10
In this final chapter, I first reexamine the reasons that public credit made states in Western Europe but seldom outside it. As should now be evident, the answer to this question builds on the argument and findings presented throughout the book: European states benefited from foreign capital scarcity. Second, I elaborate on the implications of this book for three debates in the literature on development: loan conditionality, foreign intervention, and the resource curse. Third, I propose two ways to extend the analysis of external finance on state building—one focusing on postcolonial institutions, the other on civil conflict. I conclude the chapter with some thoughts on the joint examination of debt and tax instruments in the study of state building.
10.1 Why Did Public Debt Make States in Europe?
International financial markets in early-modern Europe were small and expensive.1 Lacking an outside option, European monarchs were compelled to turn inward to cope with growing war expenses, the main budget obligation at the time. As early as the thirteenth century, Italian and German city-states had borrowed long term from local elites, usually urban merchants, who also decided on the taxes that funded the debt.2 Territorial states followed suit: as of the second half of the sixteenth century, Elizabeth I (r. 1558–1603) stopped issuing short-term loans in Antwerp at rates between 12 and 14 percent and switched to London merchants, who charged 2 points less than their Flemish counterparts.3 That switch laid the foundations of public credit in England.
Almost simultaneously in France, Henry IV (r. 1598–1610) began to borrow from Parisian merchants, marginalizing increasingly expensive Italian lenders.4 Far from exceptional, domestic debt expanded under absolutist kings. The Company of General Farms, an oligopoly of tax farmers created by J. B. Colbert, became the primary lender of the French Crown.5 Credibly excluding the ruler from new quotations in case of default, French kings gained access to increasingly competitive long-term loans.6
Public credit in the Low Countries developed by imposition from Madrid. Charles V (r. 1519–1556) had made the Dutch provincial assemblies responsible for collection and repayment of the long-term debt of the empire. Local merchants were heavily represented in the provincial estates and secured tax revenue to refund the same government bonds that they had previously acquired.7 The Low Countries kept this system in place after independence (declared in 1581, recognized by Spain in 1648). Strict control by taxpayers over spending decisions brought Dutch credit to unprecedented levels and consolidated the Low Countries as the financial capital of Europe until the turn of the eighteenth century.
Over centuries, city-states, Britain, France, and the Low Countries created robust systems of domestic public credit. The local nature of sovereign debt is crucial to understanding its consequences for state building and political reform. The reason lies in the consequences of defaulting and how those consequences structured the incentives of monarchs to expand tax capacity and—even unintentionally—initiate political reform. Default on domestic debt carried severe repercussions for a sitting ruler: loss of access to credit and asset seizure in the best case, and overthrow in the worst-case scenario.8 National and regional parliaments and tax farm oligopolies eased merchants’ coordination to monitor the monarch’s actions and deny fresh loans unless standing obligations were met.9 Seizing loan collateral was credible because it was often directly managed by the same merchants who lent to the Crown.10 Ultimately, the monarch’s tenure in office hinged on the support of big taxpayers and Crown lenders, who were willing to withdraw political support if the monarch breached the fiscal contract, replacing him or her by a new one of their liking.11
Because the political cost of domestic default was both sizable and credible, European monarchs implemented fiscal innovations to meet debt obligations. Over time, new and more efficient taxes were passed, fiscal centralization and the professionalization of the tax administration were adopted, and treasuries and central banks were inaugurated for the purpose of government funding and public debt repayment. From an analytical point of view, the political cost of domestic default for a sitting monarch sustained the long-term equivalence between debt and taxes for the purpose of state building. That is, loans in early-modern Europe acted as deferred taxes, and for that reason war and military budgets made the state.12
10.2 Why Did Public Debt Not Make States in the Global South?
In general, domestic capital markets in the periphery in the nineteenth century were tight or nonexistent; however—and here lies the key difference—recently created countries and those forced to join the Western international system had access to vast sources of capital in European financial centers, first London and later France and Germany as well. The first round of sovereign loans in the 1820s quickly ended in default. Debt readjustment negotiations were lengthy because bondholders had not perfected sanctioning mechanisms. In the second half of the nineteenth century, imperial competition among the Great Powers accelerated. Foreign bondholders seized geopolitical rivalry to impose harsher clauses in sovereign bonds, extracting new concessions and enabling temporary confiscation of state monopolies or revenue sources in case of default. I refer to this practice as extreme conditionality.
Whether intentionally or compelled by geostrategic considerations, creditors’ governments became involved in private financial markets. They exerted diplomatic pressure, brokered fresh loans, and participated in default settlements. Military involvement or gunboat diplomacy was rare, something to be expected if all actors behaved consistent with their beliefs—the definition of rationality. A sign that asset and revenue confiscation in case of default turned credible was that pledges in loan contracts in London reduced the premium levied on borrowing countries in the decades of high imperialism.
Foreign financial intervention and debt-equity swaps were unpopular and should have disciplined leaders to float only necessary loans and spend them wisely. The fiscal exigencies of war, blatant corruption, and local political instability in many emerging economies probably led to downplaying the political costs of a hypothetical default. From an incumbent’s viewpoint, default sanctions were a problem of the future, very likely someone else’s; well negotiated (e.g., if accompanied by substantial debt relief), pledging might have been perceived as the lesser of two evils compared to the immediate costs of taxation, particularly sharing fiscal policy powers with taxpayers.
Thus, extreme conditionality did not preempt rulers from floating new loans. All types of state monopolies and sources of revenue were pawned. Unsurprisingly, the precarious fiscal position of recently formed countries brought many to suspend debt service. Default settlements would execute previously agreed terms—debt-equity swaps and receiverships—or impose them as part of the debt readjustment negotiations. One way or another, foreign bondholders took control of state monopolies and sources of revenue while injecting fresh sovereign loans to reactivate the economy. The tax base available to the local government thinned and outstanding debt grew. A new budget crisis often followed, requiring fresh debt, more concessions, and further hypothecation. This cycle pushed many countries into debt traps, creating lasting fiscal disequilibria.
From an analytical point of view, the exchange of external debt obligations for nontax revenue (and debt relief in the best-case scenario) precluded the long-term equivalence between debt and taxes for the purpose of state building. War and major expenses would be financed with foreign debt and repaid in specie, not tax money, preempting advances in local fiscal capacity—the central pillar of the modern state. Counterintuitively, countries in the Global South may have benefited from less dynamic international lending markets because that would have strengthened the incentives to raise taxes to finance government, stimulate domestic borrowing, and conduct the political reform associated with long-term fiscal capacity—which Europeans had been pushed to do only centuries before, when international credit markets were virtually nonexistent.
Consistent with this argument, the empirical exercises and qualitative evidence in chapters 7–9 suggest that rulers who were excluded from international capital markets during wartime—that is, when government funds were badly needed—were compelled to reshuffle the tax administration and assume the political cost of taxation, namely, power-sharing institutions. Those early reforms potentially put in motion the political and bureaucratic mechanisms of transmission advanced in this book, carrying the effects of war finance into the long run. All in all, the erratic behavior of international capital markets in the first globalization of capital offered opportunities for both change and continuity in fiscal capacity building.
10.3 State Building beyond War Finance
The domestic nature of public credit is one key reason for political compromise and fiscal innovation in Europe, but not the only one. State building is a multifaceted process with multiple causes, and students of state making should at least consider the roles of economic enlightenment, institutional emulation, and political competition. Joel Mokyr’s scholarship shows that a “market for ideas”13 was a fundamental driver of economic prosperity and cultural pluralism in Western Europe. Economic enlightenment transformed the economies and the relationships of individuals with their environment. The search for innovation-friendly policy created political institutions that solidified one of the three pillars of capable states: property rights protection, also known as legal capacity.14 Innovation-driven economic growth expanded commerce and monetized the economy, growing the bargaining power of holders of mobile assets (traders and financiers) vis-à-vis monarchs, facilitating political compromise and investment in capable states.
“Institutional learning”15 is a second important reason for the proliferation of capable states. In Europe, the Hanseatic League and Italian city-states gradually and voluntarily adopted efficient institutions from territorial states. They standardized coinage, reduced the number of weights and measures, and created legal certitude by strengthening internal hierarchy. Lowering transaction and information costs, these smaller polities survived the expansion of territorial states until the mid-nineteenth century.16 Meiji Japan is the paramount example of state building by emulation in the Bond Era.
Finally, investment in state capacities can occur for purely political reasons. Tax policy creates opportunities of cooperation and competition between different elites, who might agree to tax reform for mutual benefit or to penalize political rivals. Once in place, the sponsors of fiscal innovation may lose control of it or be ousted from power, offering opportunities to new political players to expand the scope of taxation and state capacities in the long run. My work with Isabela Mares on the origins of the income tax in Western Europe offers one such example. Initially adopted in the mid-nineteenth century to exclude the working class from the political arena, the income tax became after WWI the most progressive tax instrument ever seen.17
Economic enlightenment, institutional learning, and political competition are proven non-bellicose paths to state building, giving hope and arguments to students and practitioners of state building today.18 Our understanding of the causes of state capacity benefit from studying its multiple causes—bellicose and not—and from unpacking their microfoundations and potential complementarities. The goal of this book is to place external public finance on a par with existing explanations of state building (and its stagnation) in recent world history.
10.4 Implications for Today
Whereas the core of the argument focuses on how the first globalization of finance pushed countries into different state building trajectories, the findings speak to a variety of other modern-day issues, including debates on loan conditionality, foreign intervention, and the oil curse.
10.4.1 LOAN CONDITIONALITY
I advanced the notion of extreme conditionality, that is, the hypothecation of national assets as a requirement to access foreign credit, to shed light on the secular decline of interest rates in the nineteenth century. Extreme conditionality and its implementation—supersanctions—have not been practiced since WWII (perhaps with the exception of Chinese loans19) for at least three reasons. First, asset seizure via debt-equity swaps and receiverships was feasible only because bondholders’ governments were involved in imperial competition. These severe political sanctions represented strong breaches to national sovereignty—ironically implemented in the era of “absolute” judicial sovereign immunity—that could not have been executed without diplomatic pressure from creditor governments.
Second, the key players in international finance have changed and with them the mandate of foreign financial intervention. Private lending to foreign governments declined after WWI and was replaced by official lending, virtually nonexistent before 1914.20 Although private funds gained some momentum in the last decades of the twentieth century, private-only loans today represent less than 11 percent of all sovereign debt.21 Financial crises are also managed differently. To balance the budget, borrowers do not have to grant concessions or extraterritoriality rights to foreign investors. Since WWII, the IMF has acted as the lender of last resort, specializing in ordered debt restructuring. Despite orthodoxy and limitations of IMF conditionality—the source of inspiration for vibrant research22—this institution never sought to make profit out of intervention, unlike receiverships in the Bond Era. IMF conditionality is meant to bring fiscal stability to the borrowing country even if it is at the price of one-size-fits-all neoliberal policy. In recent years, the IMF has recognized the importance of building local capacity, and it includes it as part of new bailout programs.23 Back to figure 1.3, international bailouts today push distressed countries into path D of state building, leaving no room for extreme conditionality.
Third, as of the 1970s, the notion of “absolute” sovereign immunity was relaxed in American and British courts.24 This legal change allowed private bondholders to bring to court sovereign debtors who had defaulted on their external debt. The institutionalization of dispute resolution in international lending made coercive strategies like debt-equity swaps and privately run receiverships unnecessary.25
Extreme conditionality and supersanctions in the nineteenth century are important today for another reason: these practices unraveled the long-term equivalence of debt and taxes for state building. The confiscation of state monopolies and revenue sources by foreign investors allowed debtor countries to settle on their debt and regain access to international credit markets without first having made significant efforts to improve their capacity to tax. Loans did not act as deferred taxation. What is worse, by putting parts of their already thin tax base in the hands of foreign investors, debtor countries remained highly exposed to new fiscal setbacks, requiring fresh loans and further hypothecation. Debt traps, characterized by high indebtedness, strong dependence on foreign capital markets, a thin tax base, and a weak tax apparatus, often followed.
Importantly, unlike Hobson’s one-sided imperialist view of international finance, my research suggests that the responsibility for debt traps and long-run underdevelopment was shared between aggressive foreign investors and irresponsible domestic rulers who preferred to assume the risk of foreign intervention over tax reform and power sharing with taxpayers. Foreign lenders were certainly no angels, but neither were domestic leaders.
10.4.2 FOREIGN INTERVENTION
Although tangentially, the findings of this book speak to the challenges of foreign financial control aimed at state building. In the Bond Era, foreign financial control differed from modern applications in many ways: it was guided by private interests and profit-maximizing considerations, not capacity building. Neither version of foreign control, however, seems to have met the goals they once pursued. The lack of legitimacy of international interventions may amplify when foreign agents seek private gain—be it in the realm of tax collection in the Bond Era or security provision today (e.g., Blackwater, later Academi, in Iraq and Afghanistan after 2003). Foreign-led state building is an extremely challenging task, and profit maximization may not be the right approach to overcome legitimacy obstacles.
10.4.3 THE “EASY MONEY” CURSE
The perverse consequences of external finance for the ruler’s incentives to build capacity resonate with those associated with foreign aid and oil. Unearned income is said to have two negative effects: First, it precludes accountability mechanisms associated with taxation.26 The ruler does not need to grant political rights to citizens to induce tax compliance because government is funded with nontax revenue from oil royalties and aid flows. Morrison and Ross show ample evidence of the negative effects of oil revenue for democracy,27 and Ahmed and Smith, among others, find equivalent results for foreign aid.28 Second, abundant nontax revenue is meant to weaken state capacity because it makes investment in the tax administration expendable.29
The two effects of easy money—accountability and bureaucratic weakening—are consistent with those elaborated in this book for external public finance. Access to credit overseas offers endless opportunities to developing nations, from tax smoothing30 to overcoming growth barriers.31 No policy, however, comes without trade-offs. Broner and Ventura warn about unintended macroeconomic effects of external public finance, including crowding out domestic credit markets.32 This book contributes to the debate by pointing out unintended political consequences: easy money in the form of sovereign loans can distort rulers’ incentives to strike deals with taxpayers and preempt long-term bureaucratic reform.
The foreign aid community has come to recognize the perverse incentives of unearned income in local governance and has strengthened the monitoring of the use of funds.33 Similar efforts might be necessary in the design of official lending to the developing world. In other words, conditionality might complement current technical conditions designed at building capacity (e.g., the adoption of value-added taxes) with political provisions (e.g., transparency standards and public dissemination of information) aimed at activating tax bargaining between rulers and taxpayers. By fostering political accountability locally, foreign intervention may overcome common legitimacy obstacles to state building.
10.5 What’s Next?
I envision two paths to continue the study of external public finance in the realm of state building and political reform: one focuses on the relationship between colonial public finance and long-term political institutions; the other, on the connection between civil war finance and state building.
10.5.1 COLONIAL FINANCE AND POLITICAL OUTCOMES
European colonies had access to the international credit market, and they were also responsible for their own expenses. Imperial war was heavily subsidized by the metropole, but everything else was financed locally. Although colonies were obliged to meet the revenue imperative, they were not allowed to articulate political institutions conducive to quasi-voluntary compliance, specifically representative parliaments. Acemoglu and Robinson as well as Stasavage warn us about the wedge between strong bureaucracies and weak societies. “Despotic Leviathans” emerge when the society lacks the capacity to control the state.34 Checks and balances are needed to prevent elites from exploiting the state apparatus for their own benefit. That is, the Leviathan is to be “shackled” so that both elites and nonelites can benefit from advances in state capacity. Stasavage shows that “the early democracy” was created to substitute for strong bureaucracies. In the absence of a coercive capacity, leaders could not rule alone, and decision making was necessarily collective. As the state strengthened and rulers gained the capacity to assess wealth and enforce tax compliance, the search for consent became expendable. Today, “modern democracy” and strong bureaucracies coexist only in some parts of the world, and “sequencing” is important to understand why. Democratic rule is harder to achieve when bureaucratic capacity has grown too strong.35
The insights of Acemoglu and Robinson and Stasavage call for a dedicated examination of the long-term effects of public finance on democratic consolidation in the postcolonial world. The consequences for political reform derived from early access to external finance for colonies might have differed from that of emerging sovereign nations. The latter, I have argued, potentially benefited from capital exclusion because rulers were forced to strengthen power-sharing institutions on a par with bureaucratic capacity. In other words, in sovereign countries, war and major fiscal shocks in times of capital exclusion activated both the bureaucratic and political mechanisms of transmission. Under the same circumstances, colonies were expected to strengthen bureaucratic capacity to mobilize government funds while keeping political institutions despotic (details in chapter 8). By implication, colonies that were disproportionally compelled to mobilize domestic resources to fund local government might have initiated the postcolonial era with relatively stronger bureaucracies and weaker political institutions, impeding the consolidation of democratic politics. The specificity of colonial finance calls for a dedicated examination of the obstacles to political reform in the former colonial world with a special focus on sequencing.
10.5.2 CIVIL WAR FINANCE AND STATE BUILDING
Another important area of research leads us to figure 6.1b, which shows a sharp increase in civil conflict after the end of the Cold War. With the exception of DiGiuseppe, Barry, and Frank, one finds little evidence and understanding of the external finance of civil war and its implications for local capacity and political reform.36 The evidence in this book suggests that the effect of the external finance of independence war, arguably a very specific type of civil conflict, is virtually indistinguishable from that of interstate war for the purpose of state building. Whether this result is generalizable to every type of civil war remains open. Doubtless, this is an important avenue of further research that would make a significant contribution to the understanding of state building and political order in the developing world today.
10.6 Final Remarks
Public debt, internal and external, is on the rise in both the developed and developing world, with no sign of change in the near future. In this book, I sought to broaden our understanding of state building by studying the interaction between taxes and loans—namely, domestic and external sources of government funding. Whereas existing research in political science and economics focuses on one policy tool while keeping the other constant, I argue in favor of their joint consideration as a means to improve understanding of the political dilemmas of public finance for rulers and taxpayers and the consequences for short- and long-run state building. I hope this approach will be followed in the coming years by scholars and practitioners interested in international finance, political change, and state building throughout history and today.
1. Homer and Sylla (2005); Prestwich (1979).
2. Epstein (2000, p. 26).
3. Outhwaite (1966, 1971).
4. Stasavage (2011).
5. Johnson and Koyama (2014).
6. Hoffman, Postel-Vinay, and Rosenthal (2000).
7. Tracy (1985).
8. Saylor and Wheeler (2017).
9. Johnson and Koyama (2014); Stasavage (2011).
10. Tracy (1985, p. 58).
11. Schultz and Weingast (1998, p. 23).
12. Refer to chapter 8 for a counterfactual in early-modern Europe: Genoese loans to Philip II of Spain.
13. Mokyr (2017, p. 170).
14. Mokyr (2017, pp. 183–185) for the origins of property rights protection of science and innovations; Jones (1981) and North (1981) for the paramount importance of property rights protection for economic growth; and Besley and Persson (2011) for the central role of legal capacity in state building.
15. Spruyt (1994, p. 179).
16. Abramson (2017).
17. Mares and Queralt (2015, 2020).
18. See Mokyr (1991, pp. 184–185) for the orthogonality between economic innovation and war before the Industrial Revolution.
19. Some authors argue that the goals of China’s aid and loans do not differ from bilateral and multilateral overseas lending from the West (Brautigam, 2020; Dreher and Fuchs, 2015); however, conclusions are generally drawn from partial datasets. Horn, Reinhart, and Trebesch (2020) show that official statistics between 1949 and 2017 are missing 50 percent of China’s lending to developing countries. Gelpern, Horn, Morris, Parks, and Trebesch’s (2021) closer look at 100 debt contracts reveals collateral arrangements, such as lender-controlled revenue accounts, reminiscent of the Bond Era. The debate about “debt-trap diplomacy” remains open.
20. Stallings (1972, p. 15).
21. Bunte (2019, p. 7).
22. Copelovitch (2010); Stallings and Kaufman (1989); Vreeland (2007).
23. Berg et al. (2009).
24. Verdier and Voeten (2015). See Weidemaier and Gulati (2018) for a critical interpretation.
25. Schumacher, Trebesch, and Enderlein (2021) suggest that specialized distressed debt funds, or “vulture investors,” recently pushed for seizing assets, but located in the creditor country (e.g., bank accounts).
26. Paler (2013).
27. Morrison (2009); Ross (2004, 2012).
28. Ahmed (2012); Smith (2008).
29. Bates (2001, ch. 4); Bräutigam and Knack (2004); Moore (1998).
30. Barro (1979); Lucas and Stokey (1983).
31. Rajan and Zingales (1998); Summers (2000).
32. Broner and Ventura (2016).
33. Dietrich and Winters (2021) for a recent survey and Cruz and Schneider (2017) for an application.
34. Acemoglu and Robinson (2019).
35. Stasavage (2020).
36. DiGiuseppe, Barry, and Frank (2012).