AbstractSovereign debt is one of the most enduring puzzles in economics. Why wouldanyone lend to an entity not subject to external enforcement? This chapterexamines the emergence of sovereign loans, their transformation from personalto transpersonal debt, and their evolution through time. The different models thathave been proposed to explain the rationale and sustainability of sovereign
M. Drelichman (*)The University of British Columbia, Vancouver, Canadae-mail: [email protected]
lending are discussed and evaluated in light of the historical record, together witha brief discussion of data sources and the political economy of debt.
Debt and time are inextricably linked. The very existence of debt requires at leasttwo transactions – the disbursement of a loan and its subsequent repayment – atseparate points in time. The price of debt, which is simply the interest paid on a loan,is determined by the time elapsed between these basic transactions. Governmentdebt instruments usually mature over several decades, and lending relationshipsbetween states and financial institutions can last centuries. It is no surprise, then,that the study of debt relationships is central to cliometrics, a discipline fundamen-tally defined by the study of economic magnitudes, problems, and behaviorsthrough time.
The element of time intrinsic in any debt contract introduces an implicit, yetunavoidable element of risk. Once a loan has been disbursed, it is always possiblethat the debtor will fail to repay it, either because of insolvency or because they judgethat breaking the contract will have a lower cost than complying with it. Default risk,the probability that a loan is not repaid in accordance with its original terms andconditions, is a key determinant of the structure of debt instruments, the pricing ofloans, and, indeed, the very existence of debt markets. If default risk is not addressedas part of the institutional structure of a debt market – that is, if any debtor can decidenot to repay a loan with impunity – it is quite possible that no loans will be made inthe first place. Without transactions, there are no markets.
Among the myriad institutional arrangements and legal instruments throughwhich different societies, polities, and individuals have conceived and implementeddebt through history, sovereign debt emerges as a special category, exercising anundying appeal for theorists, applied economists, and cliometricians alike. Thereason is that there is very little to mitigate default risk when the debtor is a sovereignwho holds both legislative powers and a comparative advantage in the exercise ofviolence. In the case of a loan to an absolutist ruler, to use an obvious example, it isusually impossible to compel a reluctant borrower to repay a loan. But even when theborrower is a democratic government subject to a large array of internal checks andbalances, foreign creditors have found that legal frameworks can be changed withsurprising speed, often to their detriment.
The study of sovereign debt, both as a theoretical subject and in its historicalexpressions, almost always converges to a well-defined set of lines of inquiry. Whyis sovereign debt possible in the first place? Just how much debt can a sovereigncarry? What is the nature of defaults, and what are their implications for the viabilityof sovereign debt? The remainder of the analysis expands on these questions andexamines the interplay of theory and history in the scholarly efforts to address them.
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The Big Questions
What Makes Sovereign Debt Possible?
Debt agreements subscribed between private parties usually fall under the legaljurisdiction of a state entity. In case of nonperformance, the creditor can, at leastnotionally, seek redress in court. Enforcement may pose complications, especiallywhen the parties reside in different jurisdictions, but these are no different than thechallenges in enforcing any other type of contract. Some debt arrangements, such asthose extended by criminal organizations, fall outside the legal protections of thestate, but in these cases, the creditor is typically the stronger party and usually hasaccess to a coercion or punishment technology. The Mafia does not take out loans,and it is very effective at collecting the ones it extends. Sovereign debt is unique inthat creditors are typically the weaker party, while debtors control the means ofcoercion.
Loans to sovereigns have not always been voluntary arrangements. Medievalcity-states in northern Italy used forced loans on wealthy citizens, called prestanzeprestitix, as their primary means of financing (Pezzolo 2003). Charles I of Englandalso levied forced loans and imprisoned reluctant noblemen as part of his escalatingconflict with Parliament (Cust 1985). Forced debt was also a preferred method offinancing by German occupation authorities in Greece during World War II(Christodoulakis 2014). To the extent that these forced loans can be considereddebt at all, rather than the outright confiscation of resources they often resulted in, itis not hard to see what makes them possible. Debtor participation is coerced underthreat of violence.
The interesting case, therefore, is the one in which a lender freely enters into adebt contract with a sovereign entity. Because the sovereign can choose not to repaythe debt with apparent impunity, the question of what makes sovereign debt possiblemight well be reformulated as “Why do sovereigns ever repay their debts?” or,extending the logical chain one step further, “Why would a creditor ever extend aloan to a sovereign?” These questions stand at the very core of the sovereign debtliterature in economic theory and history. The first mainstream answer has empha-sized reputation-based lending relationships, while an alternative explanation hasfocused on the possibility of creditors imposing costly sanctions on borrowers. Boththese schools of thought are explored in detail further below.
How Much Debt Can States Carry?
Sovereign states carry a wide range of debt loads, using different instruments andcommitting themselves to varying repayment schedules. Some borrow very little andonly for short periods. Others take on fantastically high obligations and may carrythem for very long periods, even intending never to reduce their overall indebted-ness. What explains these differences, and what are their determinants?
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These questions relate to what economists call the “sustainability” of debt. Theterm is used in a somewhat ambiguous fashion throughout the literature, as it mayrefer to either the fiscal ability of a sovereign to service and repay their debts or to theincentives and willingness to do so, regardless of fiscal capacity. The section onfiscal sustainability explores the first aspect, while the discussion of each model ofrepayment incentives elaborates on the latter.
The Nature of Defaults
Anyone extending a loan for a profit motive clearly expects to be repaid. Lendersfacing a higher risk of default demand additional compensation in the form of higherinterest or other guarantees. If the risk is too high, or the potential losses too large,lenders will choose not to lend at all. In such cases, a market for sovereign debt mightunravel, or not emerge in the first place.
The traditional approaches to the theory of sovereign debt usually feature rationalagents in a context of complete information. In these models, borrowers want tosignal their willingness and ability to repay; lenders only lend to those borrowers thatare solvent and credible enough. Incentives are aligned, debt is properly priced, andloans are repaid. In such an environment, however, there is no place for default. Evenin contexts with uncertainty generated by external events, insurance markets can beused to spread the risk. Default is, in economic parlance, an off-the-equilibrium-pathoutcome.
The problem is, of course, that sovereign default is common – in fact, far toocommon to be explained away by informational mistakes. The history of sovereigndebt is heavily punctuated by episodes of kings reneging on their obligations,developing countries declaring bankruptcy, and revolutions disowning the financialcommitments of the preceding regimes. Nor are creditors always eager to punishstates that default. Castile under the Habsburg monarchs decreed general paymentstops seven times in less than a century, before finally falling out of favor withinternational financiers. Argentina and Venezuela boast comparable records in thenineteenth and twentieth centuries, with others not far behind. For the past fivecenturies, up to 10% of borrowers ended up suspending payments in any givenperiod, with default rates reaching 20% in particularly turbulent times (Reinhart andRogoff 2009). The notion of off-the-equilibrium-path phenomena appears insuffi-cient to explain the general ubiquity of sovereign default and the surprising resilienceof “serial defaulters.”
Relying on advances in contract theory and on the idea of incomplete markets, theliterature has begun to interpret defaults as part and parcel of sovereign debt trans-actions. In a new generation of models that reflect some of the myriad complexrelationships in sovereign debt markets, defaults are more fully integrated into thepotential equilibrium outcomes. Defaults that are triggered by unexpected, exoge-nous events through no fault of the borrower can be deemed “excusable” by lenders,and not held against a borrower’s record (Grossman and Van Huyck 1988). Insituations where lenders have market power, defaults can be a stable feature of the
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market equilibrium (Kovrijnykh and Szentes 2007). And, when markets are incom-plete, the impossibility of creating provisions for every possible eventuality meansthat lenders and borrowers both operate in the knowledge that some states of theworld will bring about defaults, and price their loans accordingly (Arellano 2008).
Why Does Sovereign Debt Exist at All?
Sovereign debt repayment may be subject to the whim of a ruler, plagued with thepossibility of defaults, or susceptible to political upheaval and macroeconomicinstability. Why would lenders put up with the uncertainties inherent in such amarket and the vagaries of whimsical kings and turncoat politicians? The answerhas been the same throughout history – because “there’s gold in them thar hills.”While some investors certainly suffered losses in individual crises, returns to sover-eign debt have on average exceeded those of comparable safer investments over thelong run, even after accounting for the effect of defaults. Lindert and Morton (1989),for example, found that between 1850 and 1983, government loans generated anaverage excess return of 0.4% over similar American or British bonds, considered tobe reference safe assets. This also proves true going further back in history; even thatmost iconic of serial defaulters, King Philip II of Spain, generated profits for hislenders. Drelichman and Voth (2011b) showed how bankers that lent through the lasttwo Castilian defaults of the sixteenth century earned an excess return of approxi-mately 2% over safer bonds. A market for sovereign debt exists because it delivers apremium that risk-neutral lenders find attractive.
On the sovereign’s side, the motivation for borrowing is no different from that ofany other borrower – bridging a gap between expenditures and revenues. In a contextof economic growth, debt can be a powerful tool to finance public investment. Aslong as the social rate of return on the projects financed with debt exceeds the interestrate paid by the government, state borrowing can increase overall welfare andcontribute to a sustained development path.
Of course, not all loans are motivated by the desire to finance growth-orientedprojects, and in any case sovereign debt predates the onset of modern economicgrowth by several centuries. Debt is often used to finance current expenditure ratherthan investment, and, both in current and historical times, the funding of militaryenterprises has been a prime motivator. In cases like these, borrowing is essentiallyan intertemporal transfer of resources, with future taxes being committed to pay forcurrent expenditures. It is possible that, if a war financed by debt is won, the spoilsmight provide the means for repayment. These instances, however, are not common;the imperial expansion of eighteenth- and nineteenth-century Britain constitutesperhaps a rare exception. A sovereign’s motive for borrowing need not change alender’s disposition, as long as future funds are available. However, if borrowing ismotivated by short-term political vanity or survival, and is unlikely to result in agrowth payoff, access to debt markets might well result in negative welfare conse-quences for the country as a whole.
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Sovereign Debt in History
The study of state financing has always been one of the top areas of interest ineconomic history research, perhaps second only to that of economic growth. Itsdevelopment as a scholarly field started long before the cliometric revolution,yielding pioneering works like those of P. G. M. Dickson (1967) for England, thatof Ramón Carande for Castilian short-term debt (Carande 1987), and the collectedworks of Giuseppe Felloni for Genoa (Felloni 1999), among many other prominentexamples. This literary tradition, which continues to the present day, is typicallyfocused on uncovering the institutional features of sovereign lending through historyand, whenever possible, on quantifying its magnitude. This invariably requirespainstaking archival work, parsing centuries-old documents to carefully reconstructthe minute details of each transaction. The resulting works are an indispensablefoundation for any cliometric work, providing invaluable context to frame andinterpret quantitative models and results.
Instruments and Innovations: A Very Short Summary
One of the main concerns of the historical literature is documenting the evolution ofcontractual and institutional instruments used throughout history – the “technology”of debt, in some sense. Of note is the fact that public debt largely did not exist beforethe twelfth century; not even the Roman Empire, with its sophisticated tax andcoinage systems, had anything resembling public debt instruments. Europe wouldhave to wait until the onset of the Commercial Revolution and the emergence of themerchant city-state to witness the first manifestations of what would become gov-ernment obligations.
Since antiquity, rulers had issued token coinage, which can be thought of as aform of debt. In a full-bodied currency system, replacing a gold coin with aconvertible token requires a degree of trust in the ruler if the token is voluntarilyaccepted or coercion if not. Devaluations, restampings, and debasements can all bethought of as a form of default. This conception of currency as a sovereign obligationlasted well into the twentieth century. After World War I, the British governmentused the notion of currency as debt to justify its deflationary impetus, eventuallyreturning the pound to its prewar gold parity rather than devaluing (Eichengreen1996).
The consolidation of city-states first and territorial states later made it possible forrulers to count on reliable tax revenues that could be used as security for debtrepayment. The first sovereign loans were not very different from tax farming. Agroup of merchants would advance a sum to the state in exchange for the right tocollect a specific tax for a number of years. This method was introduced by theGenoese compere, which are documented as early as the first half of the twelfthcentury and would later be widely adopted throughout Western Europe, eventuallybecoming the favored system of issuing long-term debt (Felloni 2006). Castilianjuros, French municipal rentes, Dutch renten, and the Florentine loans to Edward III
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all used specific revenue streams as the source of repayments for cash advances totheir governments. In some polities, such as Genoa, the management of public debtwould become part and parcel of the city’s mercantile activities. The Casa di SanGiorgio, the company of Genoese merchants that lent funds to the Republic andadministered its debt, introduced many of the innovations that would make modernstate financing possible (Felloni 2006). Debt secured by specific tax streams iscommonly referred to as “funded debt.”
David Stasavage (2011) has convincingly argued that, during this formativeperiod, the ability of polities to issue and service their debts depended crucially onthe presence of representative assemblies that gave strong voices to merchants, aswell as on the ease of travel and communications between different merchant centerswithin the polity. This gave an initial advantage to city-states and small territorialunits like the Netherlands over larger territorial states like Castile and France. Theadvent of the fifteenth-century Military Revolution, which saw the introduction ofstanding armies and complex fortifications, tilted the scales in favor of territorialstates with the ability to muster the enormous resources required to finance them.Thus Castile, then the Netherlands, and finally France and England all accumulateddebts whose size, relative to GDP, rivaled those of contemporary states (the sectionon fiscal sustainability below provides a quantitative discussion). The period alsosaw the rise of the legal construct of “state” debt in the context of territorial states.While in the Late Middle Ages, all loans were personally underwritten by the kingand guaranteed by his revenues and demesne; by the sixteenth century, debt hadbecome clearly transpersonal; it was an obligation of the Crown, rather than of theperson wearing it.
The pledging of specific tax revenues, which underpinned almost all medieval, aswell as most early modern debt issues, is quite removed from modern conceptions ofdebt. It elegantly solved the problem of the credibility of a ruler by transferring theexploitation of a revenue stream to a lender for a specified period or in perpetuity.The debt was treated like property and, being subject to the applicable jurisprudence,provided a certain level of security against repudiation. The format of pledgingrevenues also allowed for the circumvention of usury laws, as the transaction wasconsidered a sale or a rent contract, rather than a loan. One step closer to moderninstruments was taken with the appearance of unsecured debt instruments, whichhinged only on a ruler maintaining their word. By far the largest unsecured loans byvolume in the early modern era were Castilian asientos, debt contracts between theHabsburg kings and bankers from all over Europe. Asiento lending started in earnestunder Charles V, who borrowed from the Fugger and Welser families. Fueled by thesilver remittances from South American mines, it reached its maximum expressionunder Philip II, for whom Genoese bankers, building upon centuries of financingtheir own Republic, designed a system that had most of the characteristics of modernsovereign debt (Drelichman and Voth 2014a). As innovative as Castilian debt was,neither the asientos nor the tax-backed securities used by most rulers and munici-palities were tradable in secondary markets (though juros, the Castilian version oftax-backed securities, could be reissued in a different name upon the payment of afee). The innovation of tradable securities would be introduced by the Dutch
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Republic in the following century. The creation of the Wisselbank, arguably the firstfully functional central bank, completed the Dutch financial revolution andestablished the first truly modern state financing system (Tracy 1985).
By the eighteenth century, the locus of innovation in the arena of public debt wasshifting from Amsterdam to London. The reforms of the Glorious Revolution(discussed below) enabled a large expansion of government borrowing, whilemilitary successes in Britain’s many wars and the profits generated by imperialtrade and industrial development provided the resources needed to keep publicfinances in good health. The early eighteenth century saw some experimentationwith schemes using the stock of chartered companies as a vehicle for refinancinggovernment debt. Variations of this idea were behind both the South Sea Bubble inBritain and the Mississippi Bubble in France (Carlos and Neal 2006; Velde 2007).Eventually, virtually all British debt would be issued and held in the form of consols,perpetual annuities that could be redeemed at face value. This allowed the govern-ment to take advantage of falling interest rates by offering coupon rate reductions.Consols would be the dominant form of debt in Britain until World War I, when theenormous financing needs imposed by the war required the issuance of shorter-termdebt (Ellison and Scott 2017). The last British consols were redeemed in 2014.Nowadays, states the world over typically have a debt structure of bonds of differentmaturities, with those above 30 years being relatively uncommon.
Currency of Issue
One key choice for any government issuing debt in modern times is whether to do soin domestic or in foreign currency. Domestically marketed debt is almost alwaysissued in a country’s own currency. As for debt contracted with foreign lenders, thetrade-off is clear: debt denominated in domestic currency can lose value as a result ofinflation, while debt denominated in foreign currency leaves the borrowing govern-ment exposed to exchange rate risk. Governments with little credibility or with asmall domestic market tend to prefer foreign currency-denominated debt issues as away of attracting investors that would otherwise not be willing to take on theinflationary risk, while developed economies on a solid fiscal footing can oftenafford to issue debt denominated in their own currency.
Before the twentieth century, cross-border debt was overwhelminglydenominated either in gold or silver, or in a currency subject to a metallic standard,thus leaving little leeway for rulers to reduce the value of their debt by tinkering withthe currency. Scholars have argued that for countries that were not major financialpowers – the so-called periphery – issuing debt in foreign currency was a commit-ment device. Under the Classical Gold Standard, perhaps the most studied interna-tional monetary system in history, peripheral countries tied the value of theircurrencies to gold as an instrument to increase their creditworthiness – a “goodhousekeeping seal of approval” (Bordo and Rockoff 1996).
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Data Sources
Some of the most important contributions of cliometricians to the sovereign debtliterature are data collection efforts that cover several countries over long periods,thus enabling the panel analyses that are key for validating modern theoreticalframeworks. While a thorough enumeration of such compilations is beyond thescope of this chapter, there are nonetheless some noteworthy entries. For medievaland early modern times, Stasavage’s (2011) dataset offers a window into theemergence of sovereign debt across 31 European countries and city-states, togetherwith political and demographic correlates. Likewise, Bonney’s (2007) EuropeanState Finance Database, while not as homogeneous, has become a repository for awide variety of fiscal and financial data from European countries. Neal (1991)provides series of British and Dutch joint-stock company shares and governmentdebt prices between 1710 and 1820. Homer and Sylla (2005), a work that has grownin scope and depth through its four editions in over four decades, offers the longest-term view of the return on all sorts of assets, including government obligations, fromBabylonian times to the early 2000s. More recently, databases have prioritizedcomprehensiveness, attempting to capture the majority of known debt issuestogether with a large number of covariates suitable for the increasingly demandingquantitative analysis associated with newer-generation models. In this vein, one canfind the contributions of Reinhart and Rogoff (2009) and Abbas et al. (2010), amongothers.
The Interplay of Theory and History
The main comparative advantage of cliometrics is the harnessing of quantitativedata, in combination with detailed institutional knowledge, to evaluate the predic-tions of economic theory. Conversely, by using the deep repository of history touncover situations and data types that may not be available in contemporary expe-rience, cliometrics also contributes to the development and refinement of economictheory. This section explores how such a dialogue has emerged in the context ofsovereign debt, reviewing the different models proposed to explain its main stylizedfacts, the inconsistencies pointed by historical studies, and the revisions introducedin theoretical frameworks as a result.
Fiscal Sustainability
One of the first empirical tests to which a sovereign borrower is typically subjected –both in scholarly scrutiny and in actual practice – is whether it can possibly repay theamount of debt it has taken or intends to take on. If a borrower does not have themeans to repay a debt, there is no point in going forward with the transaction. For thepurposes of this first evaluation, the borrower is assumed to be willing to repay andto employ their every last penny in doing so if necessary. The ability to repay a debt
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in the context of sovereign lending receives the name “fiscal sustainability.” It shouldnot be confused with the willingness or strategic convenience of a borrower to repay,for which the term “sustainability” (without the “fiscal” modifier) is also sometimesloosely employed.
The resources to repay government debt must ultimately come from taxation. Atthis point, it is important to distinguish between debt denominated in local currencyand loans issued in foreign currency and some other unit of account over whosevalue the government has no power (e.g., precious metal weight). In the former case,the government might reduce the value of the debt through inflation. While inflationis typically interpreted by economists as a tax, it does have a particularly largeincidence on holders of debt denominated in domestic currency, who see it erode thevalue of their future coupon and capital repayments. Lenders do, of course, factor intheir inflationary expectations when pricing domestic debt, but a government canalways print more money ex post. While unanticipated inflation may be regarded as apartial default on domestic debt, it can also help avoid an outright suspension ofpayments. A government whose debt is largely denominated in domestic currency,and which has access to effective monetary policy instruments, will therefore facerelatively lax fiscal sustainability constraints. If, on the other hand, government debtis largely denominated in foreign currency, or the government must adhere to anominal anchor (as in the case of a currency board, a dollarized economy, or a full-bodied monetary medium), then the means of debt repayment must consist entirelyof real resources, and the fiscal sustainability constraint will be strictest. In order toprovide a streamlined analysis, the discussion in this section focuses on foreigncurrency-denominated debt; the section on political economy provides additionalinsight into currency mix decisions and their effects.
As mentioned previously, some of the earliest forms of sovereign debt directlyacknowledged the centrality of fiscal sustainability by tying loan repayment to aspecific revenue source. As early as the fourteenth century, Castilian juros – perpet-ual or lifetime bonds – entitled the holder to regular interest payments sourced from aspecific tax stream. The bond was said to be “placed” (situado) on the tax stream,which was described as having been “sold” (enajenada), and could not be used forany other purpose. The annual payment was typically collected directly from the taxfarmer or administrator. As long as the tax stream generated sufficient revenue, therewas no question about the sustainability of the debt. This practice was later adoptedby the French Crown when it established the rentes sur l’Hôtel de Ville and echoed inthe practice of earmarking, one of the key financial reforms of the Glorious Revo-lution (North and Weingast 1989). In the case of Castilian juros, the arrangementeffectively shifted the risk of fiscal nonperformance to the borrower; if the tax streamon which the bond was placed dried up, the Crown was not obliged to make up theshortfall and was not considered to have defaulted. After the Glorious Revolution,the British government improved on this by guaranteeing debts regardless of thehealth of earmarked fiscal streams; a sinking fund absorbed surpluses and coveredshortfalls.
Most debt, however, is not tied to specific fiscal sources. In order to assess itssustainability, it becomes necessary to consider the overall solvency of the state.
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Evaluating the solvency of an individual is a straightforward exercise conducted bybanks and other lenders countless times per day; one asks whether the present valueof the individual’s free cash flow exceeds the present value of scheduled debtrepayments. The formula can, in principle, be extended to a sovereign, with someimportant modifications. First, while an individual’s earnings are limited by their lifecycle, a state is, in principle, an infinitely lived agent. This carries a key advantage, inthat the state never has to repay the debt principal if it doesn’t want to; it can simplyrefinance its loans indefinitely and only pay interest. The second difference is that,while an individual’s earnings first grow and then decline over their life cycle, astate’s revenues may conceivably grow indefinitely, and hence they could support anever-increasing debt load without risking insolvency. A financial solvency test for astate may therefore be reformulated as requiring that the present value of revenuesexceed the present value of future interest payments.
In practice, estimating the future growth path of state revenues is quite challeng-ing, as government policies and the business cycle can introduce large fluctuationsover the short run. An alternative approach is to operate on the assumption that thegovernment has the tools to claim a relatively stable portion of GDP (especially ifaveraged over a longer period) and require that the debt-to-GDP ratio not grow inorder to consider the debt load sustainable. This criterion, developed by the Inter-national Monetary Fund, is overwhelmingly favored by international lending orga-nizations (IMF 2003). It is noteworthy that such a rule is agnostic regarding howlarge the debt level can be relative to GDP; a stable debt-to-GDP ratio implies thatinterest payments are being met out of ordinary revenue rather than new borrowing,and hence the debt is deemed sustainable. Conversely, unsustainability can bedefined as a situation where a country needs to incur new debt just to pay intereston its existing obligations.
Assessing the sustainability of a country’s debt during a particular period usingthe IMF methodology requires fairly complete information on its national accounts.The ideal data to carry out this exercise include annual or more frequent estimates ofrevenue, ordinary (noninterest) expenditure, interest payments, the stock of debt,interest rates, and the growth rate of the economy. These can be plugged directly intoa sustainability criterion equation, as derived, for example, in Aizenman and Pinto(2005), to obtain a straightforward answer on whether the debt-to-GDP ratio isstable.
While the data needed to assess fiscal sustainability are often readily available fordeveloped countries in modern times, they can pose significant challenges for thecliometrician working on pre-statistical periods. Annual GDP series are available forseveral developed economies from the early twentieth century onward; further backin time their frequency becomes more sporadic, their reliability declines, andobtaining continuous series requires increasingly strong assumptions. Currently,the most complete set of historical GDP statistics suitable for fiscal sustainabilityanalysis is the one provided by Bolt et al. (2018), who rebase and extend theestimates originally compiled by Angus Maddison for 14 countries starting as farback as 1820. For earlier periods, the analysis must rely on increasingly noisy
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income estimates calculated at much longer intervals or focus on a different measure,such as fiscal revenue.
A second empirical hurdle is the compilation of fiscal accounts –revenue, expen-diture, and interest payments – as well as estimating the stock of outstanding debt.The availability and completeness of these data vary enormously across time andstates. Gaps in the data, however, can sometimes be overcome by resorting to thestandard accounting identities linking the different variables. The earliest usablecontinuous historical series is the one compiled by Drelichman and Voth (2010) forCastile between 1566 and 1596. Other early examples include the Netherlandsbetween 1601 and 1712 (De Vries and Van der Woude 1997), the United Kingdombetween 1698 and 1793 (Crafts 1995; Mitchell 1988), and France between 1720 and1780 (Sargent and Velde 1995; Velde 2007). Additional fiscal accounts for these andother European countries are available in the European State Finance Database(Bonney 2007). Table 1, based on Drelichman and Voth (2014a), summarizes thedata for the United Kingdom, Castile, and France.
The figures in Table 1 must be used with ample caution, as GDP estimates inparticular are subject to substantial noise. Taking them at face value, however, theseearly modern economies appear, on many dimensions, similar to contemporary ones.Their debt-to-GDP ratios are in the same range as modern developed countries, andtheir rate of revenue growth matches or exceeds that of twenty-first-century econo-mies. Where they differ is in the magnitude of debt service; while a country thatdevoted 50% of its tax revenue to paying interest would be considered in seriousfinancial distress today, these pre-modern polities spent money on little else thanwaging war and paying interest on the debt they had incurred for fighting previouswars. Without a large civil service or a social safety net, they managed to generatelarge enough primary surpluses to keep their debt loads manageable. In fact, of thethree economies represented in Table 1, only France found itself in a manifestlyunsustainable equilibrium, largely for political reasons (Sargent and Velde 1995).Castile’s debts were eminently sustainable (Drelichman and Voth 2010). The UnitedKingdom, for its part, reached debt-to-GDP ratios as high as 260% in 1821 withoutsustainability being called into question (Reinhart and Rogoff 2009). Deft fiscalmanagement and effective government bureaucracy supported one of the largestimperial expansions known to history (Bordo and White 1991; Brewer 1988). Thedebt burden was progressively reduced throughout the nineteenth century on thestrength of Britain’s economic growth and the long Pax Britannica. The UnitedKingdom once again experienced very high debt-to-GDP ratios after World War II,peaking at 238% in 1947, but almost half of the outstanding obligations during thatperiod were intergovernmental loans provided by the United States at preferentialterms, rather than market-traded bonds (Ellison and Scott 2017).
Any analysis of fiscal sustainability is only as good as its underlying data. Whentrustworthy statistics are readily available, correctly performed sustainability calcu-lations are no more than a mechanical exercise that consulting firms and internationallenders can perform without too much trouble. As the focus shifts to thepre-statistical past, the craft of the cliometrician becomes increasingly important inunearthing scant sources and compiling the bits and pieces of information that may
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eventually offer a glimpse of whether a king could actually repay his loans. So far,the literature has found that in the vast majority of cases, debt turns out to besustainable. This is good news for homo economicus – it would be worrisome iflenders offered their capital to borrowers that could not possibly pay them back. Theresources used to repay loans – or, at least, to pay interest in perpetuity – are by andlarge present in most historical instances of sovereign debt. The next step, therefore,is to ask what incentives sovereigns have to actually keep their commitments, whydefaults happen, and why financiers still want to lend to seemingly fickle rulers andstates.
First-Generation Reputational Models
The seminal theoretical treatment of sovereign debt in the economics literature is dueto Eaton and Gersovitz (1981). At its core, the model features a repeated gamebetween a borrower and one or more lenders. The equilibrium involves a triggerstrategy. As long as the borrower services the debt and repays the principal onschedule, the lenders keep providing new loans or rolling over old ones. Should theborrower default, however, the lenders will permanently withdraw. The borrowerloses access to the income smoothing provided by debt and must self-finance. This isa costly outcome, as the entire state operations will now have to be financed out oftaxation or inflation, regardless of the business cycle.
The first requirement for reputational equilibria to be possible is that lenders mustbe able to maintain a solid boycott on defaulting borrowers. While this can beplausibly achieved in certain situations, it can prove problematic in others. Sustain-ing a boycott against a defaulter is easy if there is only one lender but becomesincreasingly difficult as the number of market participants grows. If there are a largenumber of lenders, a defaulting borrower can attempt to overcome the boycott byoffering a premium to some of them. In the absence of coordination, such a strategyis likely to succeed (Greif et al. 1994). To overcome this problem, second-generationmodels (discussed further below) incorporate coordination devices among lenders,such as cheat-the-cheater strategies.
The second requirement is that sovereigns must not be able to replicate on theirown the income-smoothing services offered by lenders. A borrower with sufficiently
Table 1 Fiscal accounts for early modern economies
deep pockets, for example, could institute a self-financing scheme. This could takethe form of building a sinking fund or establishing a large deposit with a trustedfinancial institution, commonly referred to in the literature as a “Swiss bank.”Whenever income exceeds expenditure, the government would deposit the surplusin the sinking fund or the Swiss bank. Conversely, when facing a shortfall, it wouldwithdraw from them, thus exactly replicating the financial flows provided bysovereign debt. It is nonetheless unlikely that defaulting countries would be ableto save enough so as to effectively smooth over future budgetary shortfalls. The vastmajority of defaults occur in times of fiscal distress, when governments are least ableto put aside substantial resources to guarantee steady financial flows (Tomz andWright 2007). As for Swiss bankers, despite their reputation as impervious toexternal pressures, they turn out not to be a great option when it comes to actingas financial agents for delinquent borrowers. Historically, international financiershave sometimes gone under, taking with them the deposits of foreign governments.In modern times, defaulting countries have found it extremely costly to operate inglobal financial markets before reaching a settlement with their creditors. After its2001 default, the threat of legal action by creditors meant that Argentina was unableto hold any sizable financial assets outside its own borders until it reached a finalsettlement in 2016.
The Eaton–Gersovitz model is important because it establishes that sovereignlending relationships can exist even when lenders do not have access to legal ormilitary enforcement mechanisms. The mere threat of losing access to capitalmarkets is sufficient to keep borrowers honest. This feature of the theory alignswell with the historical record, as lenders seldom have the ability to impose punish-ments on sovereigns other than by withdrawing their loans. The model, however,runs into trouble when contrasted with other aspects of historical experience. Thefirst one of these is that there are no cases in which a borrower has been permanentlyexcluded from capital markets, something that typically happens only when a stateentity is itself dissolved; even then, its debts are typically inherited by the successorstate (Reinhart and Rogoff 2009). Most defaulters regain access to credit within afew years, often borrowing again from the same creditors. This is a common problemfor theoretical frameworks focusing on why borrowers repay; its implications arediscussed in the section on the nature of defaults further below.
The toughest hurdle for the Eaton–Gersovitz model comes from quantitativecalibration exercises. Even assuming that defaulters can be effectively excludedfrom capital markets forever, the loss in utility to the sovereign resulting from thelost smoothing services is not large relative to the onetime gains from confiscatingthe lenders’ assets. As a result, the simple reputational mechanism can only sustainvery low levels of debt, typically around 10% of GDP (Arellano and Heathcote2010). Since the vast majority of borrowers carry much higher debt levels, some-times up to ten times more, alternative explanations are needed.
Sanction-Based ModelsIn the Eaton–Gersovitz setup, the only punishment a defaulter faces is an exclusionfrom capital markets, which appears to be insufficient to keep borrowers from
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engaging in opportunistic behavior. It is also unrealistic to expect that a defaulterwould be excluded in perpetuity. If the marginal utility of a sovereign’s debt is reallyhigh, it would make sense to offer high interest rates or a lump-sum settlement toentice one or more lenders to return to the market. In light of these shortcomings ofreputational models, an alternative literature proposes that punishments above andbeyond the mere exclusion from capital markets – known as “sanctions” – areneeded to sustain debt repayment as an equilibrium.
The first sanctions model was proposed by Bulow and Rogoff (1989). They notedthat, at any point in the life of a loan, the contract can be thought of as an immediatecash transfer and a schedule of similar future transactions. For example, when a loanfirst originates, the disbursement is the immediate transfer, while the scheduledrepayments are the promised transactions in the future. However, because thesovereign can default, the future schedule is essentially “cheap talk,” as the partiescan agree to renegotiate it at any time. A loan can therefore be thought of as a seriesof renegotiations – a “constant recontracting” process. Punishing defaulters withcosts above and beyond the exclusion from capital markets (sanctions) providesappropriate incentives for borrowers to honor their debt obligations. In the parlanceof game theory, the imposition of sanctions supports renegotiation-proof lendingequilibria.
The central difficulty for any model based on sanctions is immediately apparent.How can a private lender sanction a sovereign? The relationship is by definitionlopsided – the borrower has access to enforcement mechanisms and can exert someform of legitimate violence, while lenders, in principle, cannot. Bulow and Rogoffconceptualize their model by allowing lenders to cause a defaulting country to lose afraction of its GDP, for example, by imposing trade sanctions or freezing assets heldin foreign bank accounts. But can this idea capture actual events? In modern times,governments are reluctant to impose wide-ranging trade restrictions for the benefit ofbondholders; Eichengreen and Portes (1989), for example, document that it was theForeign Office’s policy in the 1930s not to intervene on behalf of British investors ininternational credit disputes. Private efforts to freeze a defaulter’s assets are similarlyunlikely to succeed, either because of sovereign immunity or because defaulters arequick to shelter any liquid holdings from the reach of international courts(as Argentina did, e.g., after its 2001 default, thought at the cost of having its abilityto operate in global markets severely curtailed).
There are, however, specific historical episodes that robustly support the sanc-tions view. The most obvious of these is the military takeover of revenue-generatingassets, such as Britain’s seizure of the Khedive’s financing in the 1870s, beforedirectly incorporating Egypt into the British Empire. Another example is the “Roo-sevelt corollary,” an addition to the Monroe Doctrine, which saw the US threatenmilitary action in Latin America in case of default; markets responded positively, andbond prices increased substantially. These extreme examples, dubbed “super-sanctions” by Mitchener and Weidenmier (2010), clearly fit the Bulow–Rogoffframework and have been shown to increase borrower compliance. Supersanctions,by their very nature, require the cooperation of a military power; it is much harder to
Sovereign Debt 15
show that private parties could impose a punishment on the same scale, and there arevirtually no historical instances of such an event.
Though it is unlikely that a country that does not honor its debts will be slappedwith trade sanctions, trade does nonetheless shrink significantly following a default.Typically, no private party is granted a higher credit rating than the country in whichit is based, and hence exporters and importers see their ability to borrow severelycurtailed. As a consequence, GDP falls sharply (Rose 2005). The loss of output andthe difficulties of operating in international markets can be interpreted as a punish-ment beyond the exclusion from capital markets, thus providing additional supportfor the sanctions view.
The sanctions literature shares the same weak spot as first-generation reputationalmodels. If the threat of punishment is effective, defaults should not be observed inequilibrium, as no lender would want to incur the steep costs associated with them.Under this theoretical framework, defaults remain an off-the-equilibrium-path out-come, and the ones that do take place should carry severe consequences for debtors,which are seldom observed in practice. While it is possible to interpret some featuresof sovereign lending at specific points in history as being consistent with thesanctions theory, the sheer prevalence of defaults, as well as the many debtors thatemerge from them not much worse for wear, continues to suggest that a differentapproach is needed.
The Eaton–Gersovitz and Bulow–Rogoff models were both seminal contributions tothe sovereign debt literature. They provided powerful explanations for severalstylized facts while capturing some important institutional features of sovereigndebt arrangements through history. Nevertheless, historical evidence made it clearthat important gaps remained, opening the door for a wave of second-generationmodels, in which reputation, aided by advances in contract theory, once again tookcenter stage.
Reputational equilibria uniformly rely on the ability of borrowers to exclude adefaulting lender from further participation in capital markets. As hinted earlier, thiscan be a difficult proposition in a competitive environment. If a ruler is unable toself-finance in order to mitigate the consequences of sharp income fluctuations, themarginal utility for external financing is very high, setting the stage for attempts atbreaking the boycott. A government in default could pick out one or two powerfulfinanciers and offer them sufficiently attractive interest rates to break ranks withthose refusing to provide funds. In a similar setup involving rulers that confiscate thegoods of merchants, Greif et al. (1994) show how, absent a coordination device,rulers will always be able to find fresh trading opportunities by enticing individualmerchants with richer-than-normal rewards.
In practice, boycott breaking in sovereign debt markets is rare. When observed, itis often the result of official lending for political reasons, rather than market-
16 M. Drelichman
mediated transactions. For example, the Soviet-era lending to Cuba and the Vene-zuelan government loans to Argentina in the 2000s both occurred during interna-tional boycotts. The former, at preferential rates, was never repaid, while the latter,well above market rates, was quite profitable for the Venezuelan government.Importantly, both were extended for geopolitical reasons rather than for a strictlyfinancial profit motive.
Kletzer and Wright (2000) asked how the boycotts underpinning reputationalequilibria could be maintained in the absence of effective institutional enforcementon the lenders’ side, which they termed an “anarchic” environment. Their modelproposed a “cheat-the-cheater” strategy. If one lender, enticed by rich promises froma defaulting sovereign, breaks the boycott, all other lenders retaliate by refusing toconduct any further business with the boycott breaker and confiscating any assetsthey may be able to seize. A similar behavior between traders had been documentedby Greif (1993) in his famous study on the Maghribi traders. Kletzer and Wright didnot anchor their theory with any historical examples, but Drelichman and Voth(2011a) showed how Genoese and German bankers lending to Philip II of Spainoperated under this exact principle. In normal times, lenders participated in what wasby all accounts a well-functioning, competitive market. During the 1575 and 1596default episodes, however, all lending stopped. Genoese bankers joined forces in acoalition that offered a single negotiating front to the king. At the time, virtually allbankers had dealings with each other outside of sovereign lending, engaging incommercial ventures, holding each other’s financial deposits in several Europeanlocations, and marrying into each other’s families. This provided ample opportunityfor retaliation against boycott breakers and ensured the stability of the coalition.Although the king repeatedly tried to reach separate agreements with some of therichest families, the bankers always refused. Remarkably, cheat-the-cheater incen-tives also worked to keep non-Genoese bankers from breaking the boycott. The mostnotable case was that of the Fugger of Augsburg, who did not have any commercialor lending relationships with the Genoese. The king also tried to entice them toresume lending by offering twice the normal interest. The head of the German housedeclined, and their correspondence shows they feared that the king would use anynew loan to settle his debt with the Genoese and default on the Fugger instead,effectively cheating on the cheaters.
Theories of Default
A lingering shortcoming of all the models discussed thus far is their treatment ofdefaults. The single-minded focus on explaining why sovereigns repay their debtsoften leads to ignoring that quite substantial proportion of loans – up to 20% inparticularly troubled years – that are not serviced or repaid according to their originalterms. Any theory where defaults are an off-the-equilibrium-path outcome willstruggle with such a sobering statistic. Accordingly, from the very early studies ofsovereign debt in both theory and history, scholars have been proposing ways in
Sovereign Debt 17
which defaults could actually be conceptualized as equilibrium outcomes, at leastsome of the time.
Bubbles, Sentiment, and IrrationalityOne of the first and most enduringly popular explanations for the prevalence ofdefaults is that lenders are myopic. Braudel (1966) argued that most early modernsovereign bankruptcies were made possible by the greed of bankers, who, blinded bythe promise of high interest rates and easy profits, were time and again driven to theirruin by calculating, unscrupulous kings. An updated version of this argumentunderpins the work of Reinhart and Rogoff (2009), who argue that irrational lendersentiment is the common denominator of most defaults across the five centuries ofhistory they examine.
Explanations based on irrationality are hard to reconcile with the central tenets ofeconomic theory; individuals that are motivated by sentiment over reason, or arefooled by smart rulers, should be driven out of the market. In order for sovereignlending not to die out, it would be necessary for an endless supply of new myopicfinanciers to keep stepping up, replacing those that suffered the last suspension, onlyto be defaulted upon in turn. The historical record shows that such dynamics areimplausible. When lending resumes after a default is settled, the lenders that providethe new funds are typically the same that were affected by the suspension ofpayments (Drelichman and Voth 2014a). They won’t have necessarily profitedfrom the episode, but they certainly are not ruined, nor do they appear to be chastisedenough to abandon the market.
A different approach considers some defaults as being enabled by debt bubbles.Flandreau and Flores (2009) show how Latin American bonds in the early 1820sbecame extremely popular with investors, who drove up their prices only to losesubstantial amounts in a wave of defaults from 1825 onward. Bubbles, however,need not rely on irrationality; investors may be fully aware that the market prices ofan asset do not reflect its fundamentals yet will still buy it with the explicit intentionto sell at a profit before the trend is reversed and the bubble bursts. All buyers in abubble are, in a sense, rational; some are just unlucky. However, despite beingclearly important in a few specific episodes, bubble dynamics seem to be of littleimportance in the vast majority of defaults.
Excusable DefaultsIn an early adaptation of the Eaton–Gersovitz framework, Grossman Grossman andVan Huyck (1988) noted that not all defaults are the result of opportunistic borrowerbehavior. Countries sometimes face extreme adverse events over which they have nocontrol and which seriously strain their ability to make timely payments on financialobligations. Foreign military attacks, the sudden collapse of a key commercial orproductive sector through blockade or natural disaster, and a rapid and unanticipatedrise in interest rates are all factors that can undermine the fiscal capacity of asovereign. When exogenous events like these lead to a default, borrowers typicallyunderstand it as a consequence of force majeure and do not impose a punishment onthe borrower. Further lending is suspended only until the extenuating circumstances
18 M. Drelichman
are reversed; the borrower is allowed to make a settlement payment, some of the debtmay be forgiven or rescheduled, and new loans are offered in short order. Suchdefaults are termed “excusable,” as borrowers are not held responsible for them tothe same extent as with opportunistic behavior.
Identifying excusable defaults in the historical record involves establishing thatthe suspension of payments was triggered by an exogenous event, that the exclusionfrom capital markets was lifted as soon as a settlement became feasible, and that theborrower regained access to credit largely on the same terms as before the default.This necessarily involves setting thresholds for what should be considered a “stan-dard” exclusion length. Benjamin and Wright (2009) calculate that, between 1800and the present, defaulters are excluded from capital markets for an average durationof 8 years. Drelichman and Voth (2014b) argue that Philip II of Spain’s defaults in1575 and 1596 were excusable. Both episodes were triggered when delays inprecious metals shipments from the Americas coincided with Castile’s militaryadversaries ramping up military operations and requiring an increase in outlays.Both were settled in less than 2 years, and the financing terms available to the kingafter each episode were essentially unchanged from those that prevailed before.
Market Power and Incomplete ContractingOne approach considers that lenders, rather than competing with each other in anatomistic way, may possess a degree of market power (Kovrijnykh and Szentes2007). This may happen because only a handful of financiers are willing to lend tothe government or because there is a large concentration of capital in the hands of afew prominent bankers. In such cases, lenders will use their leverage to increaseinterest rates and obtain profits above those that would prevail in a competitivemarket. Because of these extraordinary profits, however, they will also be reluctantto completely sever a lending relationship after a default. Borrowers, knowing this,will find it optimal to renege on their obligations every now and then. The frequencyof these equilibrium defaults will be higher the more concentrated the market powerof lenders. Conjunctures like the extreme concentration of capital in the hands ofFlorentine bankers in the Late Middle Ages, or the outsize influence of the Roth-schild and Morgan banking houses during the late nineteenth and early twentiethcenturies, may be good fits for this type of framework.
A second line of research starts from the observation that it would be desirable forborrowers and lenders to write contracts that account for different possible futuresituations, usually called “states of the world” in the specialized literature. Thus, forexample, if a country were to unexpectedly experience a serious recession, lendersmight extend the repayment horizon, perhaps in exchange for a slightly increasedinterest rate. This type of contingent contract has the potential to avoid the costsassociated with a default and an exclusion from capital markets. An early examplecan once again be found thanks to the seemingly endless financial creativity ofsixteenth-century Genoese bankers. Many of the contracts they offered to theSpanish monarchy contained clauses that explicitly modified the repayment termsin specific circumstances, such as a delay in the arrival of the Atlantic treasure fleets(Drelichman and Voth 2014b). These contingent clauses typically increased the costs
Sovereign Debt 19
of borrowing following adverse events for which the king was deemed responsible(such as a unilateral rescheduling), but left them unaltered, or even reduced them, incases that were outside his control (such as bad weather in the Caribbean delayingthe arrival of precious metals). More recently, some emerging economies haveexperimented with GDP-linked bonds, which increase payments to bondholders ingood years and reduce them in recessions.
Despite their apparent efficiency and desirability, and the ingenuity of Genoesebankers notwithstanding, contingent sovereign debt contracts are, in practice,extremely rare. One possible explanation for their lack of popularity is that it isdifficult to find objective indicators tied to the state of the economy that cannot beinfluenced by the sovereign. Philip II did not control the weather, and, through itsinfluence on treasure shipments, the weather happened to be directly tied to the stateof his finances. But magnitudes like GDP or inflation are a different story. Govern-ments can certainly influence GDP growth or inflation rates, although doing so toavoid debt payments would seem much too costly a strategy. More importantly,however, a government can tinker with the measurement of macroeconomic mag-nitudes, biasing them in a direction contrary to the interest of creditors.
Between the moral hazard issues and the sheer number of unpredictable circum-stances that may exogenously impact the fiscal position of a government,implementing fully contingent debt contracts appears to be little more than achimera. It is simply not possible to provide for every potential state of the world;this leads to a situation known in contract theory as “incomplete contracting.”Arellano (2008) pioneered a literature showing that, in such circumstances, whenevents take a turn not contemplated in the original agreement, defaults can arise as anequilibrium outcome.
That lenders and borrowers cannot write complete contracts, however, does notmean that they are ignorant of the nature of the game. Quite to the contrary, everyactor in the market understands that, if events take an unpredictable turn for theworse, default is a likely outcome. In technical terms, defaults are part of an “implicitcontract,” which will be reflected in the risk premium built into the interest rate ofany loans. Lenders are not naïve; they lend to sovereigns fully aware that default is apotential outcome and are compensated for that risk. This also explains why lendersmay “forgive” defaulters after a partial settlement: they have been already compen-sated earlier through the higher rates they received throughout the course of thelending relationship.
The incomplete contracting literature jives well with the excusable defaultsinterpretation. Both recognize the uncertain environment in which sovereign lendingtakes place, and both allow for reputational equilibria that do not require sanctions,thus matching many of the empirical characteristics of lending and default thatemerge from historical data.
20 M. Drelichman
The Preeminence of Reputation
In the horse race between reputational and sanction-based models, both have found ameasure of empirical support, and both bring important elements to our understand-ing of sovereign lending. The sanction story is clearly superior in instances where theuse of force has been applied to collect loans or to deter sovereigns from defaulting,with the gunboat diplomacy era providing a few historical junctures in support ofthis view. The negative impact of defaults on a country’s trade can also be interpretedas being aligned with the sanctions view, but trade represents an increasinglyshrinking source of income as one looks farther into the past. Tomz (2007) examinedthe universe of sovereign lending on a global scale during the last three centuries,concluding that reputation, rather than sanctions, was the central factor underpinningloan repayment and default settlement in the vast majority of cases. Coupled withadvances that can account for defaults as an occasional equilibrium outcome, thisevidence suggests that market mechanisms and incentives are sufficient to makesovereign lending viable. The final linchpin is that sovereign lending is also profit-able. As mentioned earlier, investors in government bonds received an averagepremium over safe assets of 0.4% in the nineteenth and twentieth centuries and upto 2% in early modern times, after accounting for the losses sustained in defaults.Sovereign finance may be complicated, kings may be whimsical, and defaults mayshock investors and even ruin some. However, when viewed through the long lens ofhistory, sovereign debt markets have been remarkably resilient and, in their bestincarnations, have needed little more than the usual self-interest of borrowers andlenders to deliver gains for both.
The Political Economy of Debt
The scholarly dialogue between the theoretical and historical literatures has shownthat sovereign debt markets can work, sustained by reputational equilibria. As soonas the first reputational models emerged, however, a new set of questions appeared:how do rulers build a reputation? What makes a government trustworthy? Thesewould become an integral part of the research agenda of the then-nascent “newinstitutional economics” (NIE), a field itself deeply rooted in the intellectual sphereof economic history.
The question of what underpins the credibility of a ruler is at the center of Northand Weingast’s (1989) study of the political and financial consequences of theGlorious Revolution, undoubtedly one of the most influential pieces in the entireeconomic history literature. Its main argument is one and the same with the centralcreed of the NIE: institutions, not individual behavior, determine the long-run out-comes of state policy and, ultimately, of states themselves. The Glorious Revolutionwas, at its core, a radical institutional reform that enshrined merchant interests at theheart of the British system of government (O’Brien 2009). By subjecting the Crownto parliamentary supremacy, it stripped the king of the ability to expropriate subjectsand foreign lenders alike, while ensuring that overall government policy would be
Sovereign Debt 21
more aligned with the preferences of the triumphant commercial elites. This policywas, in turn, crystallized in a set of institutions, among which the most prominentwere the earmarking of taxes, the sinking fund, and the establishment of the Bank ofEngland. These acted as constraints on the government’s borrowing ability and assafeguards that ensured the availability of funds for repayment. The boost incredibility they generated, North and Weingast argued, enabled Britain to issueunprecedented levels of debt while drastically reducing its borrowing costs. Thisfinancial capacity would then prove crucial in defeating its enemies militarily,establishing an overseas empire, and, ultimately, creating the conditions that fosteredthe Industrial Revolution.
While the central argument of North and Weingast continues to inspire scholarsand politicians alike, its empirical analysis has been called into question. Sussmanand Yafeh (2006) showed that the interest rates in North and Weingast’s article,calculated on the basis of bonds’ face value rather than auction prices, did not reflectBritain’s true cost of borrowing. Once corrected, the effects of the Glorious Revo-lution are much harder to detect. Interest rates remained at pre-revolutionary levelsfor several decades, before finally inching down in lockstep with those of otherEuropean countries. In fact, the pace of military events would appear to be a betterpredictor of rates than political reforms. More recently, Cox (2011, 2015) has arguedthat political institutions, such as the establishment of ministerial responsibilityunder Walpole, played as important a role as financial reforms in the wake of theGlorious Revolution.
Conclusion
Four decades after the development of the first reputational model, the sovereigndebt literature has reached a reasonably mature state. Cliometricians, by creatingcomprehensive databases of debt issues and defaults, painstakingly uncovering keyinstitutional details, and taking testable predictions to sometimes centuries-old data,have been at the very frontier of these intellectual efforts. Historical research hasprovided inspiration for diverse historical frameworks, supplied the data to validatethem, and pointed to areas where further advances were needed. It is fair to say thatfew areas of economic research are so tightly integrated with economic history as thestudy of sovereign lending.
Cross-References
▶Eastern Europe Financial History▶ Institutions▶ Interest Rates▶Origins of the U.S. Financial System▶ Political Economy
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