This book examines two interconnected and previously unsolved puzzles: why do governments repay their debts to private foreign lenders, and what gives bondholders and banks the confidence to lend billions of dollars abroad each year? To address these puzzles, I develop a theory of reputation that involves incomplete information, political change, and contextual inference. I then test my theory and the leading alternatives by analyzing a new body of evidence that covers all sovereign debtors in the world across three centuries of financial history.
A Theory of Cooperation through Reputation: According to my theory of reputation, the preferences of governments are heterogeneous: some governments assign greater value than others to maintaining good relations with creditors, and their preferences can change over time. Investors cannot fully know the preferences of a foreign government, but they do have beliefs about the government’s “type.” Those beliefs, which constitute the government’s reputation, evolve as investors observe behavior in context—as they review the government’s record of repayment during good times and bad. Borrowers understand this reputational logic and take it into account when deciding whether to default.
My theory explains why investors lend (because they perceive the borrower as a reliable type) and why governments repay (because they want a reputation for reliability, which allows access to foreign capital). Beyond that, the theory generates a wide range of testable implications about the dynamics of debtor-creditor relations. It predicts how investors treat first-time borrowers and how risk premiums evolve as borrowers become more seasoned. It explains how debtors ascend or descend the reputational ladder due to the interaction between their behavior and the historical context, and then clarifies how changes in reputation affect access to capital. The theory also helps explain why countries with favorable reputations sometimes default, and why nations with histories of noncompliance suddenly settle with foreign creditors.
Empirical Analysis of the Reputational Theory: The evidence, gathered from archives in nine countries, strongly supports my theory of reputation. From the Amsterdam market of the 1700s, through the rise of London and New York as financial centers, to the Euromarkets of today, reputations have formed and influenced behavior in a remarkably consistent way. The data strongly confirm each of the following predictions of my reputational theory:
- Uncertainty premiums and seasoning effects: Investors charge higher interest rates to new borrowers than to more established entities, to cover the risk of lending to a potential “lemon.” As borrowers acquire a record (as they become more seasoned), investors update their beliefs and recalibrate the terms of credit. Countries that pay, thereby distinguishing themselves from bad types, see their risk premiums decline asymptotically toward a risk-free rate.
- Market exclusion and market reentry: By defaulting, countries signal that they are less reliable types and lose access to international capital markets. Past defaulters regain access by signaling, through a costly compensation package, that they put a high value on relations with creditors.
- Contextual inference: Countries ascend and descend the reputational ladder based not only on their behavior but also—when available—on data about the circumstances they faced. Investors show especially low regard for borrowers that default without a valid economic excuse; do not disparage debtors for defaulting during hard times; and upgrade low-rated debtors that exceed expectations by servicing their debts under extreme hardship.
- Equilibrium defaults: In my theory (unlike many others), defaults occur in equilibrium. They arise from incomplete information, political change, and exogenous shocks. Specifically, defaults occur when investors lend to borrowers that have not yet been revealed as lemons; when political change causes bad types to inherit the loans of good-type predecessors; and when adverse economic shocks raise the cost of repayment while lowering the reputational penalty for reneging.
- Cooperation with atomized, short-lived actors: Cooperation can emerge even when investors are short-lived and have little capacity for collective action. The evidence indicates that concerns about reputation have sustained lending and repayment across the centuries, even when capital has come from thousands or millions of disparate bondholders around the world.
- Reputational rhetoric: Investors and credit rating agencies consistently identify reputation as the first test of a government bond, and governments regularly articulate a reputational rationale for repaying their loans. Historically under-rated borrowers that paid despite great hardship—epitomized by Argentina in the 1930s—have done so with the aim of raising their reputations.
The same evidence that supports my theory also casts doubt on the leading alternative accounts of reputation in world affairs. For example, I find little support for “desire-based” theories of reputation, according to which people draw systematically biased lessons from history, and “current calculus” theories, which suggest that past behavior has little impact on present beliefs.
Empirical Analysis of Nonreputational Mechanisms: My book not only builds a case for reputation but also questions the importance of the nonreputational mechanisms that are central to the existing sovereign debt literature. Many researchers argue that lenders enforce debt contracts via issue linkage: they threaten to punish defaulters by imposing nonfinancial penalties such as trade sanctions, diplomatic pressure, or military intervention. I find that such issue linkage has proven relatively unimportant in practice.
In particular, my work challenges a common view about the historical importance of gunboat diplomacy. It is widely believed that, before World War I, the fear of gunboat diplomacy motivated countries to repay foreign loans. I show that the apparent correlation between sovereign default and military intervention is mostly spurious. Militarized disputes between creditors and debtors arose not because creditors were using arms to defend bondholders, but because default coincided with other disputes (civil wars, territorial conflicts, and tort claims) that attracted the involvement of foreign powers. Even the so-called bondholder war against Venezuela in 1902 was really about torts, not bonds. Analyses of diplomatic correspondence, geographic patterns of investment, and default rates against strong and weak creditors are also inconsistent with the gunboat hypothesis.
My book also disputes the relevance of enforcement via trade sanctions. During the interwar period, the alleged heyday of tactical linkage between debt and trade, the countries most exposed to international commerce did not repay at a higher rate than more insular nations. Moreover, defaulters did not discriminate in favor of their major trading partners, as trade sanctions theory would predict. Researchers often cite interwar Argentina as the prime instance of using trade to bully borrowers. Close inspection of archival evidence, however, shows that even in the Argentine case, the government repaid to enhance its reputation, not to avert a trade war. I came across only two references to trade sanctions in more than 96,000 newspaper clippings about sovereign debt, and my systematic survey of investment commentary from the 1920s found almost no evidence for the trade sanctions hypothesis.
Finally, my research disconfirms the common claim that collective action (collective retaliation) is necessary to enforce loan contracts. For centuries, money flowed to sovereign borrowers via atomized bond markets, even though bank lending would have provided more punishment power. When investors finally began to lend through commercial banks in the late twentieth century, neither the terms of lending nor the patterns of repayment matched the predictions of sanctioning theory. Single banks lent on the same terms as well-organized syndicates, and governments that had borrowed from both bondholders and banks did not treat the latter more favorably, despite the enormous disparity in retaliatory power. These patterns, though anomalous from the standpoint of sanctioning theory, are consistent with my reputational argument, which supports lending and repayment even when investors are atomized and short-lived.
Implications for Cooperation under Anarchy: The theory and evidence presented in my book have potentially broad implications for understanding cooperation under anarchy. With an improved theory of reputation—one that emphasizes incomplete information and political change, and posits that observers study behavior in historical context—I was able to discover reputational effects that had previously been overlooked. The concluding chapter discusses how these insights about reputation could apply to other areas of international relations, including foreign direct investment, international trade, military deterrence, and alliance politics.