The analysis demonstrates that a debt crisis can be expected when borrowing decisions are made by corrupt agents whose behaviour cannot be controlled by their principals.
Continued from Part One . . .
Now consider the situation in which the agent is a ‘dictator.’ Such an agent feels no obligation to follow the controls, or the interests, of the principal. It is willing to borrow as much as would be allowed by the creditors. 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. If the investment opportunities in the country are limited, the rate of return on investments beyond a certain level will fall below the cost of funds. The average rate of return on total investment will decline as investments beyond the optimal point are undertaken and may even reach zero at some point, if a sufficiently large volume of investment funds are forced upon an economy with a limited capacity to absorb these funds. At zero average rate of return, the output just equals original investment and after repaying the external debt, the principal is left without any increase in the value of domestic savings. The average rate of return will become negative when investment is increased beyond this point. Creditors will allow investment in this situation only up to a point where all the output is required to repay the external debt. The principal loses even the savings it had started with. The creditors will refuse to extend loans beyond the point where the investment of the sum of domestic and non-appropriated foreign funds results in total output which just equals foreign debt repayment. The agent will, because of its self interest, borrow funds up to this point even if the principal’s net income is reduced to zero. It is assumed that in the political system being considered, the principal is unable to prevent the agent from incurring these high and inefficient levels of foreign debt and domestic investment. If the agent, however, misjudges either the principal’s resistance to a decline in its income or the principal’s ability to prevent the agent from appropriating the output to repay foreign debt, a debt crisis will result because the creditors will not receive payments due to them. A debt crisis will also result if the output falls below its expected level due to unexpected shocks. A decline in export revenues in the early 1980s was one of the events that triggered the crisis in 1982.
To recapitulate, we have considered two extreme situations. In a functioning democracy, the principal has effective control over its agent and consequently the foreign debt increases the welfare of the principal. The agent’s gains result from unobservable corruption. The corruption in this case redistributes some income from the principal to the agent, reducing the welfare gains the principal would obtain in the absence of corruption. The agent’s corruption causes minor distortions in the allocation of national resources. In a complete dictatorship, however, foreign debt reduces the absolute level of welfare of the principal because the principal loses control over the actions of the agent. The agent’s corruption distorts economic decision-making by creating a separation between those who gain from the decisions and those who pay for them. Poor and forced investments cause welfare or deadweight losses on the economy as well as redistribution of income.
In between these two extreme situations, that is, in a partially functioning democracy, the benefit of debt for the principal depends upon the balance of the powers of the agent and the principal. The agent will neither be able to borrow as much as in a dictatorship, nor will it have to borrow as little as in a functioning democracy.
The analysis demonstrates that a debt crisis can be expected when borrowing decisions are made by corrupt agents whose behaviour cannot be controlled by their principals. The existence of an actual debt crisis in the 1980s, however, does not necessarily imply corruption on the part of the agents. There could be other reasons for such a crisis. We will have to demonstrate causal links between the existence of corruption and the present debt crisis to support the model developed above. Such a proof, however, is difficult because the required data are not easily available. On the one hand, there is a problem in defining and measuring corruption.15 Those involved in corruption do not like to leave traceable evidence behind. On the other hand, political corruption causes distortions in the resource allocation process which causes income to decline which in turn causes debt repayment difficulties. Due to this chain of causal links, it is difficult to provide direct evidence for the effects of political corruption on the debt crisis. Evidence presented above, however, indicated that in many of the countries that face debt repayment difficulties, political corruption coexists with non-democratic regimes on the one hand and that a large segment of the principal has suffered a loss of income over the period of the debt crisis on the other hand.
In searching for evidence of the links between corruption and the debt crisis, it should be born in mind that the external debt is responsible for only a small part of the total income of the principals in most borrowing countries. Most of the principal’s income is derived from the investment of domestic savings. Unlike the stylized model developed above, creditors cannot really lend against all of this income because of the problem of convertibility: all the domestic output is not convertible into foreign currency revenues. Foreign debt is almost always denominated in a foreign currency and the creditors look only to the foreign currency earnings of the principal. Hence the credit limit is imposed at a level much below what would reduce the principal’s total income to zero. We would, therefore, expect to find not that the principal’s income will reduce to zero but that there will be some reduction in income. In reality, no principal can be expected to survive without an income, especially not the majority of populations in developing countries without access to past savings. The principal can be expected to show resistance, even a violent one, to a significant drop in income. Rational agents will anticipate such a response and hence not attempt to force very large debt repayments on the principal.
A proof of the model presented above is further complicated by the fact that a borrower can avoid repayments of first period loans in a multi-period framework by using the borrowings in the second period to repay the previous loans. The repayments can be avoided for as long as creditors are willing to lend. By avoiding repaying the loans in one period, an illusion of high income can be created because the reduction in income that would result from the repayment of loans is postponed to the period in which the creditors finally refused to lend. Since the present debt crisis began in 1982 and since the creditors had been willing to increase loans for most of the borrowing countries until 1982, we do not expect to find evidence of a decline in the principal’s income until after 1982 even though corrupt agents had appropriated wealth long before 1982.
Finally, it would be difficult to separate the effects of exogenous global shocks on the principal’s income from those resulting from poor investments caused by the agent’s corruption without detailed information on each investment in each country. Such information, unfortunately, is not publicly available.
Solution to the crisis and concluding remarks
The link between corruption of the leader and the decline in society’s income is not fortuitous. The analysis in this chapter establishes the link between the two. A crisis can occur when corruption crosses the undefinable and imaginary line between income-redistributing corruption and resource-misallocating corruption.
The evidence presented at the beginning of this chapter was limited to countries where excesses have drawn world attention. In most cases, corruption, unless extreme, is accepted as a way of life. We do, however, find that corruption among the political elite, broadly defined to include the leaders and their supporters, is quite common in the indebted countries. Since the debt crisis in the early 1980s, one consequence of the resource misallocation resulting from this corruption has been a decline in the income of wage earners, one group in society which usually has the least control over a corrupt leader.
The solution of the debt crisis, therefore, is inseparable from the question of allocation of income within the borrowing countries. The allocation of income is tied to the question of control of the political system. The solution to the debt crisis, therefore, will have to interfere with domestic politics, and involves the question: how are those who make economic decisions to be selected?
The analysis presented here suggests that, in the long run, lending to governments influenced by powerful citizens within democratic societies will be a better risk than lending to excessively authoritarian, corrupt leaders. From the perspective of the external creditors, democracies are to be preferred to dictatorships. As we have seen, corruption and inefficient policies can be an inevitable consequence of authoritarian models of government in the Third World.16 Lenders may thus have to choose between possible but often illusory short-term gains from authoritarian systems, and the long-term benefits associated with the now more common democratic systems across the globe.
Arvind K. Jain is Associate Professor of Finance at the John Molson School of Business at Concordia University, Montreal, Quebec.
* This paper has benefited immensely from the comments of Prof. R.T. Naylor. The author is grateful to him for the comments, to the Faculty of Graduate Studies, McGill University, for research funds and to Ms. Nalini Johnson for research assistance.
1. For an analysis of corruption in a system with only the second of these two problems, see Rose–Ackerman (1978).
2. Many sources can be given here. For example, on Mobutu see ‘Zaire: Mobutu’s $4 billion stash,’ Nation, 25 February 1983; George (1988), Ch. 7. The journal Corruption and Reform continues to provide similar documentation.
3. C.E. Ritchie, ‘How to Lighten the Heavy Load,’ Globe and Mail, 19 February 1988, p. A7. Such grim economic conditions have produced a reaction among the IFIs. See Cheru (1989) and Ghai (1991).
4. Pratt and Zeckhauser (1985).
5. Jensen and Meckling (1976).
6. Ibid., p. 313.
8. Fama (1980).
9. For a recent survey, see, for example, Huntington (1991).
10. See Deysine (1980) or Rose–Ackerman (1978) for an analysis of this phenomenon.
11. The threat of non-reelection does not necessarily provide a perfect control mechanism; see Lott (1987) and Knoeber (1982).
12. Etzioni–Halevy (1979), p. 7.
13. It is not unrealistic to argue that the leaders of some totalitarian governments in the Third World do not allow themselves to be subjected to any controls by the general public. Readers may disagree as to the exact number of such countries, now or up to 1982 when most debts were being negotiated, that fit the description. Few, however, will have difficulty accepting that the description is appropriate at least for Duvalier, Mobutu, Somoza and Marcos.
14. In this analysis we ignore the second major use for external funds which is to smooth random or periodic fluctuations in domestic income. We assume here that all external funds are used for supplementing investment funds. For the use of external funds for smoothing out fluctuations, see Eaton and Gersovitz (1981).
15 Deysine (1980) pp. 447–9. For some documentation, see Naylor (1987). For evidence of corruption before the 1980s, see Clarke (1983), especially Ch. 9, ‘On Presidential Graft: Latin American Evidence,’ by Laurence Whitehead.
16. A typical example is provided by George (1988), Ch. 7. Zaire’s Mobutu went ahead with the expensive Inga–Shaba power project on the recommendation of the US Ambassador to Zaire. Construction contracts were awarded to US firms. Similarly, France had supplied Zaire with a satellite through firms run by a cousin of the president of France. Commercial banks provided the loans to finance these projects. Due to these, and other, wasteful projects, Zaire has been unable to generate funds to service its debts. The same lender-country governments are now involved in providing concessions to the Zairian government to meet renegotiated debt repayments.
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To read Part One of “Dictatorship, Democracies and the Debt Crisis” by Arvind K. Jain, please see: https://journal.probeinternational.org/1993/06/01/dictatorship-democracies-and-the-debt-crisis-part-i/
Arvind K. Jain, The Politics of Global Debt (ed.) Stephen P. Riley, St. Martin’s Press, June 1, 1993