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Michael Tomz

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"In Reputation and International Cooperation, Michael Tomz uses the experience of international lending over four centuries to assess the sources of international conflict and cooperation. Tomz argues that debtors collaborate with creditors because they are concerned about their reputations, refuting a host of widely accepted explanations for why sovereign debtors pay their debts. He marshals a wealth of evidence, ranging over time from eighteenth-century Amsterdam to the present, and using everything from bond yields through data on military disputes to current interviews. The result is a remarkably thorough, concise, and convincing analysis of the political economy of international debt with profound implications for the study of international politics more generally."--Jeffry Frieden, Harvard University

"Based on meticulous research from a wide variety of sources, Tomz's book clearly establishes the importance of a state's previous behavior and its resulting reputation for the rate of interest it must pay when it next enters the international financial market. Carefully conceived and ingeniously executed, this study is a real model."--Robert Jervis, author of System Effects and Perception and Misperception in International Politics

"This book is a gem. I cannot think of a better book on political economy and economic history. In all important categories, the book makes major contributions. Tomz's argument is original and logically compelling, and it produces unique, testable implications. His data represent years of painstaking research and stand as an almost impossible achievement."--J. Lawrence Broz, University of California, San Diego

"No other work in international relations is more impressive in its systematic use of so many kinds of evidence--archival, available quantitative data, case studies--to test such a clear set of alternative hypotheses. Michael Tomz has produced a pathbreaking study."--Robert Keohane, Princeton University

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Reputation and International Cooperation

Princeton University Press

Chapter One

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

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

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

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

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

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

The Puzzle

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

Repeat Play

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

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

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

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

How have scholars explained investors' apparent inattention to history? Some cite ignorance. Vinod Aggarwal opens his massive study of debt rescheduling by contending...