1 Paradise lost: when lending was still more in line with the rule of law and market efficiency

Linau starts with the early twentieth century, which is a pity as the nineteenth century and its debt crises would have sharpened her line of argumentation considerably. Debt crises happened in the US, Latin America and Europe, including the Ottoman Empire. After independence in 1829, Greece literally stumbled from one default to the next. Creditors tolerated massive and open buy-backs by debtor countries (for the following cf Raffer 2010, pp.1ff). Many countries could buy back up to half of their distressed bonds at secondary market prices. Economically this is identical to surreptitious default. Bolivia in 1886 or Ecuador in 1898 stand out as especially successful cases. Chile even had special entries in her budget to finance buy-backs. The US – then a developing country – has an interesting history of non-payment. Quasi sovereign with regard to debts pursuant to the 11^th Amendment, US States have an impressive record of defaulting, which is even reflected in Dickens’s Christmas Carol. One night Scrooge suffers a nightmare: his solid British assets have turned into a “mere United States’ security.” The US solved the question of State debts for good (legally and ethically rather for bad). The 11^th Amendment simply barred creditors from suing the debtor, rendering US States quasi sovereign (without any waiver of sovereignty) with respect to debts, depriving creditors of any legal relief. In a way, this Amendment is a No-Bailout Clause. It was introduced to avoid that the Union would have to pay for States’ debts, proving the intention not to bail States out: if creditors cannot sue, enforced debt service cannot cause payment crises. Contrary to the case of Euro-countries that should have followed the US example – it has never been violated: no federal guarantee for State debts. This deserves mentioning as the US is now pressing other federal countries to guarantee the debts of their states or provinces. What’s good for the US is obviously – according to Washington – not good for other countries. Foreign bondholders circumventing the 11^th Amendment by suing at state courts, such as in Arkansas and Mississippi, did win their cases. The States, however, simply refused to obey their own courts and pay. The federal government itself defaulted on debts to France at the end of the eighteenth century. Ironically, the new republic argued that these were debts to the former king, but not to France. Although that matter was settled eventually – the US began to make regular payments on its French debts starting in 1790 – it shows that it is a wide-spread myth that the US – as opposed to its member States – has never defaulted. “In 1795, the United States was finally able to settle its debts with the French Government with the help of James Swan, an American banker who privately assumed French debts at a slightly higher interest rate. Swan then resold these debts at a profit on domestic U.S. markets. The United States no longer owed money to foreign governments” (US Department of State; U.S. Debt and Foreign Loans 1775–1795).

Mississippi seems to have coined the term repudiation when it simply refused to honour its debts. It was not the only case, though. Even referenda were held to vote whether (foreign) creditors should be paid. Some of the States defaulting during the 1840s paid – though not always all money due – when the situation improved, some never paid anything. The US railway system was largely financed by Europeans. Railway companies that enjoyed government support routinely went bankrupt, leaving foreign creditors with worthless papers and the US with the infrastructure. There once was a specific insolvency procedure for railways. There still exist specific legal norms for such companies today – Subchapter IV – Railroad Reorganization, Chapter 11, Title 11 US Code. Established in 1868(!) the British Council of Foreign Bondholders has tried to get compensation for damages suffered because of unilateral breach of contract. In the 1940s nine US states suspended interest payments on loans they had received to build railways and canals, when the price of their main export good, cotton, left them short of resources. A look at the US’ own past would have put US concern about “civilized international behaviour” in useful perspective, and would have strengthened her argument. Lienau (2014, p.96) describes this concern in her excellent Chapter on Soviet repudiation or the Roosevelt Corrolary (Lienau 2014, p.119) claiming the necessity of interventions to correct “chronic wrongdoing” by less civilized sovereigns not honouring their debts.

Reading that the International Bank for Reconstruction and Development (IBRD) expected the settlement of debts as old 1829 and of colonial rulers, insisting on a “reasonable settlement offer” (Lienau 2014, p.136), one cannot avoid mentioning that the IBRD has never even mentioned the US. This casts doubts on the Banks’s honest intentions to establish a global rule, treating all countries equally.

The final outcome of Latin American’s debt crisis in the 1930s may be seen as de facto insolvency. After negotiations Brazil’s debts were reduced by over 75 % in 1943. “Debt default eased payments constraints” (Maddison 1985, p.28) in Chile. Colombian local governments (municipalities, possibly) pioneered debt default, central authorities followed later. Some big European debtors were themselves delinquent regarding their debts after World War I. The British and French governments defaulted in the 1930s, considering their peoples’ needs more important than legal obligations to creditors. The essence of this argument is familiar to insolvency specialists.

In 1876 the representatives of private bondholders, hard-nosed nineteenth century capitalists, decided to use Egyptian insolvency law as the yardstick to solve Egypt’s debt crisis. Within a very short time they managed this crisis much better and more quickly than international public sector institutions nowadays, solving the problem.

After Mexico’s default of 1914 the US Ambassador proposed following Egypt’s example, but did not prevail. After years of debt management debt service was finally geared to Mexico’s capacity to pay. Creditors received less than 10 % of face values. The Egyptian solution would most probably have delivered a better outcome more quickly and more cheaply for anyone involved.

Corroborating Lienau, though in slightly different wording, it can be shown that sovereign lending before 1945 was more in line with the Rule of Law, and economic reason. Occasional military interventions and threats notwithstanding, economic mechanisms and reason mostly prevailed before 1945. Risk was allowed to play its role. Legal principles, such as debtor protection and debtor rights, were generally accepted. After some negotiation and foot-dragging, claims were in most cases reduced by agreement. Suffice it to mention two examples Raffer (2013) uses to support this point:

1. Especially during the nineteenth century, international tribunals held that states were not bound by contracts made by someone without proper authority, so-called ultra vires contracts. When Venezuela’s President Páez had his consul improperly enter into contracts that fell within the legislature’s authority, claims under these contracts were rejected. In 1922, Costa Rica refused to honour a contract between the former dictator Federico Tinoco and a British oil company, a concession granted by him and approved by the Chamber of Deputies. The constitution would have required approval by both chambers. The new government repudiated the contract on the grounds that those who had entered it had acted ultra vires.

The very law rests on the condition that one can only be bound by contracts freely entered into and signed by oneself or— especially in the case of legal entities—by someone properly authorized to do so. Checking the authority to sign is an obligation of creditors. Lenders, who do not fulfil it, do so at their own peril, unless they lend to Southern Countries (SCs). Although this is self-evidently the very cornerstone of law, and such checks are routine for Northern corporate or sovereign debt, this principle has de facto been waived in sovereign lending with the support of Northern governments and International Financial Institutions (IFIs). To give but one example: Article 75 of the Argentine constitution reserves the authority to incur sovereign debts to Congress. Article 76 prohibits Congress from delegating this prerogative to the administration. Sovereign debts multiplied under the military dictatorship from $7.8 billion in 1975 to $46 billion in 1984 without one single loan raised in the proper, constitutional way. Her creditors, especially the official sector, made Argentina pay nevertheless. Lienau’s “deranged junior employee” carried the day. No debtor, except an SC deprived of self-evident rights, would be expected to “honour” such null and void “‘contracts”.

1. Although customarily cited as a case of odious debts, Taft’s arbitral award in Costa Rica (described well in the book) simply applied due diligence and lenders’ obligations. The Royal Bank of Canada “knew” or had to know that it was financing Tinoco’s personal expenses. The problem boils down to equal treatment before the law. No creditor lending to a corporation’s CEO, or to a cabinet minister in any OECD country, knowing that this money would be embezzled but lending nevertheless, could even dream of having this claim “honoured” by taxpayers. Quite to the contrary, lawsuits for damages by the legal entity and quite possibly penal law consequences would follow.

Lienau’s (2014, p.213) quote “the odious debt argument was not acceptable inside the Treasury” in the case of Iraq needs some qualification. First, the US government revived its odious debt doctrine. Once enthusiastic reactions and calls to apply it in other cases as well made the US realize what it had done the administration started to back-pedal vigorously, finally denying it had ever advocated it. The damage of giving credibility to the doctrine was done, though. It could only be limited. (cf Raffer 2010, p.51ff)

One cannot but second Lienau: important changes occurred after 1945 mostly spearheaded by the official sector, which led to an international system some people are tempted to call the legal equivalent of apartheid. Looking a bit further down into history than she did, would have added considerable strength to her points.

2 Institutional self-interest in violating one’s own statutes

Her point that the Bretton Woods Institutions (BWIs) promoted – one might also write installed – a strongly statist view is well taken, doubtlessly right and well documented. An economist is tempted to add an economic explanation. One can show that this serves their very own institutional self-interests to the point of openly and unashamedly violating their own statutes. Allowed to play a role by their statutes, the market mechanism was simply perverted into its opposite. The statist view has been necessary to support this illegal change, a welcome theoretical fig leave. One had to argue that everything must be repaid. Supporting the statist view is thus helpful. One should note that the quoted internal memorandum on risk taking (Lienau 2014, p.124) logically supports the non-statist view, encouraging the IBRD to observe traditional market practice before it was perverted in order to bail out under any circumstances. IFI practice has perverted this admonition.

Deliberately, their founders did not confer any preference on the BWIs. Quite the contrary, they stipulated subordination of BWI-claims. Before the Second Amendment, the IMF’s Articles of Agreement “contained a provision suggesting that others would have preference on the Fund” (Martha, 1990, p.825). According to him the “intention” of this change by the Second Amendment “was not to repudiate the underlying thought that it was beneficial to encourage bank lending by giving banks and others a preference in repayment” (Martha, 1990, p. 814). Unfortunately, rather than making the IMF clearly financially accountable when conditionality was introduced, as economic reason would demand, initial intend was blurred, and it is now difficult to argue any longer that the IMF’s claims are subordinated.

3 Recent tendencies back to non-statism?

Considering that all historical cases of sovereign debt overhang prove that debts must eventually be reduced by substantial amounts reduces the practical relevance of the dichotomy statist – non-statist considerably. During 1970–2002 19 out of 26 cases of large debt reduction “were associated with a debt default.” (IMF 2003, p.140)

Although the early period after WWII has been characterized by debt continuity, there were two spectacular cases of de facto insolvency after 1945: Germany’s London Accord and Indonesia’s reduction 1969. Both roughly halved the present values of debts, both were politically motivated. Recalling them might be useful to prove that debt continuity was not always accepted or enforced by its most vocal defenders. But they were definitely not the rule.

Comparing Germany’s debt indicators with those considered “generous” under HIPC II shows a technically inexplicable difference between debtors. Germany’s Debt Service Ratio (debt service divided by export earnings) before debt reduction was below 4 %. Unlike 15 % for HIPC II this was considered unsustainable. Its debt (stock)/exports ratio was well below 100 %. No doubt Germany’s reparations after World War I, which the country had to pay against Keynes’s advice, were one important reason why Germany’s debt burden – relatively much lower than the burden of many SCs – was seen as unbearable for a sovereign debtor in the 1950s, stifling Germany’s economy. Greece and Ireland, creditors forgiving German debts in 1953, became recently victims to Germany’s adamant attitude that debtors – unlike Germany itself – have to repay all debts on moral grounds. The “loan” Germany extorted from the Greek central bank in the 1940s has never been repaid too, nor have payments been made Germany had agreed to under the London Accord. Clearly, Germany is no longer as weak as in 1953. In a first period after 1953 Germany invoked the “legal benefit” of the London Accord not to have to pay before a conference on reparations, which Germany has thwarted successfully later with a great deal of effort. Meanwhile Germany refuses to pay, claiming that its stipulated obligations were already antiquated, chiding the Greek why they did not demand payment earlier, although they had actually done so.

Although an SC, Indonesia was strategically most important after the putsch against Sukarno. After the new Suharto regime had allied itself with the West, proving its staunch support for freedom and democracy by slaughtering many thousand real or alleged communists, the new Western ally had earned a proper compensation. The US – incidentally not having many claims if any at all – strongly pressed for debt reduction. It turned out to be German type debt relief including equal reductions of claims by the East. Germany already opposed debt reductions on moral grounds but had a difficult stance, especially so as the master mind behind Indonesia’s solution was the same German banker, who had engineered Germany’s own debt reduction. Unlike in Greece or Ireland today, they could not really speak out loudly.

In the early 1990s Poland benefitted from a generous debt reduction. The US, once again having very few if any claims was the engine. In 1991 Senate Resolution No. 84 praised the people and the Government of Poland for their efforts in trying to transform their economy, specifically referring to the “precedent” of the “London accord after World War II”. (Raffer 2010, p.21). Once again all those official creditors otherwise most staunchly defending debt continuity were happily granting generous debt reduction.

More and more countries have recently resorted to unilateral actions. Argentina is arguably the best known example. Such actions are emergency solutions, necessary because proper sovereign insolvency proceedings are unavailable, a second best solution or optimization under restrictions. Fair and Rule-of-Law-based insolvency proceedings would definitely have been better. Ecuador (described in Lienau 2014, pp.215ff) put pressure on creditors via her debt audit commission, receiving a large reduction after quite an unpleasant debate.

Apparently, Ecuador’s Integral Auditing Commission was meant to frighten creditors rather than produce proper legal arguments. In this respect it was successful. Enumerating several examples, Richards (2010) identified a clear trend toward unilateral exchange offers as a technique for restructuring sovereign debt. When Congo (Brazzaville) – after a series of restructurings in which creditors were either completely bypassed or slighted after initial overtures for dialogue – responded favourably to promoting a negotiated solution over unilateral exchange offers, he called this “a ray of sunshine cutting through the shadow cast by the cases of Ecuador and Argentina.” (Richards 2010, p.298) Without a fair solution, debtor countries had to become more assertive. Iceland refused to nationalise the debt of her private banks, resisted considerable pressures, by the UK and the Netherlands in particular, exited from the crisis quickly and is meanwhile called a success by the IMF (2011). Ukraine’s behaviour vis-à-vis creditors – although supported by the West for political reasons – also shows a new attitude.

Thus, one may well see signs of another change in perceptions of sovereign debt. The UN initiative for sovereign insolvency procedures clearly shows a huge and justified desire for change, although it should not be seen in the statist or non-statist perspective. Debtors other than sovereigns may go bankrupt without a “change in management” and any thoughts about whether there should be continuity in their debts. This UN initiative is thus only another attempt finally to establish the Rule of Law also for the South.

But there also is at least one distinct movement the other way: the reaction during and to the crisis in Euroland. Public creditor behaviour cannot simply be described by statist. That would be incorrect and grossly unfair. As the private sector suffered haircuts (see e. g. Roubini 2012), Greece did not pay her initial debts anyway. Claiming untruthfully that Greece would repay her private creditors and that they would help to do so, an incompetent official sector has inflicted severe damages on the country and its people, turning a small problem into catastrophe (cf Raffer 2014). Suffice one fact: when the crisis broke, Greece had a relation debts/GDP of roughly 120 per cent, mid-2015 it is roughly 180, and the IMF already estimates it to reach or surpass 200 – in spite of massive debt reductions from private creditors. Greece would have been much better off without any EU-Type “rescue”, but a proper sovereign insolvency procedure (this author’s favourite model is Raffer 1990; also described in Raffer 2010, pp.78ff). But debts are apparently not the real point. If it were, the result of “rescue operations” bringing the relation debts/GDP from about 120 to about 180 (the IMF even fearing 200) would demand changes in debt management. As no changes have been made, but more of the same is demanded, another explanation must hold. Economically colonializing Greece and forcing privatization at fire sale prices seem the real issues. Asset grabbing is a much more plausible explanation for what happens in Greece. If Germany, e. g., actually believed in what it claims and debt continuity, it would have paid off its Nazi debts. It might also be explained by the desire to make Greece a terrifying example warning other member countries likely to become bankrupt.

4 Conclusion

Commenting on Lienau’s stimulating book two main comments were made: the more civilized treatment of sovereign debtors before World War II and the role of the Bretton Woods Institutions after 1945 that – as Lienau correctly notes – changed the position of debtors fundamentally. Especially so, after they took over as “debt managers” after 1982. To some extent this can be explained by institutional self-interest. Finally, the new movement back to a non-statist regime the author observes is briefly commented on.