June 1, 1993
The fall of the Saddam Hussein regime in Iraq has called on lenders to account for their funding decisions as never before. Only two decades ago, the prevailing wisdom held that loans to governments were the least likely to go sour because government guarantees eliminated commercial risk. Dictators, in other words, posed no more or less risk than anyone else.
According to Walter Wriston, the former chairman of Citicorp and a man described as “the intellectual author of overlending to developing countries,” the “country does not go bankrupt . . . Any country, however badly off, will ‘own’ more than it ‘owes.'” A view echoed today in creditors’ attitudes toward Iraq, a potentially rich country and one of the world’s second largest oil reserves.
During Wriston’s time, this attitude created the moral hazard that led creditors to suspend their normal risk judgment, culminating in the world’s most intractable debt crisis ever.
Today, while campaigners demand the cancellation of debts racked up by dictators like Hussein, who borrowed on the state’s credit card but not for its benefit, the issue of lender culpability is coming to the fore.
Papers such as “Dictatorship, Democracies and the Debt Crisis” written by Arvind K. Jain in 1988 and later published in 1993, were prescient. An associate professor of International Banking and Finance at Concordia University in Canada, Jain argues the concept of agency theory to demonstrate the likelihood of a debt crisis when borrowing decisions are made by corrupt agents, such as dictators, who are not subordinate to the state or accountable to their citizens.
Jain likens the political system of a country to a principal-agent relationship, whereby political leaders act as agents of the population to manage the country’s resources, defining the principal, in this case, as the people. Writes Jain: “Few developing countries can be said to have political systems in which large sections of the principal are able to exercise genuine control over the behaviour of their agents . . . Whatever their route to power, leaders who acquire power without the support of large segments of the population do not feel any need to represent [their] interests.”
The most serious problem in such a relationship Jain warns, is that an agent will have an incentive, as well as opportunities, to allocate resources either for its own benefit, or for the benefit of its supporters. An agent with control of all government resources can appropriate the principal’s wealth either directly by way of corruption or indirectly by reallocating resources to favour its own supporters, he says.
The public can try to control the behaviour of the leaders through legal actions but leaders, on the other hand, can reduce the effectiveness of the public’s control because they, as agents, control all the national resources. The leaders may use the government apparatus to prevent the public from bringing about a change, violent or otherwise, of the leadership.
When the agent is a dictator, Jain says “the absolute income of the agent rises with the level of borrowings. In this situation, the constraints on the agent’s behaviour will come only from the creditors.”
A force of logic reinforced by the Doctrine of Odious Debts, shaped by legal scholar Alexander Sack more than 70 years ago, when he argued that creditors who extended loans to despotic powers without regard for the interests of the borrowing nation, in the knowledge that these funds would not be used for the benefit of the state, had committed a hostile act against the people and their claim to repayment, therefore, would be legally unenforceable.
In his analysis, Jain shows that “from the perspective of the external creditors, democracies are to be preferred to dictatorships.” Years later, Iraq proves his point.
Categories: Odious Debts