------------ EH.NET BOOK REVIEW --------------
Published by EH.NET (February 2008)

Michael Tomz, _Reputation and International Cooperation: Sovereign 
Debt across Three Centuries_. Princeton, NJ: Princeton University 
Press, 2007. xxi + 299 pp. $60 (cloth), ISBN: 978-0-691-12930-3.

Reviewed for EH.NET by Kim Oosterlinck, Solvay Business School, 
Universit? Libre de Bruxelles.


In view of the sovereign nature of their issuer, and in the absence 
of a supranational court to judge them in case of default, one may 
wonder why countries would ever bother to repay their debts. The 
economic literature has suggested several motivations: fear of 
reputation loss (which would ban the access to future borrowing or 
make it much more costly), fear of a military intervention or of 
trade sanctions, as well as, but to a lesser extent, fear of the 
seizure of collaterals. Michael Tomz, assistant professor of 
political science at Stanford University, provides an interesting 
analysis of the importance of reputation for sovereign debt repayment 
and on its relevance in a broad historical perspective.

After a brief review of the literature, Tomz presents his theory of 
cooperation through reputation. Its development proceeds as follows. 
Investors cannot know in advance whether a given government will 
decide to honor its debts or decide to default. However, these 
investors may form beliefs regarding the probabilities of each of 
these outcomes. These beliefs represent the country's reputation. 
Tomz classifies countries in three broad groups: stalwarts (for which 
repayment is expected whatever the economic conditions), fair-weather 
(expected to repay in good conditions but not during hard times) and 
lemons (expected to default in all times). According to Tomz, 
investors will reassess the reputation of each country in view of its 
actions. Domestic elections may change priorities and the importance 
of reputation. However, decisions to default or repay allow 
governments to try shifting from one form of reputation to another. 
The remainder of the book aims at testing the validity of the 
above-mentioned theory.

Chapter three compares the reputations of new and seasoned borrowers. 
More precisely, the author tests whether new borrowers face worse 
credit terms than seasoned ones with a good reputation, whether there 
is a "graduation effect" (new borrowers who repay should eventually 
get similar terms as seasoned borrowers) and whether defaulters are 
excluded from the market. The author relies on empirical evidence 
from the Amsterdam market in 1771 and 1783 and from the London market 
in 1824 and 1872. Comparing the yield for new and seasoned borrowers, 
he finds that new borrowers had to pay a statistically significant 
premium to borrow.

I found Chapter 4 one of the most interesting and original chapters 
of the book. Tomz has done an impressive job by analyzing the 
investment literature published between 1919 and 1929. To my 
knowledge the history of economic thought in this field remains 
unwritten. By relying on expert opinion as expressed at the time, 
Tomz shows that reputation was perceived as the most important 
element, especially when compared to other conventional reasons 
invoked for debt repayment.

Chapter 5 assesses to which extent governments' actions are judged in 
a similar way in good or bad economic times. More precisely, it 
analyzes the reward for states which exceeded expectations during the 
Great Depression by repaying their debts. The author finds that 
defaulters in bad times where not badly punished but that unexpected 
good payers such as Argentina, Australia and Finland were rewarded.

Chapters 6 through 8 are dedicated to the alternative theories 
suggested to explain debt repayments: gunboat diplomacy (Chapter 6), 
trade sanctions (Chapter 7), and collective retaliation (Chapter 8). 
Regarding military enforcement, Tomz puts into perspective the number 
and motivation of actual interventions, the number of debt defaults 
and the respective military strength of lenders and defaulters. In 
view of the limited number of interventions attributable to defaults, 
he concludes that military intervention only played a minor role in 
the repayment process. Trade sanctions are analyzed by comparing debt 
service and trade dependency with creditors. Here again, Tomz finds 
only limited evidence that potential trade sanctions forced debtors 
to repay. Chapter 8 discusses the relative importance of creditors' 
ability to form a retaliatory cartel. Based on evidence from the end 
of the twentieth century, Tomz finds that lending and default 
patterns were the same for unorganized lenders as for more organized 
ones, suggesting that retaliation by cartels was not viewed as 
credible. Chapter 9 concludes by stressing once more how crucial 
reputation is when assessing motivations to default.

The book has several obvious merits. First, it relies on extensive 
data sources, most of them original and covering a very large 
time-span and geographical area. Secondly, it shows the importance of 
politics when assessing debt defaults, an element often overlooked by 
economists. Indeed, defaults represent a unilateral decision made by 
a given government: defaults are not automatically triggered by an 
economic variable (even though these variables play an obvious role 
in the decision to default). Furthermore, this book provides an 
interesting and refreshing approach to reputational theories in the 
sovereign debt context. The main point of the book is to prove that 
reputation is key to understanding decisions to default. At the end 
of the book, the reader should end up being convinced of its 
prominent role.

All interesting books raise questions and remarks and this one is no 
exception. Despite its qualities, as an economic historian I found 
the book presents a series of shortcomings. Economic variables are 
omitted most of the time when comparing yields, and when included, 
limited to one or two macroeconomic factors. For some periods, these 
data do not exist; for the more recent ones they do and have been 
used in recent papers. In a sense, the reader gets the impression 
that economics plays almost no role in the perceived probabilities of 
defaults. This is rather hard to believe. The author analyzes each 
alternative motivation to repay separately. It would have been 
interesting to analyze the relationship between these motivations (as 
for example, in Mitchener and Weidenmier, 2005a).

Another question is raised by the way the yields are computed. "For 
each country [the author] identified the lowest nominal interest rate 
on bonds that were not guaranteed by a foreign power, and then 
calculated yields based on the average of the minimum and the maximum 
quoted prices for bonds at that interest rates" (footnote, p. 41). I 
am unconvinced by this approach since it does not take into account 
volatility, a key measure in finance when one wishes to assess risk. 
In other words, two bonds with similar coupon rates would end up 
having the same yield even if one remained constant at, for example a 
price of 80 percent of par, whereas the other moved from 60 percent 
to 100 percent. Unless investors were risk neutral at the time, which 
I doubt, they should find the second bond riskier and hence ask for a 
higher yield. Furthermore, the yields used by the author are current 
yields (the ratio of the coupon rate divided by the price of the 
bond). Even though current yields have often been used by economic 
historians, yields to maturity would have provided a much better 
measure since they take into account the impact of bonds' duration 
and maturity and capture expected returns from capital gains (for 
example zero-coupons would have a 0 percent current yield because all 
their return is made via capital gains).

The relative importance of each motivation to repay has been analyzed 
in very different ways. Whereas for reputation the main indicator was 
the current yield, the author relies on other variables for military 
interventions or trade sanctions. These variables are certainly 
interesting, but one wonders whether some of the impact of potential 
military interventions or trade sanctions would not have materialized 
had the author relied on current yields in these sections. Recent 
work by Mitchener and Weidenmier (2005a and 2005b) seems to indicate 
that this would have been the case.

Since the book is subtitled, "Sovereign Debt across Three Centuries," 
I was expecting a more in-depth historical analysis. I fully 
understand that the book jumps from one time period to another 
depending on the point the author wants to make. However, I found 
surprisingly little references to history when discussing the 
findings. In Chapter 3, the author concludes that the higher yield 
paid by a series of countries in 1771 stemmed from their new borrower 
status. For some of these countries, alternative historical 
explanations seem more (or at least as) convincing. Was the high 
yield required from Russia in 1771 a consequence of its "new 
borrower" status or was it due to the Russo-Turkish War? To what 
extent can we attribute the Swedish high yield to the political 
instability at the time? Etc.

Eventually, the book omits some recent theories using historical 
approaches to assess the probabilities of defaults. For instance, no 
mention is made of "original sin" issues (Eichengreen and Hausmann, 
1999, Eichengreen, Hausmann and Panizza, 2003) or "debt intolerance" 
(Reinhart, Rogoff, and Savastano, 2003). The same holds for the few 
papers which have attempted to make a link between sovereign defaults 
and politics (political system but also type of regime, etc.) such as 
Kohlscheen (2006) or Van Rijckhegem and Weder (2004) for example.

References:

Barry Eichengreen and Ricardo Hausmann, "Exchange Rates and Financial 
Fragility," NBER Working Paper 7418, 1999.

Barry Eichengreen, Ricardo Hausmann, and Ugo Panizza, "Currency 
Mismatches, Debt Intolerance and Original Sin: Why They Are Not the 
Same and Why It Matters," NBER Working Paper 10036, 2003.

Emmanuel Kohlscheen, "Why Are There Serial Defaulters? 
Quasi-experimental Evidence from Constitutions," Warwick Economic 
Research Papers 755, 2006.

Kris Mitchener and Marc Weidenmier, "Supersanctions and Sovereign 
Debt Repayment," NBER Working Paper 11472, 2005a.

Kris Mitchener and Marc Weidenmier, "Empire, Public Goods, and the 
Roosevelt Corollary," _Journal of Economic History_, 2005b, 66: 
658-92.

Carmen M. Reinhart, Kenneth S. Rogoff, and Miguel A. Savastano, "Debt 
Intolerance," _Brookings Papers on Economic Activity_, 2003, 1: 1-74.

Caroline Van Rijckhegem, and Beatrice Weder, "The Politics of Debt 
Crises," CEPR Discussion Paper 4683, 2004.


Kim Oosterlinck is associate professor at the Universit? libre de 
Bruxelles. He recently published "Hope Springs Eternal: French 
Bondholders and the Soviet Repudiation (1915-1919)", _Review of 
Finance_, 2006 (jointly with John Landon-Lane) and "How Occupied 
France Financed Its Own Exploitation during World War II," _American 
Economic Review, Papers and Proceedings_, 2007 (jointly with Filippo 
Occhino and Eugene N. White).

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