Published by EH.NET (February 2008)
Michael Tomz, Reputation and International Cooperation: Sovereign Debt across Three Centuries. Princeton, NJ: Princeton University Press, 2007. xxi + 299 pp. $60 (cloth), ISBN: 978-0-691-12930-3.
Reviewed for EH.NET by Kim Oosterlinck, Solvay Business School, Universit? Libre de Bruxelles.
In view of the sovereign nature of their issuer, and in the absence of a supranational court to judge them in case of default, one may wonder why countries would ever bother to repay their debts. The economic literature has suggested several motivations: fear of reputation loss (which would ban the access to future borrowing or make it much more costly), fear of a military intervention or of trade sanctions, as well as, but to a lesser extent, fear of the seizure of collaterals. Michael Tomz, assistant professor of political science at Stanford University, provides an interesting analysis of the importance of reputation for sovereign debt repayment and on its relevance in a broad historical perspective.
After a brief review of the literature, Tomz presents his theory of cooperation through reputation. Its development proceeds as follows. Investors cannot know in advance whether a given government will decide to honor its debts or decide to default. However, these investors may form beliefs regarding the probabilities of each of these outcomes. These beliefs represent the country’s reputation. Tomz classifies countries in three broad groups: stalwarts (for which repayment is expected whatever the economic conditions), fair-weather (expected to repay in good conditions but not during hard times) and lemons (expected to default in all times). According to Tomz, investors will reassess the reputation of each country in view of its actions. Domestic elections may change priorities and the importance of reputation. However, decisions to default or repay allow governments to try shifting from one form of reputation to another. The remainder of the book aims at testing the validity of the above-mentioned theory.
Chapter three compares the reputations of new and seasoned borrowers. More precisely, the author tests whether new borrowers face worse credit terms than seasoned ones with a good reputation, whether there is a “graduation effect” (new borrowers who repay should eventually get similar terms as seasoned borrowers) and whether defaulters are excluded from the market. The author relies on empirical evidence from the Amsterdam market in 1771 and 1783 and from the London market in 1824 and 1872. Comparing the yield for new and seasoned borrowers, he finds that new borrowers had to pay a statistically significant premium to borrow.
I found Chapter 4 one of the most interesting and original chapters of the book. Tomz has done an impressive job by analyzing the investment literature published between 1919 and 1929. To my knowledge the history of economic thought in this field remains unwritten. By relying on expert opinion as expressed at the time, Tomz shows that reputation was perceived as the most important element, especially when compared to other conventional reasons invoked for debt repayment.
Chapter 5 assesses to which extent governments’ actions are judged in a similar way in good or bad economic times. More precisely, it analyzes the reward for states which exceeded expectations during the Great Depression by repaying their debts. The author finds that defaulters in bad times where not badly punished but that unexpected good payers such as Argentina, Australia and Finland were rewarded.
Chapters 6 through 8 are dedicated to the alternative theories suggested to explain debt repayments: gunboat diplomacy (Chapter 6), trade sanctions (Chapter 7), and collective retaliation (Chapter 8). Regarding military enforcement, Tomz puts into perspective the number and motivation of actual interventions, the number of debt defaults and the respective military strength of lenders and defaulters. In view of the limited number of interventions attributable to defaults, he concludes that military intervention only played a minor role in the repayment process. Trade sanctions are analyzed by comparing debt service and trade dependency with creditors. Here again, Tomz finds only limited evidence that potential trade sanctions forced debtors to repay. Chapter 8 discusses the relative importance of creditors’ ability to form a retaliatory cartel. Based on evidence from the end of the twentieth century, Tomz finds that lending and default patterns were the same for unorganized lenders as for more organized ones, suggesting that retaliation by cartels was not viewed as credible. Chapter 9 concludes by stressing once more how crucial reputation is when assessing motivations to default.
The book has several obvious merits. First, it relies on extensive data sources, most of them original and covering a very large time-span and geographical area. Secondly, it shows the importance of politics when assessing debt defaults, an element often overlooked by economists. Indeed, defaults represent a unilateral decision made by a given government: defaults are not automatically triggered by an economic variable (even though these variables play an obvious role in the decision to default). Furthermore, this book provides an interesting and refreshing approach to reputational theories in the sovereign debt context. The main point of the book is to prove that reputation is key to understanding decisions to default. At the end of the book, the reader should end up being convinced of its prominent role.
All interesting books raise questions and remarks and this one is no exception. Despite its qualities, as an economic historian I found the book presents a series of shortcomings. Economic variables are omitted most of the time when comparing yields, and when included, limited to one or two macroeconomic factors. For some periods, these data do not exist; for the more recent ones they do and have been used in recent papers. In a sense, the reader gets the impression that economics plays almost no role in the perceived probabilities of defaults. This is rather hard to believe. The author analyzes each alternative motivation to repay separately. It would have been interesting to analyze the relationship between these motivations (as for example, in Mitchener and Weidenmier, 2005a).
Another question is raised by the way the yields are computed. “For each country [the author] identified the lowest nominal interest rate on bonds that were not guaranteed by a foreign power, and then calculated yields based on the average of the minimum and the maximum quoted prices for bonds at that interest rates” (footnote, p. 41). I am unconvinced by this approach since it does not take into account volatility, a key measure in finance when one wishes to assess risk. In other words, two bonds with similar coupon rates would end up having the same yield even if one remained constant at, for example a price of 80 percent of par, whereas the other moved from 60 percent to 100 percent. Unless investors were risk neutral at the time, which I doubt, they should find the second bond riskier and hence ask for a higher yield. Furthermore, the yields used by the author are current yields (the ratio of the coupon rate divided by the price of the bond). Even though current yields have often been used by economic historians, yields to maturity would have provided a much better measure since they take into account the impact of bonds’ duration and maturity and capture expected returns from capital gains (for example zero-coupons would have a 0 percent current yield because all their return is made via capital gains).
The relative importance of each motivation to repay has been analyzed in very different ways. Whereas for reputation the main indicator was the current yield, the author relies on other variables for military interventions or trade sanctions. These variables are certainly interesting, but one wonders whether some of the impact of potential military interventions or trade sanctions would not have materialized had the author relied on current yields in these sections. Recent work by Mitchener and Weidenmier (2005a and 2005b) seems to indicate that this would have been the case.
Since the book is subtitled, “Sovereign Debt across Three Centuries,” I was expecting a more in-depth historical analysis. I fully understand that the book jumps from one time period to another depending on the point the author wants to make. However, I found surprisingly little references to history when discussing the findings. In Chapter 3, the author concludes that the higher yield paid by a series of countries in 1771 stemmed from their new borrower status. For some of these countries, alternative historical explanations seem more (or at least as) convincing. Was the high yield required from Russia in 1771 a consequence of its “new borrower” status or was it due to the Russo-Turkish War? To what extent can we attribute the Swedish high yield to the political instability at the time? Etc.
Eventually, the book omits some recent theories using historical approaches to assess the probabilities of defaults. For instance, no mention is made of “original sin” issues (Eichengreen and Hausmann, 1999, Eichengreen, Hausmann and Panizza, 2003) or “debt intolerance” (Reinhart, Rogoff, and Savastano, 2003). The same holds for the few papers which have attempted to make a link between sovereign defaults and politics (political system but also type of regime, etc.) such as Kohlscheen (2006) or Van Rijckhegem and Weder (2004) for example.
Barry Eichengreen and Ricardo Hausmann, “Exchange Rates and Financial Fragility,” NBER Working Paper 7418, 1999.
Barry Eichengreen, Ricardo Hausmann, and Ugo Panizza, “Currency Mismatches, Debt Intolerance and Original Sin: Why They Are Not the Same and Why It Matters,” NBER Working Paper 10036, 2003.
Emmanuel Kohlscheen, “Why Are There Serial Defaulters? Quasi-experimental Evidence from Constitutions,” Warwick Economic Research Papers 755, 2006.
Kris Mitchener and Marc Weidenmier, “Supersanctions and Sovereign Debt Repayment,” NBER Working Paper 11472, 2005a.
Kris Mitchener and Marc Weidenmier, “Empire, Public Goods, and the Roosevelt Corollary,” Journal of Economic History, 2005b, 66: 658-92.
Carmen M. Reinhart, Kenneth S. Rogoff, and Miguel A. Savastano, “Debt Intolerance,” Brookings Papers on Economic Activity, 2003, 1: 1-74.
Caroline Van Rijckhegem, and Beatrice Weder, “The Politics of Debt Crises,” CEPR Discussion Paper 4683, 2004.
Kim Oosterlinck is associate professor at the Universit? libre de Bruxelles. He recently published “Hope Springs Eternal: French Bondholders and the Soviet Repudiation (1915-1919)”, Review of Finance, 2006 (jointly with John Landon-Lane) and “How Occupied France Financed Its Own Exploitation during World War II,” American Economic Review, Papers and Proceedings, 2007 (jointly with Filippo Occhino and Eugene N. White).