The Democratic Advantage:Institutional Foundations of Financial Power in STOR International Competition Kenneth A.Schultz;Barry R.Weingast International Organization,Vol.57,No.1.(Winter,2003),pp.3-42 Stable URL: http://links.istor.org/sici?sici=0020-8183%28200324%2957%3A1%3C3%3ATDAIFO%3E2.0.CO%3B2-1 International Organization is currently published by Cambridge University Press. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use,available at http://www.istor org/about/terms.html.JSTOR's Terms and Conditions of Use provides,in part,that unless you have obtained prior permission,you may not download an entire issue of a journal or multiple copies of articles,and you may use content in the JSTOR archive only for your personal,non-commercial use. Please contact the publisher regarding any further use of this work.Publisher contact information may be obtained at http://www.istor.org/iournals/cup.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. The JSTOR Archive is a trusted digital repository providing for long-term preservation and access to leading academic journals and scholarly literature from around the world.The Archive is supported by libraries,scholarly societies,publishers, and foundations.It is an initiative of JSTOR,a not-for-profit organization with a mission to help the scholarly community take advantage of advances in technology.For more information regarding JSTOR,please contact support@jstor.org. http://www.jstor.org Sat Feb911:17:032008
The Democratic Advantage: Institutional Foundations of Financial Power in International Competition Kenneth A. Schultz; Barry R. Weingast International Organization, Vol. 57, No. 1. (Winter, 2003), pp. 3-42. Stable URL: http://links.jstor.org/sici?sici=0020-8183%28200324%2957%3A1%3C3%3ATDAIFO%3E2.0.CO%3B2-1 International Organization is currently published by Cambridge University Press. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.html. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/journals/cup.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. The JSTOR Archive is a trusted digital repository providing for long-term preservation and access to leading academic journals and scholarly literature from around the world. The Archive is supported by libraries, scholarly societies, publishers, and foundations. It is an initiative of JSTOR, a not-for-profit organization with a mission to help the scholarly community take advantage of advances in technology. For more information regarding JSTOR, please contact support@jstor.org. http://www.jstor.org Sat Feb 9 11:17:03 2008
The Democratic Advantage: Institutional Foundations of Financial Power in International Competition Kenneth A.Schultz and Barry R.Weingast Skepticism about the quality of democratic foreign policy has a long lineage in international relations scholarship.It goes at least as far back as Thucydides's concerns about the"inconstant commons."2 It reappears in Alexis de Tocqueville's famous assertion that democratic governments are "decidedly inferior"when it comes to foreign affairs.3 It is evident in A.J.P.Taylor's indictment of the West's response to Nazi Germany in the 1930s,as well as more recent analyses of this period.And it was particularly influential during the Cold War,when many ana- lysts saw the United States'political institutions as a source of weakness in its rivalry with the Soviet Union.Democracies were thought to be indecisive,slow to act,weak of purpose,squeamish about using force,and subject to the changing whims of public opinion.Democracies risked the politicization of the "national interest"by ill-informed publics and short-sighted legislatures.>Because these writ- ers took as given that leaders of democratic states lack the freedom of action en- joyed by their nondemocratic counterparts,they anticipated that democracy would face an uphill battle in its struggle against authoritarianism. The outcome of the Cold War has led to a reassessment of this conventional wisdom.Despite the supposed defects of democracy,the historical record sug- gests that democratic states have,in fact,done quite well in international compe- We gratefully acknowledge thoughtful comments from Bruce Bueno de Mesquita,James Conklin, Shinju Fujihira,Peter Gourevtich,David Lake,Jean-Laurent Rosenthal,Francois Velde,and the anony- mous referees. 1.Nincic 1992,chap.1. 2.Thucydides 1950,70. 3.de Tocqueville 1969,226-27. 4.Taylor 1962;see also Groth 1999. 5.See,for example,Kennan 1977;Morgenthau 1973,146-48;Lowi 1967;Lippmann 1955,chap.2; Friedrich 1938.One notable exception to this view among realist scholars is Waltz 1979.In his study of American and British foreign policy,Waltz concludes,"Coherent policy,executed with a nice com- bination of caution and verve,is difficult to achieve in any political system,but no more so for dem- ocratic states than for others"(311). International Organization 57,Winter 2003,pp.3-42 2003 by The IO Foundation. D0L:10.1017/S0020818303571065
The Democratic Advantage: Institutional Foundations of Financial Power in International Competition Kenneth A. Schultz and Barry R. Weingast Skepticism about the quality of democratic foreign policy has a long lineage in international relations scholarship.' It goes at least as far back as Thucydides's concerns about the "inconstant comrnon~."~ It reappears in Alexis de Tocqueville's famous assertion that democratic governments are "decidedly inferior" when it comes to foreign affair^.^ It is evident in A. J. P. Taylor's indictment of the West's response to Nazi Germany in the 1930s, as well as more recent analyses of this period? And it was particularly influential during the Cold War, when many analysts saw the United States' political institutions as a source of weakness in its rivalry with the Soviet Union. Democracies were thought to be indecisive, slow to act, weak of purpose, squeamish about using force, and subject to the changing whims of public opinion. Democracies risked the politicization of the "national interest" by ill-informed publics and short-sighted legislature^.^ Because these writers took as given that leaders of democratic states lack the freedom of action enjoyed by their nondemocratic counterparts, they anticipated that democracy would face an uphill battle in its struggle against authoritarianism. The outcome of the Cold War has led to a reassessment of this conventional wisdom. Despite the supposed defects of democracy, the historical record suggests that democratic states have, in fact, done quite well in international compeWe gratefully acknowledge thoughtful comments from Bruce Bueno de Mesquita, James Conklin, Shinju Fujihira, Peter Gourevtich, David Lake, Jean-Laurent Rosenthal, Fran~ois Velde, and the anonymous referees. 1. Nincic 1992, chap. 1. 2. Thucydides 1950, 70. 3. de Tocqueville 1969, 226-27. 4. Taylor 1962; see also Groth 1999. 5. See, for example, Kennan 1977; Morgenthau 1973, 146-48; Lowi 1967; Lippmann 1955, chap. 2; Friedrich 1938. One notable exception to this view among realist scholars is Waltz 1979. In his study of American and British foreign policy, Waltz concludes, "Coherent policy, executed with a nice combination of caution and verve, is difficult to achieve in any political system, but no more so for democratic states than for others" (31 1). Inter~zarional Organization 57, Winter 2003, pp. 342 O 2003 by The I0 Foundation. DOI: 10.1017/S0020818303571065
4 International Organization TABLE 1.World leaders and challengers as identified by long-cycle theorists Years Leader Challenger 1609-1713 Netherlands France 1714-1815 Great Britain France 1816-1945 Great Britain Germany 1946-(1990) United States Soviet Union Sources:Thompson 1983a;Modelski 1983. tition.Systematic evidence to this effect can be found in recent studies of war outcomes.Lake reports that democracies tend to prevail in wars against authori- tarian states.6 Reiter and Stam confirm this finding using more sophisticated mod- els.?Siverson,and Reiter and Stam show that democracies are more likely to win wars that they initiate and to suffer lower costs in the process.8 A similar pattern emerges when we expand the empirical domain from individ- ual wars to prolonged hegemonic struggles,such as those identified by "long cy- cle"theorists.Table 1 shows one classification of world leaders and challengers identified in this literature.It is striking that all of the leading states in this table had,if not democratic governments,at least limited or liberal governments.Al- though the franchise in seventeenth-century Holland and eighteenth-century Great Britain was too restricted for these states to qualify as democracies by current standards,both had representative institutions and a sense of appropriate limits on state action-the basic characteristics of a liberal polity.In every prolonged con- flict in modern history,such states have prevailed over their illiberal rivals. The effort to explain such observations is ongoing.Lake argues that democratic institutions constrain rent seeking by the state,therefore leading to a more effi- cient allocation of resources and enhanced economic growth.10 Reiter and Stam suggest that democracies enjoy greater legitimacy and thus have an easier time mobilizing popular support for war and motivating soldiers to fight efficiently. Bueno de Mesquita et al.argue that democratic leaders have stronger incentives to spend their resources on delivering successful public policies-such as victory in war-while nondemocratic leaders devote their resources toward paying off a small 6.Lake1992. 7.Reiter and Stam 2002:see also Stam 1996. 8.Siverson 1995;see also Reiter and Stam 2002. 9.Thompson 1983a;see also Thompson 1983b;and Modelski 1983. 10.Lake1992 11.Reiter and Stam 2002;see also Stam 1996
4 International Organization TABLE 1. World leaders and challengers as identijied by long-cycle theorists Years Leader Challenger 1609-1713 Netherlands France 1714-1815 Great Britain France 1816-1945 Great Britain Germany 1946-(1990) United States Soviet Union Sources: Thompson 1983a; Modelski 1983. tition. Systematic evidence to this effect can be found in recent studies of war outcomes. Lake reports that democracies tend to prevail in wars against authoritarian state^.^ Reiter and Stam confirm this finding using more sophisticated models.' Siverson, and Reiter and Stam show that democracies are more likely to win wars that they initiate and to suffer lower costs in the proce~s.~ A similar pattern emerges when we expand the empirical domain from individual wars to prolonged hegemonic struggles, such as those identified by "long cycle" theorist^.^ Table 1 shows one classification of world leaders and challengers identified in this literature. It is striking that all of the leading states in this table had, if not democratic governments, at least limited or liberal governments. Although the franchise in seventeenth-century Holland and eighteenth-century Great Britain was too restricted for these states to qualify as democracies by current standards, both had representative institutions and a sense of appropriate limits on state action-the basic characteristics of a liberal polity. In every prolonged conflict in modern history, such states have prevailed over their illiberal rivals. The effort to explain such observations is ongoing. Lake argues that democratic institutions constrain rent seeking by the state, therefore leading to a more efficient allocation of resources and enhanced economic growth.'' Reiter and Stam suggest that democracies enjoy greater legitimacy and thus have an easier time mobilizing popular support for war and motivating soldiers to fight efficiently." Bueno de Mesquita et al. argue that democratic leaders have stronger incentives to spend their resources on delivering successful public policies-such as victory in war-while nondemocratic leaders devote their resources toward paying off a small 6. Lake 1992. 7. Reiter and Stam 2002; see also Stam 1996. 8. Siverson 1995; see also Reiter and Stam 2002. 9. Thompson 1983a; see also Thompson 1983b; and Modelski 1983. 10. Lake 1992. 11. Reiter and Stam 2002; see also Stain 1996
Institutional Foundations of Financial Power 5 set of"selectors."2 Bueno de Mesquita and Siverson take a different approach, suggesting that democratic leaders have an incentive to select wars in which they have a high expected probability of winning;in this view,the correlation between democracy and victory reflects the selection process and not necessarily an inher- ent war-fighting superiority.13 We contribute to this literature by showing that institutional features generally associated with liberal democratic states provide a significant advantage in pro- longed international competition.The argument builds on previous research high- lighting the crucial role of financial power in determining the outcomes of conflicts such as those listed in Table 1.14 It has long been appreciated that money forms the "sinews of power."The victorious state in protracted competition is generally the one that can sustain a superior military effort-in war and peace-over a pe- riod of many decades,without succumbing to political and economic exhaustion. We argue that it is no coincidence that,over the past four centuries,states with representative,limited governments have been particularly successful in this respect. Although such governments may at times suffer from the constraints placed on their leaders,these constraints also provide the political foundations for financial power.Building on literature on sovereign debt,we show that representative insti- tutions enhance a state's borrowing power by making it easier for those with a stake in the repayment of debt to punish the sovereign in the event of default.15 The commitment technology provided by these institutions means that states pos- sessing them have superior access to credit than states that are not similarly con- strained.6 As a result,liberal states are better able to finance large wars and long arms races that require expenditures well in excess of normal receipts.Moreover, easy access to credit facilitates a policy of "tax smoothing,"whereby sharp in- creases in spending are financed through debt rather than through onerous tax in- creases.As economists emphasize,tax smoothing provides considerable advantages over the long run,lowering distortions in the economy and promoting invest- ment.17 These advantages are particularly useful for lowering the social and eco- nomic burden of sudden rises in expenditures associated with large wars.Thus institutions of limited government underpin a financial system that is capable of sustaining large expenditures on military competition in a manner that is consis- tent with long-term economic growth. We illustrate the effects of these institutions by looking at two cases of compe- tition between a liberal and an illiberal state:the rivalry between Britain and France from 1689 to 1815 and the Cold War between the United States and the Soviet 12.Bueno de Mesquita et al.1999. 13.Bueno de Mesquita and Siverson 1995.See Reed and Clark 2000 for a comparison of explana- tions building on war-fighting prowess and explanations building on strategic selection. 14.Rasler and Thompson 1983;see also Kennedy 1987;Brewer 1988;and Gilpin 1981. 15.Eaton,Gersovitch,and Stiglitz 1986;see also Bulow and Rogoff 1989;Conklin 1998. 16.North and Weingast 1989. 17.Barro 1979;see also Lucas and Stokey 1983
Institutional Foundations of Financial Power 5 set of selector^."'^ Bueno de Mesquita and Siverson take a different approach, suggesting that democratic leaders have an incentive to select wars in which they have a high expected probability of winning; in this view, the correlation between democracy and victory reflects the selection process and not necessarily an inherent war-fighting superiority.I3 We contribute to this literature by showing that institutional features generally associated with liberal democratic states provide a significant advantage in prolonged international competition. The argument builds on previous research highlighting the crucial role of financial power in determining the outcomes of conflicts such as those listed in Table l.14 It has long been appreciated that money forms the "sinews of power." The victorious state in protracted competition is generally the one that can sustain a superior military effort-in war and peace-over a period of many decades, without succumbing to political and economic exhaustion. We argue that it is no coincidence that, over the past four centuries, states with representative, limited governments have been particularly successful in this respect. Although such governments may at times suffer from the constraints placed on their leaders, these constraints also provide the political foundations for financial power. Building on literature on sovereign debt, we show that representative institutions enhance a state's borrowing power by making it easier for those with a stake in the repayment of debt to punish the sovereign in the event of default.15 The commitment technology provided by these institutions means that states possessing them have superior access to credit than states that are not similarly constrained.I6 As a result, liberal states are better able to finance large wars and long arms races that require expenditures well in excess of normal receipts. Moreover, easy access to credit facilitates a policy of "tax smoothing," whereby sharp increases in spending are financed through debt rather than through onerous tax increases. As economists emphasize, tax smoothing provides considerable advantages over the long run, lowering distortions in the economy and promoting investment.'' These advantages are particularly useful for lowering the social and economic burden of sudden rises in expenditures associated with large wars. Thus institutions of limited government underpin a financial system that is capable of sustaining large expenditures on military competition in a manner that is consistent with long-term economic growth. We illustrate the effects of these institutions by looking at two cases of competition between a liberal and an illiberal state: the rivalry between Britain and France from 1689 to 1815 and the Cold War between the United States and the Soviet 12. Bueno de Mesquita et al. 1999. 13. Bueno de Mesquita and Siverson 1995. See Reed and Clark 2000 for a comparison of explanations building on war-fighting prowess and explanations building on strategic selection. 14. Rasler and Thompson 1983; see also Kennedy 1987; Brewer 1988; and Gilpin 1981. 15. Eaton, Gersovitch, and Stiglitz 1986; see also Bulow and Rogoff 1989; Conklin 1998. 16. North and Weingast 1989. 17. Barro 1979; see also Lucas and Stokey 1983
6 International Organization Union.18 Both cases involve prolonged,militarized competition pitting the two most powerful states in the international system against each other.Although the outcomes of such rivalries depend on no single factor,we show that the ability of the liberal states to finance the competition through voluntary debt bestowed an important advantage.Britain was able to greatly outspend France in several cru- cial wars,despite its smaller population and economy.The United States was able to finance the Cold War without large tax increases and to use its impressive ac- cess to debt to outspend the Soviet Union militarily without undermining invest- ment and consumption.The Soviet Union,by contrast,financed its deficits with distortionary mechanisms that contributed to the decline of economic growth and played a major role in undermining economic reform. Our argument implies,then,that there is a trade-off associated with representa- tive government.Earlier writers emphasized the liabilities of democracy,failing to see its compensatory advantages.Although democratic institutions may hamper state decision making,their constraints bestow previously unrecognized advan- tages.This explanation may have limited relevance in accounting for the out- comes of short wars,but it does explain the success of liberal states in the prolonged military conflicts that have determined the outcomes of hegemonic struggles.The historical record suggests that this trade-off yields a net advantage. This article proceeds as follows.We first develop our theoretical arguments, showing how the constraints of limited government also serve as a source of state power.We next turn to the historical record to examine the success of liberal states in extended conflicts with illiberal rivals.The third section studies the 125-year rivalry between England and France throughout the eighteenth century,ending with the defeat of Napoleon.The fourth section focuses on the rivalry between the United States and the Soviet Union during the Cold War.Our conclusions follow. Institutional Sources of the Democratic Advantage Why have states with representative political institutions been particularly success- ful in prolonged international competition?Our strategy in addressing this ques- tion is to build on previous work identifying the economic and financial bases of state power.We seek to show that these factors are themselves a function of po- litical institutions.The argument presented here provides a theoretical link be- tween two observations:(1)states that can bring to bear superior financial resources over the long run have an advantage in prolonged rivalries,and(2)the states that have historically done so have had representative,limited governments. There are in general three different ways that states can pay for the extraordi- nary expenses associated with international competition:raising taxes,borrowing, 18.A related paper reveals a similar pattern in the Dutch revolt against Spain.See Schultz and Weingast 1998.Likewise,Kugler and Domke show similar effects in the British and American victory over Germany in World War II.See Kugler and Domke 1986
6 International Organization Union.'' Both cases involve prolonged, militarized competition pitting the two most powerful states in the international system against each other. Although the outcomes of such rivalries depend on no single factor, we show that the ability of the liberal states to finance the competition through voluntary debt bestowed an important advantage. Britain was able to greatly outspend France in several crucial wars, despite its smaller population and economy. The United States was able to finance the Cold War without large tax increases and to use its impressive access to debt to outspend the Soviet Union militarily without undermining investment and consumption. The Soviet Union, by contrast, financed its deficits with distortionary mechanisms that contributed to the decline of economic growth and played a major role in undermining economic reform. Our argument implies, then, that there is a trade-off associated with representative government. Earlier writers emphasized the liabilities of democracy, failing to see its compensatory advantages. Although democratic institutions may hamper state decision making, their constraints bestow previously unrecognized advantages. This explanation may have limited relevance in accounting for the outcomes of short wars, but it does explain the success of liberal states in the prolonged military conflicts that have determined the outcomes of hegemonic struggles. The historical record suggests that this trade-off yields a net advantage. This article proceeds as follows. We first develop our theoretical arguments, showing how the constraints of limited government also serve as a source of state power. We next turn to the historical record to examine the success of liberal states in extended conflicts with illiberal rivals. The third section studies the 125-year rivalry between England and France throughout the eighteenth century, ending with the defeat of Napoleon. The fourth section focuses on the rivalry between the United States and the Soviet Union during the Cold War. Our conclusions follow. Institutional Sources of the Democratic Advantage Why have states with representative political institutions been particularly successful in prolonged international competition? Our strategy in addressing this question is to build on previous work identifying the economic and financial bases of state power. We seek to show that these factors are themselves a function of political institutions. The argument presented here provides a theoretical link between two observations: (1) states that can bring to bear superior financial resources over the long run have an advantage in prolonged rivalries, and (2) the states that have historically done so have had representative, limited governments. There are in general three different ways that states can pay for the extraordinary expenses associated with international competition: raising taxes, borrowing, 18. A related paper reveals a similar pattern in the Dutch revolt against Spain. See Schultz and Weingast 1998. Likewise, Kugler and Domke show similar effects in the British and American victory over Germany in World War 11. See Kugler and Domke 1986
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
