Institutional Foundations of Financial Power 7 or printing money.Borrowing can be further broken down into voluntary and in- voluntary forms.The former usually involves the sale of government bonds or,in earlier periods,short-term loans to the crown;the latter involves coerced loans or forced savings plans.Any of these strategies can raise significant funds in the short term,and states have historically relied on a mix of funding mechanisms in times of war.19 Over the course of an extended rivalry,however,one strategy is clearly superior in terms of promoting economic efficiency:raising public debt through voluntary borrowing.It is here that liberal states have enjoyed a systematic advan- tage relative to their illiberal rivals. Public Debt and Financial Power The importance of public debt in determining the outcomes of international com- petition has been known for some time.In the seventeenth century,the rivals of the Dutch Republic expressed "despairing admiration"at that country's seemingly inexhaustible supply of cheap credit in wartime.20 Likewise,French officials in the eighteenth century came to envy the ease with which Great Britain could raise money at low interest rates.21 By 1795,Immanuel Kant would consider public debt to be so vital to the conduct of war that his "fourth preliminary article for perpetual peace among nations"proscribes the raising of debt for use in foreign affairs.22 More recently,scholarship on the rise and fall of world leaders has iden- tified the key role played by public borrowing.The most explicit formulation comes from Rasler and Thompson,who surveyed the experiences of Portugal,the Dutch Republic,and Great Britain and concluded that ..early winners in the struggle for world leadership owed a significant pro- portion of their success to their ability to obtain credit inexpensively,to sus- tain relatively large debts,and in general to leverage the initially limited base of their wealth in order to meet their staggering military expenses.23 Moreover,Rasler and Thompson suggest that the losers of these contests,notably France and Spain,failed to maintain uninterrupted access to credit and experi- enced frequent bankruptcies.24 19.For an excellent cross-national analysis of war finance during World Wars I and II,see Fujihira 2000. 20.Barbour1950,81-82. 21.Sargent and Velde 1995. 22.Kant 1983,109.At the outbreak of the Crimean War,William Gladstone,then Britain's chan- cellor of the exchequer,tried to integrate this philosophy into his policy of war finance.He argued in the House of Commons that paying for war with loans obscured the true costs of war and that reliance on taxes alone would serve as a "salutary and wholesome check"on "ambition and lust of conquest." Six weeks later,the Treasury sold f6 million in bonds,and,in his final weeks as chancellor in 1855, Gladstone was contemplating borrowing f12 million more.Anderson 1967,195-97. 23.Rasler and Thompson 1983,490. 24.Rasler and Thompson 1983
Institutional Foundations of Financial Power 7 or printing money. Borrowing can be further broken down into voluntary and involuntary forms. The former usually involves the sale of government bonds or, in earlier periods, short-term loans to the crown; the latter involves coerced loans or forced savings plans. Any of these strategies can raise significant funds in the short term, and states have historically relied on a mix of funding mechanisms in times of war." Over the course of an extended rivalry, however, one strategy is clearly superior in terms of promoting economic efficiency: raising public debt through voluntary borrowing. It is here that liberal states have enjoyed a systematic advantage relative to their illiberal rivals. Public Debt and Financial Power The importance of public debt in determining the outcomes of international competition has been known for some time. In the seventeenth century, the rivals of the Dutch Republic expressed "despairing admiration" at that country's seemingly inexhaustible supply of cheap credit in wartime." Likewise, French officials in the eighteenth century came to envy the ease with which Great Britain could raise money at low interest rates." By 1795, Immanuel Kant would consider public debt to be so vital to the conduct of war that his "fourth preliminary article for perpetual peace among nations" proscribes the raising of debt for use in foreign affair^.'^ More recently, scholarship on the rise and fall of world leaders has identified the key role played by public borrowing. The most explicit formulation comes from Rasler and Thompson, who surveyed the experiences of Portugal, the Dutch Republic, and Great Britain and concluded that . . . early winners in the struggle for world leadership owed a significant proportion of their success to their ability to obtain credit inexpensively, to sustain relatively large debts, and in general to leverage the initially limited base of their wealth in order to meet their staggering military expenses.'" Moreover, Rasler and Thompson suggest that the losers of these contests, notably France and Spain, failed to maintain uninterrupted access to credit and experienced frequent bankr~ptcies.'~ 19. For an excellent cross-national analysis of war finance during World Wars I and 11, see Fujihira 2000. 20. Barbour 1950, 81-82. 21. Sargent and Velde 1995. 22. Kant 1983, 109. At the outbreak of the Crimean War, William Gladstone, then Britain's chancellor of the exchequer, tried to integrate this philosophy into his policy of war finance. He argued in the House of Commons that paying for war with loans obscured the true costs of war and that reliance on taxes alone would serve as a "salutary and wholesome check" on "ambition and lust of conquest." Six week5 later, the Treasury sold £6 million in bonds, and, in his final weeks as chancellor in 1855, Gladstone was contemplating borrowing £12 million more. Anderson 1967, 195-97. 23. Rasler and Thompson 1983, 490. 24. Rasler and Thompson 1983
8 International Organization The most obvious advantage of cheap and abundant credit is the ability to fi- nance large and recurrent wars without relying solely on taxation.Since the mili- tary revolution of the seventeenth and eighteenth centuries,warfare has become exceedingly expensive,forcing governments to leverage their tax base through public borrowing.25 Whereas taxation taps into a country's income,public borrow- ing taps into its capital stock,which is generally much larger than its income in any one year.During the eighteenth century,for example,Britain's average mili- tary spending in war years amounted to I to 1.5 years'worth of normal revenue,a level of expenditures that could not be financed through taxation alone.26 All else equal,a state with access to more funds can outspend and outlast its competitor, thereby gaining a competitive advantage.27 Easy access to credit also permits a state to maintain stable tax levels during periods of unusually high expenditures.The greater a state's ability to raise rev- enue through debt,the less it has to rely on tax increases to cover the sharp rises in spending needed to pay for large wars or substantial arms buildups.Rather than impose dramatically higher taxes at such times,the state can cover its expenses through loans and then pay off the debt over a long period,a policy known as"tax smoothing."28 If the debt is sufficiently long term,the tax increase needed to pay it off can be small,especially if economic growth provides a sufficient increase in revenues. Hence,debt allows the state to spread the financial costs of war across many years,in the same way that a mortgage allows home buyers to spread the expense of a house over a long period.Though such a policy increases the total costs that have to be paid,due to interest on the loan,debt has two advantages:first,it avoids the shocks to consumption and investment that would otherwise be required in war years;and second,it allows the state to finance a larger war and thus,by brining greater resources to bear,to increase its chances of winning.Moreover,as long as economic growth is sustained,future payments will shrink as a percentage of total income. Economists have long argued that tax smoothing has a beneficial effect on the long-term health of the economy.Higher tax rates typically lead to greater eco- nomic distortions.Thus tax smoothing lowers the total economic costs of raising a given amount of revenue.29 Moreover,variance and unpredictability in tax rates affect the investment decisions of private economic agents.Higher variance im- plies a greater risk that future returns will be appropriated by the state,generally leading to lower levels of investment.This effect is permanent,as the potential for future tax increases influences investment decisions in all periods,whether or not a war actually breaks out.Higher levels of investment promote greater long-term 25.Parker 1988;see also Kennedy 1987,chap.3. 26.Sargent and Velde 1995. 27.Organski and Kugler 1980;see also Kugler and Domke 1986. 28.Barro 1979;see also Lucas and Stokey 1983. 29.Baro1979
8 International Organization The most obvious advantage of cheap and abundant credit is the ability to finance large and recurrent wars without relying solely on taxation. Since the military revolution of the seventeenth and eighteenth centuries, warfare has become exceedingly expensive, forcing governments to leverage their tax base through public b~rrowing.'~ Whereas taxation taps into a countyy's income, public borrowing taps into its capital stock, which is generally much larger than its income in any one year. During the eighteenth century, for example, Britain's average military spending in war years amounted to 1 to 1.5 years' worth of normal revenue, a level of expenditures that could not be financed through taxation alone.26 All else equal, a state with access to more funds can outspend and outlast its competitor, thereby gaining a competitive advantage.27 Easy access to credit also permits a state to maintain stable tax levels during periods of unusually high expenditures. The greater a state's ability to raise revenue through debt, the less it has to rely on tax increases to cover the sharp rises in spending needed to pay for large wars or substantial arms buildups. Rather than impose dramatically higher taxes at such times, the state can cover its expenses through loans and then pay off the debt over a long period, a policy known as "tax ~moothing."'~If the debt is sufficiently long term, the tax increase needed to pay it off can be small, especially if economic growth provides a sufficient increase in revenues. Hence, debt allows the state to spread the financial costs of war across many years, in the same way that a mortgage allows home buyers to spread the expense of a house over a long period. Though such a policy increases the total costs that have to be paid, due to interest on the loan, debt has two advantages: first, it avoids the shocks to consumption and investment that would otherwise be required in war years; and second, it allows the state to finance a larger war and thus, by brining greater resources to bear, to increase its chances of winning. Moreover, as long as economic growth is sustained, future payments will shrink as a percentage of total income. Economists have long argued that tax smoothing has a beneficial effect on the long-term health of the economy. Higher tax rates typically lead to greater economic distortions. Thus tax smoothing lowers the total economic costs of raising a given amount of re~enue.'~ Moreover, variance and unpredictability in tax rates affect the investment decisions of private economic agents. Higher variance implies a greater risk that future returns will be appropriated by the state, generally leading to lower levels of investment. This effect is permanent, as the potential for future tax increases influences investment decisions in all periods, whether or not a war actually breaks out. Higher levels of investment promote greater long-term 25. Parker 1988; see also Kennedy 1987, chap. 3. 26. Sargent and Velde 1995. 27. Organski and Kugler 1980; see also Kugler and Domke 1986. 28. Barro 1979; see also Lucas and Stokey 1983. 29. Barro 1979
Institutional Foundations of Financial Power 9 economic growth with all the attendant advantages for international competition, including a larger tax base and political stability.Access to cheap and abundant credit thus permits states to raise substantial funds and to do so in a way that lowers the economic costs of sustaining military conflict. This is not to suggest that government deficits are good for economic health. Prolonged deficits and debt accumulation can lead to higher interest rates,which raise the costs of borrowing for private actors.Given that a state has international ambitions that require extraordinary expenditures,however,a tax-smoothing pol- icy based on the use of public debt is the most efficient strategy for financing those expenditures.30 Thus our argument speaks to the contrast between different strategies of public finance for states involved in international competition but is silent as to whether those states could do better by retreating from their inter- national ambitions in the first place. This logic helps link Rasler and Thompson's argument about public debt to other strands of the literature on hegemonic rivalries.31 Two prominent schools deserve mention.32 "Long cycle"theorists,such as Modelski,and Modelski and Thomp- son,have emphasized the role of sea power in establishing global leadership and defeating potential challengers.33 They show that every hegemonic power man- aged to amass overwhelming power projection capabilities-primarily naval power, but also long-range aircraft and intercontinental missiles."World economy"theo- rists,such as Wallerstein and Chase-Dunn,have argued that global leadership rests on a combination of economic,commercial,and financial power.34 While acknowl- edging the role of public credit,they consider uneven economic growth to be the primary factor in determining the relative power of states.Global leaders,in this view,were those states that managed to outgrow their competitors economically. Rather than contradicting these arguments,we suggest both depend in part on differential access to public debt;indeed,this factor links the two strands in a hitherto unappreciated way.States that prevailed in the conflicts identified by this literature were able to amass and sustain preponderant power projection capabili- ties and to do so without compromising economic growth.As we just saw,effi- cient use of public debt plays a crucial role in making this possible. 30.While access to credit makes tax smoothing possible,it does not guarantee that states will al- ways enact such a policy.Other factors,such as short-term political needs or international strategic conditions,affect the actual mix of taxes and debt that states use to finance any particular war.During World War II,for example,Britain departed from 200 years of tradition and relied heavily on the taxation of capital income,largely because of the ideas and influence of Keynes.Cooley and Ohanian show that postwar economic growth in Britain was lower as a result of this policy than it would have been if the government had kept taxes level and raised the same amount of money through debt.See Cooley and Ohanian 1997. 31.Rasler and Thompson 1983. 32.For a more complete comparison of the long cycle and world economy schools,see Thompson 1983b. 33.Modelski 1978;see also Modelski 1983;and Modelski and Thompson 1988. 34.Wallerstein 1979;see also Wallerstein 1980;and Chase-Dunn 1981
Institutional Foundations of Financial Power 9 economic growth with all the attendant advantages for international competition, including a larger tax base and political stability. Access to cheap and abundant credit thus permits states to raise substantial funds and to do so in a way that lowers the economic costs of sustaining military conflict. This is not to suggest that government deficits are good for economic health. Prolonged deficits and debt accumulation can lead to higher interest rates, which raise the costs of borrowing for private actors. Given that a state has international ambitions that require extraordinary expenditures, however, a tax-smoothing policy based on the use of public debt is the most efficient strategy for financing those expenditure^.^' Thus our argument speaks to the contrast between different strategies of public finance for states involved in international competition but is silent as to whether those states could do better by retreating from their international ambitions in the first place. This logic helps link Rasler and Thompson's argument about public debt to other strands of the literature on hegemonic ri~alries.~' Two prominent schools deserve mention." "Long cycle" theorists, such as Modelski, and Modelski and Thompson, have emphasized the role of sea power in establishing global leadership and defeating potential challengers.33 They show that every hegemonic power managed to amass overwhelming power projection capabilities-primarily naval power, but also long-range aircraft and intercontinental missiles. "World economy" theorists, such as Wallerstein and Chase-Dunn, have argued that global leadership rests on a combination of economic, commercial, and financial power.34 While acknowledging the role of public credit, they consider uneven economic growth to be the primary factor in determining the relative power of states. Global leaders, in this view, were those states that managed to outgrow their competitors economically. Rather than contradicting these arguments, we suggest both depend in part on differential access to public debt; indeed, this factor links the two strands in a hitherto unappreciated way. States that prevailed in the conflicts identified by this literature were able to amass and sustain preponderant power projection capabilities and to do so without compromising economic growth. As we just saw, efficient use of public debt plays a crucial role in making this possible. 30. While access to credit makes tax smoothing possible, it does not guarantee that states will always enact such a policy. Other factors, such as short-term political needs or international strategic conditions, affect the actual mix of taxes and debt that states use to finance any particular war. During World War 11, for example, Britain departed from 200 years of tradition and relied heavily on the taxation of capital income, largely because of the ideas and influence of Keynes. Cooley and Ohanian show that postwar economic growth in Britain was lower as a result of this policy than it would have been if the government had kept taxes level and raised the same amount of money through debt. See Cooley and Ohanian 1997. 31. Rasler and Thompson 1983. 32. For a more complete comparison of the long cycle and world economy schools, see Thompson 1983b. 33. Modelski 1978; see also Modelski 1983; and Modelski and Thompson 1988. 34. Wallerstein 1979; see also Wallerstein 1980; and Chase-Dunn 1981
10 International Organization The Theory of Sovereign Debt and the Need for Credible Commitments Access to public debt thus constitutes an important determinant of power for states engaged in international competition.However,the need to raise money through voluntary loans also creates a dilemma.To understand this,we turn to the theory of sovereign debt.5 The central issue motivating this literature is how private lend- ers enforce loan agreements with a sovereign who possesses a monopoly on the state's judicial and coercive power.When private citizens and firms make loans to one another in modern economies,enforcement is relatively easy.The lender of- ten demands some form of collateral for the loan,and if the borrower defaults,the lender obtains the right to the collateral.Such an agreement is generally enforce- able through the courts,backed by the policing powers of the state.When the borrower is the state,these means of enforcement are typically unavailable. How,then,do lenders induce the sovereign to honor his loan agreements?In general,lenders must have some way of penalizing the sovereign in the event of default.Consider a simple model of the creditor-debtor relationship known as the "willingness to pay"model.36 Suppose that a sovereign seeks a loan of value L at an interest rate of i and that the lenders can impose a penalty of P in the event of a default.For now,we ignore the source of the penalty and how it is imposed. When the loan becomes due,the sovereign must choose to repay the creditors L(1+i)or default and suffer the penalty P.Obviously,the sovereign will honor the loan agreement if and only if the following relationship holds: L(1+i)<P. (1) This seems to present a problem for potential creditors who must somehow de- vise a penalty to ensure their loan agreements are honored.In fact,the problem is the sovereign's.Creditors presumably understand the sovereign's incentives and act accordingly.The result is a form of credit rationing:for a given penalty,P,the sovereign's credit is limited to that consistent with inequality (1);rearranging terms, the maximum debt as a function of P is given by L=P/(1 +i).No lender would ever extend loans that exceeded the maximum amount the sovereign could be in- duced to repay.If the penalty that others can impose is zero,then the sovereign cannot obtain any loans. The sovereign's credit limit arises from his inability to make credible commit- ments.The sovereign can promise to repay a loan and even sign a contract to that effect,but unless he has incentives to carry out that pledge once the loan is due, the promise is not credible.And without a credible commitment,no rational lender would ever extend a loan.This insight yields an important,seemingly paradoxi- cal,implication:because the credit available to the sovereign is limited by the 35.Bulow and Rogoff 1989;see also Eaton,Gersovitch,and Stiglitz 1986;and Rasmusen 1992. 36.Bulow and Rogoff 1989;see also Eaton,Gersovitch,and Stiglitz 1986
10 International Organization The Theory of Sovereign Debt and the Need for Credible Commitments Access to public debt thus constitutes an important determinant of power for states engaged in international competition. However, the need to raise money through voluntary loans also creates a dilemma. To understand this, we turn to the theory of sovereign debt." The central issue motivating this literature is how private lenders enforce loan agreements with a sovereign who possesses a monopoly on the state's judicial and coercive power. When private citizens and firms make loans to one another in modern economies, enforcement is relatively easy. The lender often demands some form of collateral for the loan, and if the borrower defaults, the lender obtains the right to the collateral. Such an agreement is generally enforceable through the courts, backed by the policing powers of the state. When the borrower is the state, these means of enforcement are typically unavailable. How, then, do lenders induce the sovereign to honor his loan agreements? In general, lenders must have some way of penalizing the sovereign in the event of default. Consider a simple model of the creditor-debtor relationship known as the "willingness to pay" model." Suppose that a sovereign seeks a loan of value L at an interest rate of i and that the lenders can impose a penalty of P in the event of a default. For now, we ignore the source of the penalty and how it is imposed. When the loan becomes due, the sovereign must choose to repay the creditors L(l + i)or default and suffer the penalty P. Obviously, the sovereign will honor the loan agreement if and only if the following relationship holds: This seems to present a problem for potential creditors who must somehow devise a penalty to ensure their loan agreements are honored. In fact, the problem is the sovereign's. Creditors presumably understand the sovereign's incentives and act accordingly. The result is a form of credit rationing: for a given penalty, P,the sovereign's credit is limited to that consistent with inequality (1); rearranging terms, the maximum debt as a function of P is given by L = Pl(1 + i).No lender would ever extend loans that exceeded the maximum amount the sovereign could be induced to repay. If the penalty that others can impose is zero, then the sovereign cannot obtain any loans. The sovereign's credit limit arises from his inability to make credible commitments. The sovereign can promise to repay a loan and even sign a contract to that effect, but unless he has incentives to carry out that pledge once the loan is due, the promise is not credible. And without a credible commitment, no rational lender would ever extend a loan. This insight yields an important, seemingly paradoxical, implication: because the credit available to the sovereign is limited by the 35. Bulow and Rogoff 1989; see also Eaton, Gersovitch, and Stiglitz 1986; and Rasmusen 1992. 36. Bulow and Rogoff 1989; see also Eaton, Gersovitch, and Stiglitz 1986
Institutional Foundations of Financial Power 11 ability of potential lenders to sanction him for default,the sovereign benefits from an increase in the penalties that can be imposed on him. It might seem that reputational considerations alone would be sufficient to in- duce the sovereign to honor his commitments.After all,once the sovereign de- faulted,lenders would think twice before extending further loans.The possibility of a credit boycott would then create a strong incentive for the sovereign to repay his debts.As a number of writers have suggested,however,this reputational mech- anism is insufficient to ensure that the sovereign will honor his agreements.37 Two major obstacles hinder the lending community's ability to police the sov- ereign.First,credit boycotts are difficult to organize and sustain.Because the sov- ereign is unlikely to renege on all of his creditors at once,their interests will be divided,and the sovereign will be able to play some off against others.At the same time,creditors face the usual free-rider problems associated with this kind of collective action,as there would be significant incentives to defect from a boy- cott in order to become the state's sole source of credit.38 Second,a credit boycott is costly to the lenders themselves,because they must forgo their source of liveli- hood.As Bulow and Rogoff demonstrate,this puts lenders in a bad bargaining position,allowing the sovereign to force them to accept less attractive terms than those originally agreed to.3 In addition,reputational mechanisms only work when the actor places suffi- cient weight on future costs.If the sovereign discounts the future quite heavily, the threat of a credit boycott may have little impact on his calculus.A sovereign is likely to have a short time horizon in times of war or major crises,precisely when his need for credit will be greatest.40 This does not mean that reputational consid- erations will never cause the sovereign to honor his debts-only that reputation alone is unreliable. In practice,this difficulty rations the amount of credit available to the sovereign and often raises the costs of borrowing.4 Lending money to someone who cannot be forced to repay is a risky business,so creditors demand a"risk premium"in the form of higher interest rates.Ironically,then,the sovereign's unfettered power makes it quite costly for him to raise money through voluntary loans. Limited Government as a Commitment Technology The institutions of limited government provide a solution to this problem.Institu- tions constrain individuals'actions by shaping the incentives they face.42 In par- ticular,institutional arrangements can modify the incentives of the sovereign by 37.Alesina et al.1992;see also Bulow and Rogoff 1989;Greif,Milgrom,and Weingast 1994;and Veitch 1986. 38.Weingast 1997a. 39.Bulow and Rogoff 1989. 40.North 1981,chap.11. 41.We provide a model incorporating many of these details in a companion article,Schultz and Weingast 1998. 42.North1990
Institutional Foundations of Financial Power 11 ability of potential lenders to sanction him for default, the sovereign benefits from an increase in the penalties that can be imposed on him. It might seem that reputational considerations alone would be sufficient to induce the sovereign to honor his commitments. After all, once the sovereign defaulted, lenders would think twice before extending further loans. The possibility of a credit boycott would then create a strong incentive for the sovereign to repay his debts. As a number of writers have suggested, however, this reputational mechanism is insufficient to ensure that the sovereign will honor his agreement^.^' Two major obstacles hinder the lending community's ability to police the sovereign. First, credit boycotts are difficult to organize and sustain. Because the sovereign is unlikely to renege on all of his creditors at once, their interests will be divided, and the sovereign will be able to play some off against others. At the same time, creditors face the usual free-rider problems associated with this kind of collective action, as there would be significant incentives to defect from a boycott in order to become the state's sole source of credit.38 Second, a credit boycott is costly to the lenders themselves, because they must forgo their source of livelihood. As Bulow and Rogoff demonstrate, this puts lenders in a bad bargaining position, allowing the sovereign to force them to accept less attractive terms than those originally agreed to.39 In addition, reputational mechanisms only work when the actor places sufficient weight on future costs. If the sovereign discounts the future quite heavily, the threat of a credit boycott may have little impact on his calculus. A sovereign is likely to have a short time horizon in times of war or major crises, precisely when his need for credit will be greatest?' This does not mean that reputational considerations will never cause the sovereign to honor his debts-only that reputation alone is unreliable. In practice, this difficulty rations the amount of credit available to the sovereign and often raises the costs of borrowing?' Lending money to someone who cannot be forced to repay is a risky business, so creditors demand a "risk premium" in the form of higher interest rates. Ironically, then, the sovereign's unfettered power makes it quite costly for him to raise money through voluntary loans. Limited Government as a Commitment Technology The institutions of limited government provide a solution to this problem. Institutions constrain individuals' actions by shaping the incentives they face?2 In particular, institutional arrangements can modify the incentives of the sovereign by 37. Alesina et al. 1992; see also Bulow and Rogoff 1989; Greif, Milgrom, and Weingast 1994; and Veitch 1986. 38. Weingast 1997a. 39. Bulow and Rogoff 1989. 40. North 1981, chap. 11. 41. We provide a model incorporating many of these details in a companion article, Schultz and Weingast 1998. 42. North 1990