment and launch new ventures. In the same way, domestic banks have borrowed abroad to balance their portfolios and meet the needs of local customers. Finally, provincial and municipal governments have, at times, floated bonds on international markets or sought credit from foreign banks, mainly to increase local consumption or invest in infrastructure and public works. These borrowers carry some risk, which investors can judge by watching the sovereign.

The behavior of the sovereign will convey information about the financial resources of

sub-national borrowers. The sovereign typically has first call on the available supply of foreign exchange and can prevent private firms and local governments from converting their revenues into foreign currency. In periods of difficulty, the sovereign will push sub-national borrowers to

6 It could also be argued that investors generalize from one issue (say, treatment of foreign debt) to another issue (such as treatment of foreign investment). For an early attempt to theorize about cross-issue spillovers, see Cole and Kehoe (1997; 1998).

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the end of the convertibility queue. For this reason, international investors normally assume that firms and municipalities carry higher risks of default than the sovereign does. In practice, the credit ratings of sub-national actors are capped at the level of the central government and, without special enhancements, will hover below this “sovereign ceiling.” Thus, default by the sovereign will worsen the ratings of all private and public borrowers within the country, whereas a rising sovereign tide should lift all domestic boats. As we will see, these reputational spillovers strengthen the incentives for sovereigns to pay their foreign debts, in an effort to prevent domestic actors from losing access to the international capital market.

Through its actions, the sovereign also sends signals about its guarantee to back the obligations of sub-national borrowers. Either explicitly or implicitly, many sovereigns pledge to assume the foreign debts of major corporations and political bodies in the event of default. "Sovereign guarantees" are supposed to assure investors of reimbursement, thereby helping sub-nationals attract foreign capital on better terms than they could obtain through their own merit. Of course, the perceived value of any sovereign guarantee depends on the reputation of the sovereign itself. If investors think that the sovereign will display resolve and competence during crises, they will attach a heavy weight to the guarantee, but if they regard the sovereign as a lemon or fair-weather payer, they will put less stock in the pledge of assistance. Thus, the reputation of the sovereign will affect domestic actors by suggesting whether the sovereign will rescue subordinates in times of crisis.

Sovereign behavior can impose externalities on foreign borrowers as well as domestic

ones. By watching how a central government treats its debts, investors can learn about allegedly similar administrations in other countries and update their beliefs to reflect the new information. The logical process is akin to survey research, in which analysts study a sample to draw inferences about a wider population. Like survey researchers, investors must decide how far to generalize their conclusions. It would be imprudent to assume that the experience of one country or administration provides no lessons about the likely behavior of others. Countries are diverse, but they also share cultural, political and economic features that allow some clustering for the purpose of analysis. The challenge for any investor, as for a social scientist, is to define the relevant clusters and strike the correct balance between universal and id iosyncratic conclusions. Investors have a financial incentive to cluster sovereign debtors in reasonable ways.

Geographic clusters are intellectually appealing to investors and provide the most

obvious way of breaking the world into parts. Countries within a region often have similar political institutions, economic structures, and cultural traditions that affect their ability and willingness to pay foreign debts. The value of geographic clustering is widely recognized, both inside and outside financial circles. Credit rating agencies appoint experts to oversee regions like Latin America or Eastern Europe, presumably because the countries in each zone share many characteristics. Commercial and investment banks structure their research and lending departments on geographic lines, a pattern that repeats itself in government agencies like the CIA and the Department of State. For their own part, academic institutions maintain regional studies programs and search for scholars with expertise in particular areas of the world. No one would claim that countries within a region are perfectly homogenous, but the commonalities are often striking. Thus, geographic clusters provide a useful starting point for international investors. By my analysis, the behavior of one sovereign debtor should have its greatest externality on the

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images of other sovereigns within the same geographic neighborhood, and the should be especially strong when investors regard the region as relatively homogenous.7

Even within a geographic region, reputational externalities should be more pronounced

for some countries than for others. To the extent possible, investors would like to judge a sovereign according to its own record of behavior, instead of relying on lessons from debtors in neighboring countries. Within-country inferences are more reliable than cross-country inferences and should receive greater weight in the Bayesian learning process. Consequently, a sovereign is most vulnerable to reputational externalities when investors have little direct information about economic and political conditions in the country, and when they lack data about the sovereign’s history of compliance with international debt contracts. As the quantity of country-specific information improves, investors will reduce their dependence on cross-border inferences. Thus, all sovereign debtors are vulnerable to contagion, but vulnerability varies from one country to the next.

As before, the points in this section have broad implications for the role of reputation in

world affairs. I argue that the behavior of a government can affect the reputations of contemporaries that are presumed to have similar characteristics or face analogous situations. These externalities are more likely to arise within a country, where the sovereign has authority over sub-national actors, than across countries. Nevertheless, the conduct of one government can affect beliefs about actors in foreign lands. I suggest that a state or non-state actor is most vulnerable to reputational spillovers when observers lack firsthand information about it, and that spillovers will tend to be geographically concentrated. These points can inform our understanding of reputation in many areas of international relations.

1.4 Effects on the Incentives of Investors

Having studied various sources of information about the likelihood of default, investors must decide how to allocate their capital. The screening model assumes that bondholders and bankers calibrate the terms of credit to achieve the risk-rate return that offers the highest utility. Risk – particularly the possibility of loss arising from default – reduces the utility of investors but does not necessarily deter them from lending. It is "not optimal to structure a loan agreement so that default … will not occur under any foreseeable circumstance, because risk sharing is an important source of potential gain for both borrowers and lenders.”8 For this reason, investors may lend to governments with a positive probability of default, especia lly if the probability is not excessive and the anticipated recovery would make the loan profitable. Nevertheless, investors will not accept risk without some compensation or security. I identify three main approaches that investors can use when dealing with the risks of sovereign lending.

First, investors can charge for risk: they can increase the expected return to counterbalance the disutility they experience by lending to governments with some prospect of default. Charges come in many varieties, some more explicit and publicized than others. Typically, investors respond to risk by raising interest rates and management fees, or they

7 Investors may use other variables, such as the level of economic development, to cluster countries. I focus on geography to make the argument simple and testable. 8 (Crawford, 1987, p. 2).

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purchase the loan at a discount, thereby requiring the borrower to pay interest and amortization on more money than it actually received. The extra return that investors demand as compensation for uncertainty is called the risk premium, which analysts measure as the difference between the interest rate on a risky loan and the rate on an otherwise similar asset that has no chance of falling into default. By charging a risk premium, investors may strike the optimal combination of risk and return, thereby maximizing their utility.

Financiers have long understood that risk premiums can create their own problems,

however. Raising interest rates by some fixed percentage generally will not improve expected returns by a commensurate amount, because higher rates have two offsetting consequences: they increase the contractual obligation, but they also exacerbate the probability of default. At least in theory, the net effect on expected returns is ambiguous. When interest rates are low, a small premium should help investors by increasing the contractual obligation by more than the probability of default. As interest rates climb, however, the financial and political burden of servicing the foreign debt will prove more arduous, and leaders will find themselves increasingly unable or unwilling to repay their international creditors. At some point, a marginal increase in the risk premium will reduce the expected return, as the heightened probability of default overwhelms the gains from charging the debtor a steeper price. Thus, interest premiums can provide some indemnification against risk, but investors cannot raise rates without limit to compensate for the possibility of default.

A second approach to risk is available: lenders can control the degree of uncertainty by

designing a contract with provisions that reduce the probability of default and stabilize the projected cash flow. Over the centuries, investors have used many devices to keep risk in check. They have required governments to offer collateral and, in some cases, to put pledged assets under the direct supervision of a foreign bank or a committee of bondholders. Investors have also shortened maturities, demanded sinking funds that obligate the borrower to retire a portion of the loan each year, and requested third-party guarantees involving traditionally creditworthy borrowers. Through these and other devices, investors have sought to control risk as well as charge for it. As I show in the empirical section of the book, researchers have overlooked this simple fact, and therefore produced biased estimates of the terms of credit offered to sovereign borrowers. Finally, international investors can avoid risk by refusing to lend. They will prefer this option when a government seems so risky that no interest rate could compensate for the possibility of default and no contractual provisions could keep the degree of uncertainty within reasonable bounds. In this case, investors anticipate that they would lose money -- or incur an unattractive combination of risk and return -- by offering credit to the government. They would do better by seeking alternative borrowers or refraining from lending altogether. Thus, some governments will not attract loans at virtually any price. In economic terminology, this phenomenon is called "credit rationing" and means that markets may not clear, because the supply of international loans may not meet the demands of extremely risky borrowers. Surprisingly, most studies of reputation have ignored credit rationing and focused on the risk premiums that defaulters paid when they returned to international borrowing. For this reason, studies have systematically underestimated the cost of default and overlooked the primary reason why governments pay: to avoid being rationed-out of capital markets.

Michael Tomz, p.14

In the screening model, investors choose the optimal combination of risk premiums,

contractua l protections, and credit rationing, depending partly on their beliefs about the type of government they are confronting. Other things equal, putative stalwarts will receive easier credit then reputed fair-weather payers, which, in turn, should enjoy better access to international capital markets than governments that have been classified as lemons. Any government that is widely believed to pay during good times and bad will attract large loans at nearly risk-free rates, without having to provide collateral or other legal enhancements. Investors will rely more heavily on risk premiums and contractual protections when dealing with apparent fair-weather payers, since those governments are expected to default when external conditions turn sour. Finally, investors will refuse most requests for loans to proven lemons and governments that have not settled their existing defaults. These prospective borrowers pose such great risks that credit rationing is the optimal course of action.

The foregoing predictions will hold most strongly when investors are private bondholders, rather than commercial banks. Thus far, I have treated both categories of investors as similar. I have argued that bondholders and banks apply the same techniques to learn about the likelihood of default, and they have identical options for coping with the risks of international lending. These two classes of investors differ in one important respect, however: bondholders have an overwhelming incentive to allocate credit according to their beliefs about risk and potential return. In contrast, commercial banks sometimes have conflicting priorities that could lead to seemingly perverse behavior, such as lending to governments that have fallen into arrears and offering cut-rate loans to reputed fair-weather payers. Thus, bondholders and banks assess risk in similar ways but may adopt different approaches to coping with it.

To understand why banks would lend to governments that bondholders have redlined, consider a few important differences between these types of lenders. First, commercial banks have the incentive and the ability to engage in "defensive" lending. When a sovereign defaults, banks may decide that a new infusion of loans would bring short and long-term benefits. In the short term, the government could use the proceeds from new loans to pay interest on previous debts, thereby allowing banks to avoid declaring defaults and recording losses on their balance sheets. Over the longer term, new loans could help the debtor revitalize its economy, increasing the prospect that existing loans would be repaid. Banks are large enough to engage in defensive lending, either by themselves or in concert with others. Thus, we would not necessarily expect banks to refuse loans to troubled debtors, nor should we always expect interest rates to reflect the perceived level of risk.

In contrast to commercial banks, private bondholders lack the motive and the means to

engage in defensive lending. No individual bondholder has enough resources to offer a defensive loan unilaterally, and it would be extremely difficult for thousands of bondholders to cooperate in extending such credit. An investment house like Barings could try to float an emergency bond issue, but it would not find a market for the new securities due to classic problems of collective action. In theory, each bondholder could gain from a defensive loan, which might increase the government's ability and willingness to service existing debts, but no single bondholder has an incentive to throw good money after bad. Without some means of coercing the mass of atomized bondholders into providing new credit, the emergency issue

Michael Tomz, p.15

would be doomed. Thus, bondholders usually will avoid lending to troubled debtors, whereas commercial banks might offer new credit to protect their own bottom lines.

This analysis suggests an ironic conclusion: when dealing with international banks

instead of private bondholders, a good reputation can be a mixed blessing. In normal times, a reputation for resolve and competence can help a government attract large loans at low rates. Once a crisis strikes, the relationship should reverse itself. As it bargains with international banks about the terms of a defensive loan, a government with an intermediate reputation will extract more concessions than a government with a sterling record of compliance, simply because a reputed fair-weather payer can make more credible threats than a putative stalwart. Banks know that a stalwart would not default under virtually any conditions, and therefore feel little need to provide a defensive loan or offer debt relief. In contrast, banks understand that a fair-weather payer prefers to default during external crises and will not shift from its optimal course unless the bank provides significant concessions. Naturally, a certifiable lemon will not get any credit, because banks know the loan would not buy better behavior. Thus, we should expect a curvilinear relationship between reputation and access to bank credit during times of crisis.

A second important issue distinguishes banks from bondholders. Commercial banks deal

with foreign governments on many dimensions. In addition to providing medium and long-term credit, Citibank and other large lenders maintain a network of branches in foreign countries, provide trade credit for importers and exporters, and manage the foreign reserves of central banks. These activities provide a steady flow of income that banks would like to nurture. Seen in isolation, medium-term lending to a risky borrower may appear foolish, but such lending can improve the overall ledger of the bank by advancing other, more profitable lines of business. Thus, banks may regard some sovereign loans as "loss leaders," designed to promote good relations with foreign politicians and businessmen, as well as stimulate the economy of the borrowing state. In contrast, private bondholders are not involved in ongoing multi-dimensional relationships with foreign governments. Consequently, bondholders have no reason to offer sovereigns easier credit than their riskiness would warrant. Despite their differences, both banks and bondholders can be analyzed within the context of a single screening model. Like bondholders, banks use Bayesian principles to update their beliefs about the likelihood of default and, in many cases, they offer better terms of credit to reputedly safe borrowers than to ones that pose more risk. My main caveat is that the potential slippage between perceptions of risk and access to credit is greater when governments deal with commercial banks than when they float bonds on international markets. As we will see, this slippage affects the incentives of sovereigns in surprising ways. It is worth highlighting some general implications of the arguments in this section. Actors that collaborate in world affairs must consider the risk of noncompliance, which could arise by accident as well as opportunism. Among the techniques for dealing with risk, three are particularly important. First, an actor that anticipates some noncompliance could simply increase its demands, which is analogous to raising the premium on an international loan. By requiring larger concessions, the actor may be able to improve the expected outcome by enough to compensate for the risk of a breach. Second, parties could structure the agreement to control the

Michael Tomz, p.16

level of risk, perhaps by requiring promisors to tie their hands (post collateral and offer other hostages) or by shortening the duration of the agreement. Finally, if no measure could provide adequate indemnification against risk, the actors could refuse to sign an agreement. Far from dooming the possibility of cooperation, the existence of this third option creates strong incentives for countries to keep their promises, a point I develop in the next section. Note that I have not listed sanctions among the principal techniques for dealing with risk. A major conclusion of this book is that sanctions are not necessary to manage risk and promote cooperation. 1.5 Effects on the Incentives of Governments

I now consider lending and repayment from the perspective of sovereign borrowers.

Sovereigns understand the main arguments that I have made about private investors. For convenience, I quickly review the arguments here. Investors use available information to update their beliefs about the government’s vulnerability to external shocks, and well as its resolve and competence in the face of circumstances beyond its control. Through its record of payment in a variety of situations, a government can influence the beliefs of investors. An administration that defaults when external conditions do not justify a lapse of payments will reveal itself as a lemon, whereas a government with a history of consistent payments will earn the reputation of a stalwart. Finally, a government that customarily adjusts its payments to external conditions will be classified as a fair-weather payer. Governments know that investors and rating agencies use these simple rules, among others, to screen debtors. They also anticipate that investors will avoid lending to proven lemons and will offer low-cost credit to reputed stalwarts.

The way a government treats investors will depend largely on the government’s type. Stalwarts, fair-weather payers, and lemons exist not only in the minds of investors but also in the real world. To some extent, these differences in type arise because governments are not equally willing to sacrifice current welfare for the sake of continued access to international loans. How a government balances the costs and benefits of payment will depend on many domestic political factors. The electoral strength of incumbents, the willingness of constituents to tolerate austerity, and the power of contending interest groups could all come into play. Even values could enter the calculation, since some leaders oppose defaulting on moral grounds, whereas others tend not to let principles interfere with government policy. Later in this book I analyze several sources of variation in the preferences of debtors. For now, we need only accept that leaders have diverse preferences, which reflect not only personal convictions but also the configuration of pressure groups and the institutional context in which they operate. The differences between stalwarts, fair-weather payers, and lemons can also arise because leaders vary in their understanding of economic principles and their technical capacity to implement reforms. These variations are real, and they affect how much resolve and competence a government will display under external pressure.

Given their understanding of investors, governments have strong incentives to behave

according to their true types. A genuine stalwart could default, but it knows that any interruption of payments would lead to a loss of reputation. For domestic reasons a stalwart strongly desires access to future loans and is prepared to make current sacrifices for the privilege of low-cost borrowing. To a genuine fair-weather payer, the domestic political costs of mimicking a stalwart outweigh the benefits of superior access to capital markets, but the fear of being mis-categorized

Michael Tomz, p.17

as a lemon deters the fair-weather payer from behaving opportunistically during favorable times. Finally, a genuine lemon knows that it could improve its access to foreign money by making sacrifices. Nevertheless, this government places such little value on access to future loans, faces such high political costs of repayment, or has such a meager level of economic aptitude that emulating a higher-rated government would be too much trouble. Although it is theoretically possible for each of these types to behave out-of-character, none has much incentive to do so. Sincere behavior is the best response to the updating rules that investors use.

Even though governments behave according to their true types, reputations can change over time. The explanation is simple: investors are never completely certain about the characteristics of a government, so each administration has something to prove. In part, the uncertainty is a consequence of political turnover. Resolve and competence vary from one administration to the next in ways that are not immediately apparent to investors but can be discovered as leaders become more seasoned. Uncertainty also exists because some governments have not faced rigorous tests. When external conditions are good, the exam seems easy and many debtors pass with flying colors. Only in bad times, when the test is more difficult, can creditors distinguish genuine stalwarts from fair-weather payers and lemons. By this logic, the potential for reputational change always exists but is most likely to occur in the wake of political upheaval and exogenous shocks, which bring new types of government to power and thrust debtors into challenging situations. Thus, governments behave as their preferences and abilities dictate, but reputations can change both within and across political administrations.

My predictions about the behavior of debtors hold most strongly when governments are dealing with foreign bondholders rather than commercial banks. For reasons outlined in the previous section, bondholders will be stricter than banks in allocating credit according to perceived risk. Knowing this, governments will treat bondholders with greater care than commercial banks. This prediction contradicts the conventional wisdom that governments will be most circumspect in relations with well-organized bankers. The conventional wisdom derives mainly from a sanctioning story, in which banks can collude in retaliating against defaulters, whereas private bondholders are too atomized to cooperate in imposing a collective punishment. A surprising lesson of this book is that disorganization can bring power. Seen from the perspective of screening rather than sanctioning, the disorganization of bondholders can actually promote compliance. Without the incentive to engage in defensive lending or protect multifaceted relationships, bondholders will apply strict standards of risk, thereby heightening the incentives for governments to meet their obligations.

One issue remains: how does the possibility of reputational spillovers affect the incentives of sovereign debtors? Governments within a geographic region would like to prevent nearby countries from defaulting, perhaps by offering an emergency loan to a troubled neighbor. Providing assistance could prove difficult, of course. Governments may not have enough money to help neighbors, and each member of the region could prefer to free ride on the efforts of others. These problems are serious, but they need not prevent a neighborly rescue package in all situations. Unlike private bondholders, governments are large enough to engage in defensive lending and capable of organizing for collective action, particularly in a somewhat homogenous region. If the risk of reputational spillovers is great enough and the debtor has not slipped too far

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into arrears, governments may decide that unilateral or collective action would serve their own interests by keeping the neighborhood clean.

By this analysis, governments should collaborate in paying rather than defaulting. During the debt crisis of the 1980s, may analysts argued that Latin American governments should form a cartel to confront their international creditors. This argument makes sense within a sanctioning paradigm, in which commercial banks are retaliating against defaults and governments are organizing to counterpunch. The proposal makes less sense when we consider international lending from the perspective of screening, instead of sanctioning. Given the possibility of reputational spillovers, governments have incentives to organize a payers' cartel that could uphold the image of the entire region. A defaulters' cartel, in contrast, would signal to investors that the debtors are lemons that merit no international loans in the future. As I show in the empirical section of this book, sovereigns have never organized for the purposes of confronting creditors, though they have collaborated to prevent their neighbors from defaulting on foreign debts.

Overall, my arguments provide a general explanation for compliance with debt contracts

and other international commitments. State and non-state actors keep their promises to avoid being classified as lemons and screened-out of potentially beneficial agreements. This account of cooperation has many virtues: it is simple, intuitively appealing, and does not require actors to make threats of dubious credibility. Nevertheless, the argument is controversial. In the remainder of this chapter I address two main alternatives to my argument. First, I consider a non-Bayesian theory of reputation that has attracted the attention of many international relations scholars. I suggest why this theory, first developed by Jonathan Mercer, probably does not account for the role of reputation in world affairs. Second, I examine a broad class of models that identify sanctioning, rather than reputation and screening, as the principal mechanism for promoting compliance with international agreements. I contend that sanction-based models suffer from a common limitation: they rely on retaliatory threats that are usually not credible. Thus, the screening model seems more attractive than the leading alternatives.

1.6 An Alternative Theory of Reputation

In a recent book on reputation in military crises, Jonathan Mercer proposes a theory that differs significantly from my own. 9 I have argued that a government changes its reputation by defying expectations : by acting contrary to its perceived type in a variety of situations. In contrast, Mercer contends that a government alters its reputation by doing what observers regard as undesirable, regardless of their prior expectations. For convenience, we can call these two perspectives the expectation-based and desire-based theories of reputation. If correct, the desire-based theory would invalidate many of my claims about the way governments ascend or descend the reputational ladder in their relations with foreign creditors. Here, I offer reasons for doubting that Mercer’s theory explains the dynamics of reputation in international affairs; evidence in subsequent chapters should solidify my claim.

As developed by Mercer, the desire-based theory rests on four assumptions. First, when

explaining the behavior of a government, observers must decide how much responsibility rests 9 (Mercer, 1996)

Michael Tomz, p.19

with external circumstances beyond the government’s reach, and how much is due to internal characteristics of the actor. Put another way, observers must decide whether to make a situational or a dispositional attribution. Second, “a dispositional attribution is necessary to generate a reputation,” which is defined as a judgment about someone else’s character or disposition. 10 Third, “people interpret behavior in either situational or dispositional terms depending on the desirability of that behavior. [They] use dispositional attributions to explain an out-group’s undesirable behavior, and situational attributions to explain an out-group’s desirable behavior.”11 In psychological studies, the term out-group simply refers to people that are seen as outsiders. Finally, people regard all foreign governments as belonging to the out-group. These four assumptions imply that “only undesirable behavior can generate a reputation.”12

The syllogism is logically sound but produces implausible conclusions. For instance,

Mercer’s framework makes it impossible for a government to acquire a good reputation, and it implies that reputations deteriorate monotonically over time. To see this, consider the case of sovereign debt. From the perspective of international investors, default is clearly undesirable. Using Mercer’s logic, investors will make dispositional attributions when a government defaults but credit the situation whenever a government pays. Thus, a sovereign cannot earn a reputation for honesty or reliability in relations with foreign investors and its standing before lenders will never improve. As Mercer notes, the sovereign simply “cannot win.” Yet, intuition and experience suggest that some governments, like people, do have reputations for reliability and that reputations can improve over time.13 On these grounds alone, the desire-based theory seems suspect. In subsequent chapters, I show that investors trust certain governments and that reputations rise as well as fall.

The desire-based theory also requires people to disregard obvious pieces of data. In

deciding whether to make a situational attribution, the observers in Mercer’s theory ironically ignore all information about the situation itself and focus instead on whether the actor behaved in a desirable way. If the behavior seems desirable, observers seize upon a real or imagined circumstance to rationalize what the government did, but if the behavior seems undesirable they overlook even glaring evidence of external pressure. Most of us probably do not make judgments in this contorted way, especially when money and power are at stake. It seems more likely that we consider external conditions before drawing conclusions about what motivated a government to adopt a particular policy. Was the country at war? Were export prices at record lows? Was the economy reeling from a drought? In the empirical sections of this book, I show that investors consider these and other external conditions when assigning weights to situational versus dispositional explanations.

Finally, the desire-based theory attributes a high degree of self-delusion to policymakers.

Mercer notes that “the cruc ial importance of reputation is now common sense” in policy circles. Many presidents, finance ministers and legislators apparently believe that the images of their own governments can wax and wane, and they stand ready to sacrifice for their reputations. 10 (Mercer, 1996, p. 45) 11 (Mercer, 1996, p. 9) 12 (Mercer, 1996, p. 46). 13 In the introduction to his book, Mercer himself offers several examples of people who have reputations for “reliability” and “generosity.” We cannot explain these examples with a desire-based theory, in which all reputations are unfavorable.

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Mercer adds that the preoccupation with reputation predates the modern era and appears even in Thucydides’s history of the Peloponnesian War, yet he concludes that the conventional view is wrong; a reputation is not worth fighting for. If correct, this conclusion exposes a false consciousness that has persisted for at least 2500 years. To sustain his argument, though, Mercer must ascribe to policymakers an even stronger form of false consciousness: actors think their own reputations are important, even though they pay little heed to the reputation-defending actions of others. Fortunately there is an easier explanation: the common sense about reputations is essentially correct but needs to be developed more thoroughly. My screening model explains how reputations evolve and under what conditions they affect international relations. 2. Cooperation through Sanctioning

The main alternative to my argument puts sanctioning, rather than screening, at the heart of debtor-creditor relations. In models of sanctioning, international investors enforce compliance with debt contracts by threatening to retaliate against governments that default. Retaliation could take many forms, ranging from financial and commercial embargoes to overt military intervention. Provided that the threat of retaliation is credible and severe enough, it could deter governments from breaking their promises and afford investors the confidence to lend. Charles Lipson provided an early statement of the sanctioning perspective. "Why do so many states, with such diverse political structures, continue to service their debts in spite of the political and social costs?" The answer, Lipson wrote, lies in a "network of multilateral banks, private lenders, and advanced capitalist states" that "can powerfully sanction borrowers in default.”14 This perspective, formalized in many game theoretic models of international finance, is now regarded as the “core finding” in the literature on relations between sovereign governments and foreign investors.15

The emphasis on sanctions appears not only in studies of debt, but also in seminal

contributions to the theory of international cooperation. One of the most fundamental questions in world politics concerns the emergence of cooperation under anarchy: how can self- interested actors cooperate without the assistance of a centralized agency, such as a world government, that punishes parties for breaking promises and engaging in other selfish behavior? For nearly two decades, scholars have traced the answer to decentralized sanctions: actors in international affairs can enforce cooperation among themselves by punishing parties that behave opportunistically.16 If the threat of decentralized sanctions looms large enough, it will encourage governments to honor their foreign commitments, even in the absence of a global Leviathan. Today, sanctioning is the dominant academic approach to understanding nearly all forms of international cooperation that do not involve quid pro quo exchanges. It is, therefore, a serious contender to the screening model.

Nevertheless, the sanctioning approach suffers from an important limitation: it relies on

unbelievable threats.17 In this section I offer an internal critique of sanctioning. Using the same

14 (Lipson, 1979, p. 322-23). See also (Lipson, 1981). 15 (Schultz and Weingast, 1998, p. 16) 16 The collection of essays in Oye (1986) exemplify this perspective. 17 With increasing frequency, scholars are acknowledging the credibility deficit in sanctioning models. See, for example, (Eaton, 1990), (Kletzer, 1988), Hellwig 1986, (Glick, 1986), (Kletzer and Wright, 1998), (Obstfeld and

Michael Tomz, p.21

assumptions of rationality that underpin the leading sanction-based models, I explain why governments have good reasons for doubting that investors would retaliate in the event of default. My arguments do not imply that threats never work, but they do suggest why the prospect of economic embargoes and military confrontation does not motivate most governments to pay their foreign debts. In contrast, my screening model captures the best insights in the sanctioning literature without falling prey to problems of credibility. As a first step toward developing these points, I describe the main differences between screening and sanctioning. Then I consider two broad classes of sanctioning models, showing in both cases why the alleged threats are often implausible and why screening is a more effective mechanism for encouraging cooperation between debtors and creditors. 2.1 How Sanctioning Differs from Screening

The screening and sanctioning models differ in their treatment of information about the debtor. In the screening model, investors cannot fully observe the preferences and abilities of the sovereign borrower, so they are never completely sure about the type of government they are confronting. The problem of incomplete information complicates the lending decision, but it also creates opportunities for Bayesian learning: investors can update their beliefs about resolve, competence, and other characteristics of the government by observing how it behaves in a variety of situations. In contrast, sanctioning models downplay problems of information about the debtor. These models typically assume that investors have nothing to learn, because they fully understand the desires and capabilities of the borrower. If this assumption sounds unrealistic, remember that any model is a simplification of the real world, designed to emphasize what is essential and to disregard the remainder. Proponents of sanctioning models tend to focus on the coercive power of the lender. They attach far less importance to uncertainty about the debtor and, therefore, choose to omit this feature. The screening model, on the other hand, puts information and learning at the center of the analysis. Sanctioning models do not necessarily assume that the world is deterministic. Sophisticated models, in fact, allow the income of the sovereign to fluctuate randomly in response to exogenous shocks, such as natural disasters and changes in commodity prices. In these models, the sovereign borrows from foreigners during tough times and repays when external conditions improve, in an effort to smooth its consumption over time. Neither investors nor politicians know exactly when disaster will strike, nor can they pinpoint when the sovereign will face easier conditions. Sanctioning models, therefore, contain some degree of unpredictability. Even this uncertainty is limited, however. Actors are presumed to know, in advance, the probability and magnitude of all shocks that the sovereign potentially could face. Consequently, investors have nothing to learn about the sovereign's vulnerability to external shocks, much less its resolve and competence in the face of circumstances beyond its control. The screening model is distinctive in allowing investors to update their beliefs about many features of the debtor that could influence the likelihood of repayment. Advocates of sanctioning tend to dismiss uncertainty about the debtor for various reasons. Some believe that the assumption of complete information “accurately reflects reality,”

Rogoff, 1996), (Armendariz de Aghion, 1990), (Eaton, Gersovitz et al., 1986), (Schultz and Weingast, 1998), and (Weingast, 1997).

Michael Tomz, p.22

in the sense that debtors and creditors know, with a high degree of precision, the preferences and abilities of the actors they are facing. 18 According to one proponent of sanctioning, the notion of incomplete information about the debtor is “totally implausible.”19 Other authors maintain that uncertainty about the borrower is “not necessary” to account for relations between debtors and creditors.20 In the interests of parsimony these authors delete what seems superfluous. Still others suggest that the assumption of incomplete information is “unlikely to yield empirically testable models,” whereas full- information approaches are more “operationally tractable.”21 These concerns are understandable but misplaced. As we will see, the assumption of incomplete information about the debtor is not only plausible but also necessary to explain why governments pay their foreign debts, and it will help us account for many other phenomena that would seem anomalous within a full- information framework. Moreover, researchers can use evidence to evaluate the screening model, as the battery of empirical tests in subsequent chapters amply demonstrates. The screening and sanctioning models differ not only in their approach to information about the debtor, but also in the method and rationale for responding to unwarranted defaults. Define an unwarranted default as one that occurs when external conditions do not justify a lapse of payments. Under the screening model, investors will avoid lending to any government that has violated its debt contracts without sufficient warrant. This response is easy to explain. An unwarranted default signals to investors that the government has lemon-like characteristics. Based on this disparaging information, investors will shy away from extending new credit, not because they are collaborating in a punitive embargo, but because each investor determines that additional lending would be unprofitable, given the risks of opportunism and incompetence. In the screening model, the decision to withhold funds from a reputed lemon stems entirely from forward-looking concerns about risk and potential return.

Investors think differently within the sanctioning paradigm. In the leading models of sanctions, investors can retaliate against unwarranted defaults by imposing embargoes on future loans, interfering with commodity trade, or launching military operations. If investors succeed in implementing the first option, the defaulter will lose access to capital markets, but for entirely different reasons than in the screening model. Sanction-minded investors withhold credit to retaliate against past cheating, not to reflect new assessments of risk. The latter rationale plays no role because the sanctioning model does not incorporate learning about the debtor and updating about the likelihood of default. Thus, the decision to impose credit embargoes and other sanctions is backward looking, rather than forward looking. Table 1 summarizes the main differences between the screening and the sanctioning models.

18 (Aggarwal, 1996, pp. 55-57, 544) 19 (Buiter, 1988, p. 613) 20 (Kletzer and Wright, 1998, p. 20) 21 (Kletzer, 1988, p. 602), (Aggarwal, 1996, p. 57)

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With these differences in mind, I consider whether the fear of sanctions motivates

governments to pay their foreign debts. My analysis focuses on two standard varieties of sanctioning models. In the first variety, cooperation arises through the threat of retaliation in repeated games. In the second, actors enforce cooperation by threatening to impose sanctions in one issue-area if actors behave selfishly in another. Authors have used both varieties to theorize about debtor-creditor relations, but each is vulnerable to an internal critique. 2.2 The Credibility of a Credit Embargo

In economics and political science, theorists claim that cooperation can arise from the fear of retaliation in ongoing relationships.22 If two parties interact repeatedly with each other, they could threaten to retaliate tomorrow against uncooperative behavior today. The most severe threat is the grim trigger: “cross me once and I will never cooperate with you again.” A more forgiving strategy, tit-for-tat, requires that players mimic the behavior of their opponents by matching each act of cooperation with cooperation and punishing each instance of defection by striking back for one period. Researchers have considered many other strategies, all involving threats to punish cheaters in future iterations of the game. Assuming these threats are credible, players that care enough about the future will calculate that the costs of foregoing cooperation in subsequent periods outweigh the immediate gains from behaving selfishly today. In this way,

22 Early studies of cooperation in repeated games include (Friedman, 1971), (Taylor, 1976), and (Hardin, 1982). In the 1980s many researchers, including (Axelrod, 1981), (Axelrod, 1984), (Keohane, 1984), (Lipson, 1984), and (Snidal, 1985), applied these arguments to international relations.

Table 1: Main Differences between Screening and Sanctioning Models

Screening Sanctioning

Do investors have complete information about the debtor's characteristics? No Yes

Can investors learn about the debtor by observing how the debtor behaves?

Yes No

How would investors respond to an unwarranted default?

Stop lending to the debtor

Stop lending, impose trade sanctions, or take military action

How would investors explain their response?

Adjustment to new information about risk

(forward-looking)

Retaliation against past cheating

(backward-looking)

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the threat of retaliation in a repeated game might promote cooperation, even in the absence of a world government.

Applied to international debt, this logic suggests how cooperation could arise in a

repeated lending game. To enforce compliance with debt contracts, investors might threaten to bar any government that defaults from obtaining access to fresh loans. If convincing, this threat could deter credit-hungry governments from breaking their contracts and sustain cooperation in equilibrium. Authors have formalized this argument many times over the past two decades, beginning with a classic paper by Eaton and Gersovitz, who assumed that lenders “know all relevant characteristics of individual borrowers,” including the fact that governments “are inherently dishonest.” When dealing with these governments, investors enforce cooperation by threatening to apply the grim trigger: a country that defaults will experience a permanent financial boycott. This threat allegedly deters most governments from reneging on their foreign debts.23 Subsequent authors have refined the argument by making the boycott temporary and by allowing “excusable” defaults, but they continue to assert that the threat of an embargo encourages repayment.24 This argument is problematic because it depends on an incredible threat. An effective embargo would require the cooperation of many current and potential lenders around the world, but it is unclear why profit-seeking bondholders and banks would collaborate in punishing a government for defaulting on someone else’s loans. Moreover, even the original lender may find that a boycott would undermine its own interests by eliminating gains from future exchange. Thus, a government has good reason to doubt that investors would carry out their threat in the event of default. I discuss these problems of credibility in greater detail below. 2.2.1 Would Other Lenders Participate? The threat of a credit embargo seems unrealistic, because it requires costly action by third parties that never participated in the original loan. No international embargo could succeed without the near-unanimous cooperation of current and potential lenders. Even a small crack in the sanctioning coalition would enable a defaulting government to escape punishment. In all likelihood, cracks in the coalition would be enormous. Instead of sacrificing their own welfare to punish a sovereign that caused them no harm, investors could make money by initiating profitable relationships with the embargoed government. Moreover, a sovereign under siege could offer special concessions to investors that ignore the boycott. The tighter the noose became, the more investors would have an incentive to lend unilaterally, causing the entire scheme to unravel. Thus, a government could default with the reasonable expectation that a multilateral credit embargo would never materialize.

Is there any hope of plugging this hole in the sanctioning story? I consider two possibilities. First, the victims of default could threaten to punish investors that contravene a

23 (Eaton and Gersovitz, 1981). 24 In the first refinement, lenders threaten to inflict only the minimum punishment necessary to deter the government from defaulting. Since lenders presumably have complete information about the debtor, they know how severe the punishment should be. In the second refinement, proposed by (Grossman and Van Huyck, 1988), lenders impose an embargo only if the government defaults when external conditions do not justify an interruption of payments.

Michael Tomz, p.25

boycott.25 This approach solves one credibility problem by creating another, however. If third parties did ignore a boycott, discontented lenders would face a double-duty: they would be called to punish rogue creditors as well as the defaulting government. Yet, the original lenders would lack the means and incentive to retaliate against all potential investors. How, for instance, would American holders of defaulted Chilean bonds punish British, French, or Dutch investors for extending a new loan to Chile? Any answer would stretch the imagination of governments as well as scholars. Moreover, each victim of default would have incentives to free ride on the boycott-sustaining efforts of others, and could only be induced to sanction rogue creditors if they themselves faced the threat of sanctions! It is easy to see how this argument leads to a never-ending chain of credibility problems. Thus, the idea of “punishing those who refuse to punish” does not have much appeal. 26

As a second possibility, aggrieved lenders could rely on domestic law to help sustain a

multilateral embargo. For instance, seniority clauses in debt contracts could discourage third parties from offering new loans. These clauses, presumably enforced by creditor-country law, give the holder first right to any payments that a debtor makes to international creditors. If the original loans contained seniority clauses and courts were willing to uphold them, the victims of default might be able to win enforceable judgments against new lenders. Stock market regulations could serve a similar purpose. The stock market committee could, for instance, refuse to list the bonds of any government in default. This would not prohibit a country from issuing new bonds on foreign markets, but it could increase the cost of borrowing by reducing the liquidity of the asset, making it less attractive to international investors.

These legal solutions are plausible and deserve further investigation, but they leave some

holes in the multilateral embargo. By definition, the regulations arise from domestic law, whereas foreign lending is an international phenomenon. It is not clear how stock market regulations or seniority clauses in the United States would prevent investors in other countries from extending new credit to a sovereign that had defaulted on the loans of US citizens. I show in the empirical section that such regulations did not exist in many creditor countries, so they cannot provide a general explanation for lending and repayment. I also contend that, where they did exist, stock market rules were best seen as forms of licensing -- not punishment -- to help investors discriminate between lemons and more reputable governments, just as physician licensing helps patients differentiate between well-trained doctors and quacks. The relationship between domestic law and international cooperation is a promising frontier for research, one that

25 The basic idea is presented in an influential book on multilateral economic sanctions (Martin, 1992) and applied to international debt by (Kletzer, 1988, p. 589). 26 Perhaps the victims of default could threaten to undercut, rather than punish, any party that violates a boycott. In other words, they could "cheat the cheater" (Kletzer and Wright, 1998). Suppose that a government defaults on one creditor and then initiates a relationship with a third party. When the third party's loan comes due, the original lender could re-establish ties with the debtor, removing any incentive to reimburse the third party. Foreseeing this, the third party would never lend in the first place. Thus, the threat of cheating the cheater could sustain a multilateral embargo by deterring new entrants. This intricate argument seems to suffer from a credibility deficit: the original lender would not cheat the cheater, since a fourth party could undercut any attempts at undercutting the third party. Moreover, the argument applies mainly to large and long-lived investors, so it cannot explain how debt contracts were enforced before World War II, when thousands of individual bondholders provided credit to foreign governments.

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I take seriously in this book. Nevertheless, I argue that domestic regulations are neither necessary nor sufficient to support the kind of debtor-creditor cooperation that we have observed.

The screening model, in contrast, offers a simple reason why third parties would refrain from lending. If a government defaults without adequate justification, it acquires a lemon-like reputation in the eyes of prospective as well as current investors. Given their beliefs about the riskiness of the government, third parties have no incentive to extend new credit, because lending to a lemon would be a money- losing proposition. Note that this argument is not available to advocates of sanctioning models, which do not accommodate learning about the characteristics of the debtor. The screening model becomes even more powerful if we assume that current bankers to a sovereign have more information about risk and return than other potential lenders. In this case, a decision by current lenders to withhold credit would signal to third parties that additional lending would be unwise. A follow-the-leader pattern could emerge, in which third parties mimic the behavior of principal creditors by shying away from offering new loans. Thus the screening model explains why defaulters lose access to capital markets, and it avoids credibility problems that are endemic to sanctioning. 2.2.2 Would the Original Lender Impose an Embargo?

I have argued that third parties would not participate in a credit embargo, but the problem runs deeper: even without the threat of new entrants, the original lender has reasons to refrain from imposing a costly boycott.

Imagine a purely bilateral relationship between a

sovereign government and a foreign creditor, as depicted in Figure 1. In the first period the creditor decides whether to lend a sum of money, normalized to $1, at a positive interest rate r. If the government manages to attract a loan, it will use the money to make an investment with a yield of y (where y > r) and then decide whether to repay the principal plus interest. Although sequential, the game has certain characteristics of the classic prisoner's dilemma. Both parties would gain from cooperation – the creditor would recover its principal plus interest, and the debtor could make an investment that returns more than the cost of borrowing – but the debtor could gain even more by cheating. In a single play of the game, the optimal strategy is default, which leaves the government with the principal as well as the yield on investment. Knowing this, the creditor would never lend in the first place. The pursuit of individual self- interest therefore leads to sub-optimal results for both parties.

Proponents of sanctioning claim that iteration can alleviate this dilemma. If the debtor

and the creditor play the game repeatedly, the creditor could vow to punish a government in default by withholding access to future loans. Provided the government cares enough about the future, the threat of retaliation could deter default in a bilateral setting, even if not in a

Figure 1: Debtor’s Dilemma (payoffs to lender given first)

Lend ~Lend

Repay Default

(0, 0)

(r, y-r) (-1, y+1)

Michael Tomz, p.27

multilateral one. This argument should be familiar to students of economics and political science. It is “the essence of the neoliberal institutional analysis of the problem of cooperation”27 and has been invoked hundreds of times to explain how rationa l and self-interested actors can cooperate without the aid of a central authority.

The sanctioning argument is not fully rational, however, because it depends on an

incredible threat. A financial embargo would undermine the welfare of the creditor by eliminating the potential gains from future lending. In the event of default, the creditor would prefer not to lacerate itself by carrying out this costly punishment. Because the past is sunk, it would be better to let bygones be bygones and re-start the lending relationship. It is hard to deny this objection without violating a basic principle of rationality: actors will behave similarly in similar situations. In pure sanctioning models, the history of play does not change the rules of the game or cause the creditor to revise its beliefs about the characteristics of the debtor. Thus, each subgame is strategically and informationally identical to the previous one, regardless of how the government behaved. A creditor that was willing to lend in the first round of the game should be willing to lend in subsequent rounds, which are isomorphic to the first. By threatening to boycott a government in default, then, the creditor is vowing to act in an inconsistent as well as self- lacerating manner. From a purely rational perspective, this threat makes no sense.

The screening model avoids these credibility problems, because it does not require the creditor to behave inconsistently or injure itself. A bilateral screening game changes from one round to the next as the creditor updates its beliefs about characteristics of the debtor. The history of play is relevant, not as a backward- looking trigger for punishment, but as raw data that affect perceptions about the opponent that the creditor is playing. Thus, we need not invoke schizophrenia to explain why the creditor lends in some rounds but not others. Moreover, the screening model does not oblige the creditor to act against its own interests. The creditor is never called to forego a potentially profitable loan, simply for the sake of retaliating against previous infractions by the government. Rather, the lender calibrates the terms of credit to achieve the optimal combination of risk and return, conditional on the available information. Thus, the screening model can promote cooperation without relying on incredible threats that are part of the sanctioning story.

To rescue the sanctioning model, we must introduce imperfect information about the characteristics of the lender. In particular, we must allow some probability that the debtor is confronting an irrational lender that will play a trigger strategy, regardless of the consequences for its own welfare.28 If the debtor cannot observe the kind of lender it is confronting, even a rational lender may choose to mimic an irrational type, thereby building a reputation for irrationality that could make the threat of retaliation more credible. This argument has several problems, though. First, no story about the reputation of the lender can explain relations between a sovereign borrower and an anonymous bond trader, who by definition could not obtain a reputation and would have no incentive to try. Second, the argument applies exclusively to

27 (Powell, 1991, p. 1306). 28 This idea is developed in another context by Kreps and Wilson (1982) and Milgrom and Roberts (1982), who study a chain store that attempts to deter new entrants by building a reputation for playing trigger strategies. Fudenberg and Maskin (1986) further develop the idea that trigger strategies could work if some players are presumed to be "crazy."

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bilateral sanctioning and cannot motivate third parties that never lent in the first place. Finally, the argument concedes enormous intellectual ground. To make their model work, the advocates of sanctioning must relax the assumption of rationality, and they must admit that sanctioning cannot work without imperfect information about one of the players. In this case, why not endorse the screening model, which makes a different information-based argument that does not compromise rationality, that applies to lending by bondholders as well as commercial banks, and that offers a compelling reason why third parties would not extend credit to a government in default? 2.3 The Credibility of Trade Sanctions and Other Linkages

In the previous section, I challenged the notion that cooperation can arise from the fear of retaliation in a repeated game. I argued that, when debtors and creditors interact on only one issue, the threat of a loan embargo lacks credibility, so it should not deter governments from defaulting on their foreign debts. Now I consider a second type of sanctioning model, in which parties interact on several dimensions and threaten to retaliate on one issue if partners behave selfishly on another. Many theorists have speculated that "tactical issue- linkage" can foster cooperation in much the same way as iteration: by raising the cost of engaging in purely self-serving behavior.29 Assuming the linkage is credible, actors will think twice before crossing their opponents, since the gains from defecting on one dimension may not compensate for the loss of cooperation on another.

Authors have incorporated the idea of issue- linkage into models of international debt. They often assert that investors link finance and trade by threatening to disrupt the commerce of any country whose government refuses to pay. 30 The literature does not always specify exactly how investors could throw sand in the wheels of international commerce, but I consider three potential mechanisms. First, investors could prohibit firms in the defaulting country from obtaining access to letters of credit, transfers of funds, and other financial services that facilitate international trade. Second, investors might lobby their own government to suspend commercial preferences and impose protectionist barriers as retaliation against default. Finally, investors could attempt to seize the exports and imports of the defaulting government. I maintain that these three mechanisms lack credibility, but related arguments are consistent with a screening model.

The threat to interfere with trade-related financial services has been called “the strongest weapon of disgruntled creditors,"31 but it is actually a slender reed. This threat, like the credit embargo story, requires the collaboration of third parties that never participated in the original loan and have little interest in sacrificing their own welfare to retaliate against the defaulter. If the aggrieved creditors withdrew their trade-related services, other parties could profit by stepping into the breach. Moreover, even the victims of default might find tha t punishment would undermine their own interests. In addition to foregoing potentially profitable business, 29 The concept of tactical issue linkage has a long intellectual pedigree. See, for example, (Keohane and Nye, 1977), (Tollison and Willett, 1979), (Haas, 1980), (Stein, 1980), (Keohane, 1984), (Snidal, 1985, p. 939), (Oye, 1986), (Axelrod and Keohane, 1986), (McGinnis, 1986), (Martin, 1992), (Keohane and Martin, 1995), and (Lohmann, 1997). 30 The seminal article is (Gersovitz, 1983). See also (Aizenman, 1989), (Bulow and Rogoff, 1989), (Diwan, 1990). 31 (Rogoff, 1999, footnote 5).

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retaliators could wind-up reducing the likelihood of that the sovereign would repay! To service its international debts the sovereign needs foreign exchange, which it acquires largely from exporters within its territory. By undermining the earnings of exporters, the interruption of trade-related services could prevent the sovereign from resuming payments. At the same time, trade sanctions would preclude firms from importing machinery and other productive inputs, thereby weakening the entire economy. For these reasons, no rational lender would suspend trade-related services simply for punitive reasons. In this example, as in other versions of the sanctioning story, the threat of retaliation is not credible. The screening model, in contrast, suggests a realistic connection between sovereign default and the supply of trade-related services. In the discussion of learning across space, I argued that the behavior of the sovereign imposes externalities on all firms in the domestic economy. News of a sovereign default would prompt investors to lower the credit ratings of importers and exporters. As ratings declined, investors would charge higher interest rates, demand more collateral, and reduce credit ceilings – all classic responses to risk. Thus, the supply of trade-related services would shrink, not because investors were collaborating in a punitive embargo against the government, but because they were adjusting to adverse information about public and private firms. The proponents of sanctioning correctly identify an association between default and trade, but they mis- identify the key causal mechanism. After a sovereign default, commercial credit will evaporate because of Bayesian learning, not tactical linkage. In a second version of the linkage story, investors allege that their home government would impose trade sanctions in the event of default. This threat, like many others, fades in the presence of third parties; a defaulting government could minimize its punishment by finding new commercial partners or transshipping products through other states. Moreover, trade sanctions would undermine the interests of the home country by reducing the gains from commercial exchange, and by depriving the sovereign of the ability to resume payments. Finally, trade sanctions would hurt vocal and well-organized interest groups, such as exporters and importers that do business with the defaulting country. Thus, the home government probably would not implement the investors' threat. In later chapters I show that fears of protectionism by the home country have not motivated governments to pay, even in the "most likely" case (Argentina in the 1930s) that authors repeatedly cite to illustrate this argument. According to a third version of the linkage story, investors enforce compliance with debt contracts by threatening to confiscate the exports, imports, and other foreign assets of any government that defaults. This argument, too, suffers from credibility problems. Until the mid-1970s, the strict doctrine of sovereign immunity prohibited investors from foreclosing on the assets of a foreign government. In recent years the doctrine has softened, but the scope for investor action remains limited. If they did win a judgment, investors could only seize assets that belonged to the sovereign and resided in the creditor country; they could not, for instance, confiscate the holdings of private firms with foreign operations. By all accounts, sovereign debts far exceed the value of potentially attachable assets. Moreover, law prohibits disgruntled investors from taking more than they are owed. From the perspective of the sovereign, then, the "worst case" would be no worse than paying in full, and the likely outcome would be considerably more favorable. Considering that attachment was not possible until the mid-1970s,

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and that even now the possibilities are limited, this argument cannot explain why sovereigns have honored their debts for centuries. To the extent that it succeeds, though, the confiscation story fits better within a screening paradigm. Confiscation “is not the same as retaliating action [that] punishes the host without directly helping the investor."32 Instead, it is a salvage operation. If a government defaults on its foreign debts, investors will respond in two ways. They will use Bayesian principles to update their beliefs about risk, and they will attempt to recover at least a modicum of their original investment. Confiscation, like foreclosure in a domestic bankruptcy, has nothing to do with sanctioning. Investors that seize airplanes or bananas are simply offsetting losses they incurred when the sovereign defaulted, and would not explain their behavior as an effort to “punish” the government for cheating. When investors discover that they have lent to a lemon, confiscation seems like the natural response. Now that limited confiscation is legally permissible, we should expect investors – especially bondholders – to attempt it with increasing frequency in the future. If compliance does not arise from a tactical linkage between debt and trade, could it emerge form the threat of military retaliation? Some researchers have asserted that, at least in the second half of the 19th century, “major Western powers used gunboat diplomacy to prevent debt repudiation.” They deployed warships and soldiers to far- flung regions of the globe, thereby “providing the public good of contract enforcement.”33 This argument has several problems, however. First, military intervention – like many other sanctions – imposes costs on the aggressor as well as well as the target, and it is not obvious that policymakers would pay the price. Second, military intervention can be counterproductive. Dwight Morrow, a senior partner at JP Morgan during the 1920s, called war “a fruitless remedy for breach of contract,” because conflict debilitates the very debtor that is supposed to pay. 34 Finally, as I show later in the book, gunboat diplomacy lasted no more than fifty years and disappeared entirely in the early 20th century, when Western powers renounced the right to intervene against recalcitrant debtors.35 2.4 Implications for Sanctioning and Screening

Proponents of sanctioning claim to show how rational actors can cooperate without the aid of a central authority. In previous sections I developed an internal critique of sanctioning models. Taking the assumption of rationality seriously, I indicated why investors would not implement their threats of reciprocity and linkage in the event of default, and why a sovereign would not cower in the face of incredible threats. Thus, the prospect of decentralized sanctions probably does not sustain cooperation between debtors and creditors. Some of my criticisms apply narrowly to sanction-based models of debt, but others cast doubt on the entire sanctioning paradigm. I conclude this discussion by suggesting why many sanctioning models in international relations cannot stand on their own rational feet.

32 (Gersovitz, 1983, p. 2) 33 (de Grauwe and Fratianni, 1984, p. 158) 34 (Morrow, 1927, p. 231). See also (Frieden, 1989). 35 (Finnemore, 1996)

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In studies of international relations, authors commonly invoke the "folk theorem" to justify how cooperation could emerge from the threat of retaliation in a repeated game.36 Often seen as the paragon of rationality, the theorem actually relies on irrational threats. Before the repeated game begins, each player would like to threaten the most severe sanctions (such as the grim trigger) to deter its opponent from behaving selfishly. Once the game starts, though, the players would prefer to overlook defections, since the past is sunk and retaliation would only eliminate gains from future exchange. In the jargon of game theory, the behavior of players is subject to a fundamental time-inconsistency. The folk theorem ignores this inconsistency, and therefore rests on unbelievable threats.37 It seems impossible to dodge this criticism without violating the principle that rational actors will behave similarly in similar situations.38 A truly repeated game is stationary, in the sense that each round looks exactly like the previous one, regardless of the history of play. In this context, a rational actor should not condition its behavior on previous moves by its opponent. Without history-contingent strategies, though, no actor would have an incentive to cooperate. Thus, the folk theorem requires each player to believe that its opponent would act in self- flagellating and logically inconsistent ways. By multiplying the number of issues, linkage models only exacerbate these problems of credibility.

Given these objections, screening seems preferable to sanctioning as a general theory of cooperation under anarchy. My discussion of sovereign debt suggested two methods of rebuilding the sanctioning story. First, theorists could introduce "crazy" players who would be willing to inflict pain on themselves and act differently in similar situations. This approach effectively cedes the grail, however. Once deranged players enter the story, the sanctioning model loses all hope of explaining how rational actors could cooperate without a central authority. As a second tack, researchers could argue that political institutions compel actors to impose sanctions. In the case of sovereign debt, I noted that domestic law might facilitate a credit embargo by prohibiting private investors from lending to a sovereign in default. Here, the home government uses its monopoly on force to punish investors who refuse to punish. This approach, too, concedes the prize. By invoking a Leviathan with jurisdiction over international lenders, we have ceased to explain cooperation under anarchy. The screening model, in contrast, fully retains the assumption of rationality, and it applies with or without a central authority. Thus, the screening model represents an important step toward solving the puzzle of cooperation under anarchy.

This book focuses on relations between private and public actors, but it can also inform

our understanding of intergovernmental cooperation. In the context of imperfect information, the screening model indicates how a sovereign might sort its opponents into categories based on their record of compliance with international agreements. The model explains why some governments cannot attract partners for cooperative endeavors, and it indicates why governments that partner-up generally keep their promises, except when external conditions warrant a breach. In contrast, sanctioning models have trouble accounting for government-to-government 36 Technically, the theorem states that any individually rational outcome can emerge as a Nash Equilibrium if to parties play the same stage game ad infinitum and do not discount the future too much (Fudenberg and Maskin, 1986). Authors tend to assume that parties will coordinate on the most cooperative outcome, though this assumption is debatable. 37 A version of this critique is now "widely accepted" among game theorists (Abreu and Pearce, 1991, p. 44), but it has not yet penetrated the literature on international cooperation. 38 (Güth, Leiniger et al., 1991)

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cooperation, because they require threats that rational actors would not be willing to carry out. International institutions have a hard time solving this problem. A sovereign government can compel private investors to retaliate, but an international institution cannot force sovereign governments to apply sanctions against their will. The original insight of institutional theory is essentially correct: institutions promote cooperation “by providing information to actors, not by enforcing rules in a centralized manner.”39 Many institutions supply data about the preferences and capabilities of governments, as well as their history of collaborative and self-serving behavior. These institutions promote cooperation, not by “making the threat of punishment more credible,”40 but by assisting actors in sizing-up their potential partners. The fear of being institutionally certified as a lemon and screened-out of international agreements encourages most governments to honor their foreign commitments most of the time.

Readers should not interpret the arguments and evidence in this book as a comprehensive

rejection of sanctioning models. In the case of sovereign debt cooperation arises primarily through screening, but threats may discourage default under certain conditions. My principal conclusion, however, is that effective mechanisms for supporting self- lacerating threats are unlikely in theory and rare in practice. For this reason, a sanction-based model probably cannot provide a general explanation for international lending and repayment over the centuries. Screening mechanisms, which put reputation and learning at the center of the analysis, seem far more likely to account for the history of debtor-creditor relations. 3. Competing Hypotheses and Empirical Tests

I have argued that the screening model is analytically preferable to sanction-based alternatives. Without resorting to dubious threats or introducing irrational actors, the screening model explains why governments pay their foreign debts. Some readers may accept screening solely on its theoretical merit, but most will demand evidence -- as well as reasoning – before making up their minds. After all, sanctioning models continue to dominate the literature on cooperation in economics and politics. From a Bayesian perspective, then, it may take extra effort to overturn prior opinions about the importance of sanctioning in debtor-creditor relations! In this section, I describe my methodological approach to testing the screening and sanctioning models. Detailed descriptions of the variables and empirical techniques appear in subsequent chapters.

My approach follows the basic rules of scientific inference. For each model I identify

many observable implications: patterns of behavior that we would expect to find if the model epitomized debtor-creditor relations. Then I measure how extensively the expected patterns appear in data from international capital markets. My strategy involves putting each model at risk as many times as possible, by scrutinizing a large number of observable implications over the past three hundred years. The more implications I can confirm with evidence, the more confidence readers should have in the validity of the model. Surprising results, on the other hand, would cast doubt of the model's explanatory power. To the extent possible, I focus on cases in which the two models predict distinctive behavior. These "critical" tests reveal which mechanism exerts a stronger and more consistent effect on relations between sovereign

39 (Katzenstein, Keohane et al., 1998, p. 662). 40 (Keohane and Martin, 1999, p. 31).

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borrowers and private lenders. As we will see, the preponderance of evidence rests with screening rather than sanctioning.

In the first phase of testing, I examine how private investors actually behave toward

foreign governments (see Chapter 2). Do investors extend new loans and trade existing debt in ways that suggest either screening or sanctioning? Do they cite the logic of either theory to justify the choices they make? As conscious actors, humans should be capable of articulating how they arrive at important financial decisions, such as organizing a loan for Argentina or withholding credit from Brazil. The screening model does not require investors to recite the formula for Bayesian updating, but it does imply that investors couch decisions in terms of imperfect information, reputation and learning. Likewise, sanction-minded investors need not derive the folk theorem of repeated games, but they should see themselves as retaliating against cheating, rather than adjusting to new information about risk. By noting whether investors invoke the logic of screening or sanctioning, we can gain deeper insight into their motivations. This kind of test will prove extremely useful when the models predict identical behavior, albeit for different reasons.

To some extent, the behavior of investors looks the same under screening and

sanctioning, particularly when the preferred sanction is a credit embargo. Investors stop lending to governments in default and are especially tightfisted if external conditions did not provoke the interruption of payments. Showing that investors respond this way would be an important contribution, given the conventional wisdom that creditors ignore history, but it would not help with the more difficult task of distinguishing between screening and sanctioning. How could researchers know whether investors regard the credit record of a government as information about risk or as a trigger for retaliation? To answer this question I consider many additional implications of the competing models. For reasons already noted, I probe primary sources that reveal how investors conceive of their own decisions toward governments in default. I also examine what investors say and do in a variety of other situations where the screening and sanctioning models make different predictions. A consistent pattern of screening- like behavior on many issues would boost confidence in my theory, relative to the leading alternative.

I test the screening model by developing new measures of incomplete information and

asking how investors respond to them. The screening model predicts that investors will offer worse credit to unproven governments than to better-known entities, reflecting the risk that new borrowers could be lemons. As governments become more seasoned payers, access to credit should improve. The seasoning process exemplifies a more general phenomenon: investors adjust the terms of credit when governments behave contrary to their perceived type. They grant easier access to governments that exceed expectations and tighten credit when politicians display less resolve and competence than previously anticipated. All these effects would seem anomalous within a sanctioning paradigm, where information about debtors does not vary. To the extent that lemon premiums, seasoning effects, and surprise appear in the historical data, we should gain increasing confidence that the screening model provides a general account of debtor-creditor relations. I also put my model at risk by testing for informational externalities. Under screening, the behavior of a government should ripple across time and space to affect the perceived creditworthiness of successor administrations, domestic corporations, and even foreign countries. I document these externalities, reinforcing the validity of the screening story.

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I conduct parallel tests to see whether investors behave punitively in relations with

sovereign debtors. Sanctioning models predict that “any increase in the penalty lenders can impose on the sovereign should also increase the sovereign’s access to credit”41 Investors should, therefore, conduct most of their lending through well-organized and powerful banks instead of purchasing sovereign bonds on the open market, and they should extend easier credit when domestic laws and stock market regulations reinforce the plausibility of threats. According to the sanctioning model, investors will offer better terms to countries that are vulnerable to economic and military sanctions, while withholding loans from states that are strong enough to resist punishment. In making these decisions, sanction-minded investors will fixate on their coercive power to deter the sovereign from defaulting. I show that most of these predictions do not hold, casting doubt on the sanctioning model.

After scrutinizing the behavior of investors, I turn my attention to sovereign borrowers

(See Chapter Three). Do governments act in ways that appear consistent with the screening model, or do they respond mainly to threats of retaliation by investors? At first glance this question seems intractable, since the two models predict somewhat similar behavior. Most sovereigns will pay their foreign debts, except during periods of external crisis, and countries that depend heavily on foreign loans and short-term commercial credit will meet their obligations with special vigor. These propositions are worth testing, because they provide a foundation for the screening and sanctioning models, but they cannot illuminate the principal mechanism that motivates governments to pay their debts. As a step toward solving the puzzle, I consider how politicians explain their own behavior in public and private statements. The evidence shows that governments service their debts to preserve their international image as trustworthy borrowers, not to avoid economic and military sanctions.

To verify that the screening model better explains the behavior of governments, I

consider the issue of discriminatory repayment. If the sanctioning model captures the essence of debtor-creditor relations, a sovereign should give preferential treatment to lenders that are most capable of punishing it. For instance, the sovereign should show greater care in relations with multinational banks than with atomized bondholders, and it should prioritize loans from investors that also supply trade-related services. Likewise, the sovereign should favor investors in countries that have strong anti-default laws, are major trading partners, and could launch a credible military assault. The screening model makes the opposite predictions. If the sovereign shows any bias, it will assign precedence to private bondholders, which are more likely to allocate capital based on perceptions of risk. The sovereign should not discriminate based on trade, even when lenders reside in a principal export market, nor should it favor loans from investors in militarily powerful states. The evidence on these points supports the screening model.

Finally, I check for reputation-enhancing behavior by the government. According to the screening model, underrated governments will attempt pay more than investors expect, to bring their reputations in closer alignment with reality. This behavior would seem perplexing from the perspective of sanctioning. The most sophisticated sanctioning models suggest that debt contracts are implicitly state-contingent: investors understand that defaults will arise under 41 (Schultz and Weingast, 1998, p. 16)

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adverse circumstances and only punish a government for paying less than the implicitly agreed-upon schedule. In these models, paying extra would be pointless, since meeting the schedule would suffice to avoid retaliation. The screening model also shows how governments have incentives to build and protect the reputations of neighbors, perhaps by organizing a payer’s cartel. Under a sanctioning framework, we would observe the opposite behavior: instead of banding together as eager payers, governments would coalesce for the purpose of bargaining with foreign banks. A summary of the main hypotheses appears below.

The next two chapters of this book present many empirical tests, each with its own

dependent and explanatory variables, and each relying on a slightly different empirical method. Some tests draw on quantitative data that I have collected by hand from hundreds of sources, while others use qualitative information that I gathered from field research in Europe, Latin America, and the United States. All tests, though, help us triangulate on the core question of why governments pay their foreign debts. The theory and evidence strongly suggest that compliance arises through screening, rather than sanctioning. By elaborating on the logic of screening and showing how it operates in practice, the findings of this book should contribute to resolving one of the oldest and most important problems in international relations: how can rational actors cooperate without the aid of a central authority?

Predictions about the behavior of lenders•Premium for uncertainty (offer worse credit to relatively unknown borrowers)•Adjustment to surprise (recalibrate credit in response to unexpected behavior)

•Spillover to others (contagion -- behavior of one borrower affects loans to others)•Preference for banking (lend through powerful banks, avoid sovereign bonds)•Preference for weaklings (extend easier credit to more vulnerable governments)•Statements of lenders (public and private)

Lenders say they are responding to new information about the debtorLenders say they are issuing threats and retaliating against past cheating

Predictions about the behavior of borrowers•Paying to surprise (debtors sometimes pay more than investors anticipated)

•Cartels for repaying (debtors collude to keep the neighborhood clear of defaults)•Cartels for resisting (debtors collude to thwart the retaliation of lenders)•Discrimination in repayment (prioritize loans from the most powerful investors)

Screening Sanctioning

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4. Works Cited

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