The Lending Game in History

International borrowing has been a key aspect of the European system since the Middle Ages — and of the global system since the 19th century. Rulers, whether of medieval monarchies or modern democracies, relied on this mechanism whenever they were unable to fund state expenditures from taxes and/or domestic borrowing.

Based on the record accumulated over the century, lenders who cherish peace of mind should not provide loans to rulers. International lending has occurred in Europe for at least eight centuries — and so have defaults. There was substantial lending during the Renaissance by transnational commercial and banking houses, often organized by families, that were based in major trading cities.

These banks periodically suffered sovereign defaults. Nevertheless, they continued to lend to rulers. Why? Well, those same courts — who were borrowers and might on occasion default — were a major outlet for the luxury goods these same trading families backed. Making sales thus could require making loans, but there was no third-party enforcement — and bankers could not always assess the risks. These early financial institutions were on their own.

Then as now, debt repudiations were tempting for rulers. For one, external pressures were relentless. War required foreign borrowing — precisely because the sources of domestic revenues were limited. For Britain, military expenditures accounted for between 61 and 74 percent of public spending during the major wars of the 18th century.

During the Great Northern War, Peter the Great spent 90 percent of Russia’s revenues on the military. In the last years of the ancien regime, France spent about 25 percent of revenues on the military. High interest rates and frequent defaults were the norm.

Then, during the 19th century, a truly global international financial system came into being. Communications improved. Colonial control allowed European banks to penetrate exotic locales more easily. Areas of overseas European settlement needed capital for infrastructure and industrial development.

After the Crimean War, the Ottoman Empire was compelled to seek international loans. By the end of the 19th century, net long-term international lending by major countries was about twice what it is today — relative to GDP. While most governments were able to honor their debt obligations, defaults were not uncommon.

On a global basis, there were several waves of sovereign lending which have all followed a cyclical pattern. A period of rapid expansion of loans was followed by defaults — and then a sharp decline.

The first such wave occurred in the 1820s with loans to the newly independent Latin American countries. Most Latin American countries defaulted during the first part of the 19th century, as did a number of states of the United States in the 1830s and 1840s and during Reconstruction. And so did, once again, Latin American countries, as well as eastern Mediterranean countries in the last part of the 19th century.

At the end of the 19th century, it was Argentina’s, Brazil’s and Colombia’s turn to either default or refund their loans. So did Mexico during the Mexican Revolution and Russia after the Bolshevik Revolution. All of the Latin American states, much of eastern Europe, Turkey and China defaulted on loans during the 1930s.

And most recently, in the late 1970s and 1980s, it was (once again) Latin American, but also eastern European and African states that failed to meet their original loan terms.

Over the last two centuries, countries have relied on a variety of foreign lenders including other states, foreign bankers with varying degrees of closeness to their own governments — and international financial institutions such as the World Bank and the International Monetary Fund.

Regardless of the source of funds, default or renegotiation of the original conditions of the loans has always been an issue. The private banking families that dominated European international finance during the Renaissance dealt with risk by charging high interest rates.

The international lenders of the 19th century, usually banks with close relations to their own governments, often sought control of specific revenue streams (such as excise taxes on basic commodities like salt or customs revenues from major ports.) In some cases, for instance the Ottoman Empire, foreign lenders established administrative structures which resembled in some ways contemporary international financial institutions (IFIs).

They not only collected taxes, but also promoted institutional change. By 1910, the Ottoman Financial Authority, which was run by foreign bankers, had more employees than the Ministry of Finance. During the 19th century, lenders also relied on military force — gunboat diplomacy involved taking control of custom houses, tariffs being the main source of state revenue, if a default occurred.

What is new about sovereign lending in the contemporary world is the extent to which it is designed to alter institutional structures in developing countries — not just to provide them with financial resource.

Since the 1950s, the World Bank and the International Monetary Fund have engaged in “conditionality.” Conditionality is not just designed to make sure that IFIs are repaid. It is also a mechanism for promoting reform in borrowing countries.

Conditionality makes loans contingent not just on repayment, but on changes in the domestic policies and sometimes even institutions of would-be borrowers. While IMF stand-by agreements are voluntary, they can compromise the domestic autonomy of signatory states. And even then, they are hardly a guarantee that the original terms of the agreement will be honored.

Clearly, with that history, lending to sovereigns is often not the most secure of enterprises. But it can be now, as it was during the 19th century, a vehicle through which states, not just private lenders promote their national interests.

December 15, 2001