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 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." 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 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 = Pl(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