Debt Relief and the International Enforcement of Loan Contracts

American Economic Association

Debt Relief and the International Enforcement of Loan ContractsAuthor(s): Jonathan EatonSource: The Journal of Economic Perspectives, Vol. 4, No. 1 (Winter, 1990), pp. 43-56Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/1942831 .

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Journal of Economic Perspectives- Volume 4, Number I- Winter 1990-Pages 43-56

Debt Relief and the International Enforcement of Loan Contracts

Jonathan Eaton

I t is now apparent that the governments of many developing countries will not repay their debts as initially contracted. Creditors have already forgiven loans to some poor borrowers in Africa. Loans to several middle-income borrowers, mostly

in Latin America, trade in secondary markets at enormous discounts, below 10 percent of face value in some cases. Creditors and debtors are negotiating the status of these debts, with relief now likely for them as well. Since 1983 the situation has been seen to be sufficiently troubled to constitute a "debt crisis," although whether the debts actually caused the stagnation and financial chaos in many debtor countries is questionable. Poor economic management at home, along with some adverse changes abroad, probably have more to do with their plight.

While the debts themselves may not have caused the crisis, creditors and creditor governments must now adjust to the realization that full repayment is either infeasible or that enforcing full payment is undesirable from the point of view of creditor countries as a whole. The question now is what to do with these debts.

The Baker and Brady plans have increased U.S. government involvement in the debt crisis, and have allocated public money toward its resolution. The Kenen plan, discussed in this issue, proposes still more public involvement and, in all likelihood, more public money. Each of these plans is an ad hoc response to the impasse that has arisen between some highly indebted countries and their private creditors, and aspects of each plan may help resolve this impasse. But none of these plans confronts the features of international capital markets that led to the crisis in the first place.

My argument here is that the debt crisis that began in 1983 arose from defects in how international capital markets operated the previous decade. A goal of any

* Jonathan Eaton is a Professor of Economics at the University of Virginia, Charlottesville, Virginia, and a Research Associate of the National Bureau of Economic Research, Cambridge, Massachusetts.



44 Journal of Economic Perspectives

redesign of the institutions involved in these markets should be not only to resolve the current crisis, but to keep it from happening again.

The Poor African Countries and the HICs

In analyzing what led to the crisis and how to resolve it, the situations of two very different groups of problem debtors should not be confused. One group consists of low-income African countries, the other of the 17 countries identified by the World Bank as the "Highly-Indebted Countries" (HICs).' The two groups have in common high levels of debt and GDP growth rates near zero for most of the period since 1982, well below the average for developing countries.2 Otherwise, their circumstances are very different.

For one thing the poor African debtors have little to repay with. They have a few domestic resources and their nationals do not seem to own much abroad. In contrast, the World Bank classifies all the HICs except Nigeria as lower-middle or upper-middle income countries. Many of these countries have valuable domestic resources, such as Mexico's and Venezuela's oil reserves. Nationals of many of these countries have placed a great deal of wealth abroad: Estimates of private external claims (" flight capital") indicate that, for many of the major debtors, private claims abroad equal around half of national indebtedness. At the extreme, estimates for Venezuela show it to be a net creditor. In summary, achieving resource transfers from poor borrowers to their creditors is likely to impose serious hardships on very poor people. Even setting humanitarian concerns aside, full repayment may not be feasible under any set of policies. In contrast, nationals of the HICs have the resources to pay their loans.

A second difference is that growth appears to have been low in poor African countries for reasons other than their high debts, and the argument does not seem to be made that reducing or restructuring their debts will increase growth much. In contrast, the "debt overhang" argument (put forward by Jeffrey Sachs in this issue) holds that the debts of middle-income countries impede growth, and that reducing debt-service obligations will improve the efficiency of global resource allocation.

A third difference is that, despite their high debts, the poor African countries have not made net transfers to their creditors: New loans have exceeded debt service payments. The HICs, in contrast, have made net transfers to creditors in every year since 1983. The World Bank estimates that they transferred 4.7 percent of their GNP to creditors in 1988.

Finally, the debts of the poor African countries are largely obligations to governments or to multilateral lending agencies. Hence the governments of creditor countries can mandate debt relief or restructure debt entirely on their own initiative.

IArgentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Cote D'Ivoire, Ecuador, Jamaica, Mexico,

Morocco, Nigeria, Peru, Philippines, Uruguay, Venezuela, and Yugoslavia comprise this group. See the

World Bank (1989a). 2A11 data are taken from the World Bank (1985, 1989a, 1989b).



Jonathan Eaton 45

In contrast, the obligations of the HICs are primarily to commercial banks, who will be affected by any relief or restructuring.

The response to the debt crisis in poor countries should be framed in terms of overall foreign aid objectives and policies. The argument for relief is primarily humanitarian, and debts can be restructured without interfering in private international capital markets.

The rest of this paper concerns the debts of the HICs, which seem to motivate the proposals for institutional restructuring, and which present the greater enigma. The humanitarian argument for forgiving these debts is at least questionable. In fact, since many of the HICs score high on indicators of income inequality, resource transfers from these countries to their creditors could conceivably occur without the worldwide distribution of income becoming more unequal (Berg and Sachs, 1988). In addition, debt relief for these countries may reduce funds available to poorer countries.

The case for public involvement must rely on other reasons why restructuring or relieving these debts is in the public interest. One possibility is that greater global efficiency can be achieved, even to the point where the creditors themselves benefit. Another is that enforcing repayment itself is not in the public interest, either because the resulting transfers themselves have negative consequences if the debtors do pay, or because penalizing the debtors has negative consequences if they don't.

But whatever the rationale for debt relief, debt contracts must be modified within the overall legal context in which international capital markets operate. In particular, any solution must address the ultimate distribution of the debt burden among debtors, private creditors, and the public in creditor countries. Any proposed solution raises practical questions about the structure of North-South financial relations and the design of the institutions involved. It also raises theoretical questions about how international financial relationships work.

The rationale for various proposals for solving the debt problems of the HICs are based on particular beliefs about what led to these problems.

What Went Wrong: Bad Luck, Bad Policy, or Bad Contracts?

One often-stated goal of debt relief is to "return sovereign lenders to creditwor- thiness." This goal seems to reflect a belief that the pre-crisis operation of debt markets should be restored.

But how well did the markets work before the crisis? One view is that a series of exogenous adverse events led to the crisis. In particular, higher interest rates and lower commodity prices in the 1980s left debtor countries less able or willing to honor debt-service obligations than was expected when the loans were made in the 1970s.

Another view is that bad domestic management was at fault. According to Rudiger Dornbusch (1989, p. 342), "[E]xternal factors were by no means the only influence in the debt crisis. On the contrary, domestic policies were an important, often the main, influence in bringing about the large accumulation of debt." Overval-




ued exchange rates left the private sector little incentive to earn foreign exchange. They also created expectations of devaluation, which lead to speculative capital flight. Exchange rate mismanagement was symptomatic of general macroeconomic mismanagement: Fiscal deficits have been large, and governments have made heavy use of the inflation tax. Fear of inflation and taxes to finance actual and anticipated deficits frightened away private investment. Microeconomic mismanagement was also at fault: Overvaluation and import protection grotesquely distorted domestic incentives. Borrowing not offset by capital flight ended up financing projects in the nontraded- goods and import-competing sectors, which often, when evaluated at world prices, proved to be spectacularly uncompetitive.

To the extent that either bad luck or bad management is at fault, the debt problems of country borrowers are like those of a troubled domestic corporate borrower. In either case, when the market situation or management quality takes an unforeseen turn for the worse, the value of what creditors can expect to receive declines, and the market value of the debt falls.

One approach to modeling sovereign debt is to assume that sovereign debtors are analogous to domestic corporations. A common assumption is that creditors receive a share of the debtor's GDP up to the amount they are owed, so that GDP becomes the sovereign debtor's analog of a corporation's earnings.

According to this perspective, the argument for relieving debt, rather than simply leaving it unpaid, is that its presence discourages potential new investment that might yield high returns. A corporation, for example, might experience a shock that renders its net worth negative, but highly profitable investment opportunities could remain. The corporate owners would have no incentive to make these investments since creditors would claim the returns. Forgiving some debt could even increase the incentive to invest to the point where creditors would realize a higher return (Stiglitz and Weiss, 1981).

The assumption that creditors have a claim on increments to GDP in debtor countries has led, by analogy, to a belief in a "debt Laffer curve:" By reducing creditors' claim on increases in income, debt relief will increase the incentive to invest to the point where creditors actually receive more. On their own, private lenders are too disorganized to engineer a reduction in the face value of these debts to realize this gain, through a " leveraged buyout," for instance. Hence public involvement is justified. Creditors only feign hostility to public pressure for debt reduction to attempt to improve their individual bargaining positions in debt negotiations.

In the case of domestic firms, U.S. bankruptcy law attempts to overcome such problems either by protecting debtors from creditors during Chapter 11 reorganiza- tion, thus denying creditors a full claim on marginal returns to new investments, or by allowing creditors to operate a bankrupt firm directly, thus internalizing the external- ity associated with the investment decision. Turning over the fiscal affairs of debtor countries to commercial creditors is currently infeasible, eliminating the second option. One way of viewing the various debt plans is as different ways to provide a one-time international equivalent to Chapter 11.



Debt Relief and the International Enforcement of Loan Contracts 47

Establishing some such mechanism is probably worthwhile, not only for the current crisis, but for situations likely to arise in the future. It would not, however, solve the current crisis or prevent crises in the future.

Basic differences between a creditor's relationship with a domestic debtor and with a foreign sovereign make the analogy between domestic corporate debt and international sovereign debt misleading. Indeed, the operation of international capital markets in the 1970s failed to reflect these differences, with the current crisis a consequence.

Why then did the participants in the market enter into the arrangements that they did? One possibility is that they simply did not understand the difference between lending domestically and lending to governments of developing countries. The debt crisis should then be viewed as an expensive lesson for bankers and sovereign borrowers. Assuming that the difference is now understood, the parties involved will reform their behavior and the crisis will not recur. Another possibility, however, is that the loans were the appropriate response to the incentives that the policies of creditor country governments created. A solution should then change these incentives.

I now turn to why the debts of foreign sovereigns do in fact pose very different problems from those of domestic corporations.

Do Creditors "Tax" the Income of Sovereign Debtors?

First, as an empirical matter, do commercial creditors have a claim on increments to GDP, as the debt Laffer curve argument assumes? The poor African countries and the HICs do not constitute the universe of highly-indebted developing countries, but only the countries where debt is associated with low growth, and where servicing debt has created strains between debtors and creditors. Non-HIC Indonesia, while poorer than any of the HICs except Nigeria, is estimated to have a debt equal to 72 percent of its GNP in 1988 and to have transferred 2.1 percent of its GNP to creditors that year. Despite the drop in oil prices its GDP grew at 3.6 percent during 1980-1987, compared with the 1.1 percent average for the HICs. In 1985 non-HIC Korea had a debt equal to 56 percent of its GNP, and in 1987 it transferred 11 percent of its GNP to creditors. Its growth rate during 1980-1987 was nevertheless 8.7 percent. Venezuela, a HIC, despite its growth rate of only 0.5 percent during 1980-1987, remained substantially richer in 1987, with a per capita GNP of US$3230 versus US$2690 for Korea. Its net transfers to creditors relative to GNP, while high in some years, have not been as high as Korea's. Hence the stagnation of the HICs cannot be attributed solely to their high levels of debt or to the net transfers they are making to creditors. Other countries similarly in debt and making transfers in similar amounts are growing at rates above the average for LDCs.

Furthermore, data from the HICs themselves do not indicate that commercial creditors are imposing a high marginal claim on increments to GDP. A simple regression of net transfers from the 17 HICs to private creditors during 1983-1988,




using annual data from the World Bank (1989a), yields:

R= .01 lQ1 + .141Dil- 1 + .915Pit + u,i (2.13) (5.09) (3.08) R2= .8639

where R - is the amount transferred, Q51 is GDP, Di, end-of-year debt to private creditors, and Pi, net transfers to public creditors, each for country i in year t, and ui1 incorporates country and time effects, a constant, and an error term. Coefficients in parentheses are t-ratios. (I included country and year dummies in the regression but do not report their coefficients.) While the coefficient on GDP differs significantly from zero at the 5 percent level, it implies a marginal tax rate of 1.1 percent, a level unlikely to disturb even an ardent supply-sider.3

Given the brevity of experience with debt repayment, this result is certainly not conclusive, but it raises questions about the existence of a debt Laffer curve or even whether creditors impose a high marginal claim on the GDP of debtors. The assumption that they do has been a major argument for debt relief and for further public involvement in the debt problems of the HICs. More evidence substantiating this claim seems warranted before more public money is spent. One is reminded of the original Laffer Curve, another theoretical possibility elevated to empirical certainty with disastrous consequences for public policy.

I now turn to why creditors cannot readily appropriate much of any increment to the income of a sovereign debtor.

The Enforcement Problem

A creditor's legal system typically gives it the right to seize a debtor's assets in the event of default, but enforcing the right beyond the jurisdiction of the creditor's government requires the cooperation of another government. In the case of sovereign default, the creditor cannot expect its own government to seize the domestic assets of the sovereign, nor can it obtain the domestic assets of a private foreign borrower without the help of the borrower's government. Keynes (1924) went so far as to argue that a creditor's powerlessness in the face of default leaves a sovereign debtor no reason to repay at all: "Indeed, it is probable that loans to foreign Governments have turned out badly on balance... . The investor has no remedy-none whatever- against default. There is, on the part of most foreign countries, a strong tendency to default on the occasion of wars and revolutions and whenever the expectation of further loans no longer exceeds in amount the interest payable on old ones."'

Since many middle-income sovereign debtors have recently made net resource transfers to creditors, Keynes was too pessimistic. Clearly, creditors do have some

Time-series regressions for each individual HIC yielded no significantly positive coefficient for GDP. The hypothesis that the coefficients of Q -, Di1, and Pi, were the same for the 17 HICs was not rejected at a 5 percent confidence level. 4I thank Brian Wright for bringing this quotation to my attention.



Jonathan Eaton 49

clout. Assessing the value of a loan, and how well the loan market works, is then a

problem of determining how much leverage is available. The national assets of

middle-income debtors exceed their debts in value; they are solvent in this sense. What

impairs the value of these loans is that the debtors are unwilling to transfer these assets

to their creditors to the extent required to fulfill their loan contracts.

Officials of a debtor government may honestly object that they are unable to

raise enough revenue to service debt. It is possible that both the government and the

public want the debt paid, but that the administrative cost and excess burden of

taxation prevent the government from raising what it owes. More likely, however,

domestic political opposition is what keeps it from doing so. Viewing government

officials as (imperfect) agents for their domestic constituents, nonpayment reflects a

perception that avoiding the cost of default is not worth the burden of repayment, not

that the country or the government has insufficient resources. Forecasting debt service

then becomes a problem of identifying the perceived costs and benefits of paying.

One possible deterrent to default, for example, is the creditor's ability to seize the

debtor's overseas assets. But this threat will not suffice if the borrower is a net debtor.

Overseas assets will not cover the debt.

Another deterrent is the ability of a creditor to reduce the defaulting country's

gains from trade. The wronged creditor might seize payments to firms that attempt to

export to the debtor and payments made by firms that attempt to import from it.5

A third deterrent is that default might leave a country unable to borrow and lend

again for some time. Other potential lenders would not lend in fear that the earlier

lender would seize payments on subsequent loans and the borrower would find any

assets placed abroad taken by the lender. Finally, the original lender may desist from

lending again to a country that has defaulted in the past even if the creditor can

prevent the debtor from doing business elsewhere. For a deterrent of this form to

provide an incentive to lend initially, and to repay subsequently, requires that the

country and creditor community always expect that net transfers in either direction

could occur in the future. If, at any point, transfers in only one direction are

anticipated thenceforth then it is in the interest of the party making those transfers to

end the relationship.6 A problem is that, if sovereign default is punished by impeded trade or a credit

embargo, then creditor countries stand to lose along with the debtor. Unless creditor

countries are willing to bear this cost, the banks' threat to impose these sanctions may

not be credible. Bulow and Rogoff (1988) address the problem of the credibility of sanctions by

separating the banks from the rest of the creditor community. A declaration of default

is not harmful to the banks, since they get to seize whatever assets the debtor has

'Mark Gersovitz (1983), Robert Kahn (1984), and Jererny Builow and Kenneth Rogoff (1989) provide rmodels of sovereign debt in which default leads to a loss of trade. fTlhis point is developed by Eaton, Gersovitz and Joseph Stiglitz (1986) and by Barbara Craig (1988). Eaton and Gersovitz (1981), Kenneth Kletzer (1984), Rodolfo Manuelli (1984) and Herschel Grossman and John van Huyck (1988) have models in which the cost of default is an inability to borrow and lend subsequently.




abroad, but is harmful to the public, who would lose the benefits of trading with the debtor. Bulow and Rogoff assume that the lender's ability to impose sanctions is inviolable, so that the lender may extract payment from the public not to declare default. A particular form that the side payment can take, of course, is public assumption of the loans at a price above their market value.

However, an open question is whether the creditor's rights are truly inviolable. According to Lewis Alexander (1987, pp. 24-25), the law in most developed countries distinguishes between the "sovereign" and the "commercial" activities of governments. The first are acts that "governments undertake to fulfill their responsibilities as states," like " maintaining military forces, operating embassies, and providing a national currency." The second are "those things governments do that are commonly performed by private agents for economic gain," like "the production and sale of goods, owning and operating commercial property, and selling services."

The U.S. Foreign Sovereign Immunities Act of 1976 exempted the commercial activities of a government, including sovereign borrowing, from sovereign immunity. Presumably the legislation was intended to encourage commercial bank lending by preventing sovereign debtors in default from invoking sovereign immunity to avoid sanctions in U.S. courts. Alexander's discussion of the Allied Bank Case casts doubt, however, on the willingness of a U.S. court to enforce a creditor's claim if the U.S. government were to deem enforcement contrary to the national interest.

On occasion, a government may find that enforcing a contract between a private agent and a foreign government is not in its national interest. Sovereign immunity provides a means of avoiding enforcement in these circumstances. A party entering into a contract with a foreign sovereign assumes the risk that, if the terms of the contract are not fulfilled, then sovereign immunity may deny the standard legal remedies.

The deep involvement of the U.S. government in the current debt crisis shows that enforcing existing debt contracts with some sovereign debtors is not in the perceived U.S. interest. The distinction between the sovereign and commercial activities of borrowers has thus proved meaningless: The law could not remove political considerations from sovereign lending.

Indeed, these were the only considerations. Since a sovereign cannot become bankrupt in a commercial sense, the status of these loans depended on the borrowers' incentive to repay, which depended in turn on the willingness of creditor country governments to enforce payment. When the banks first made these loans they put themselves entirely in the hands of the political system.

The enforcement problem raises questions about the effect of many debt relief policies. One implication is that reducing debt-service obligations (a component of the Brady package) may not reduce transfers from debtors. If debts are not reduced below the level at which the enforcement capacity of the banks, rather than contractual obligations, limit resource transfers, then lowering the face value of debt may not affect resource transfers at all. The simple regression reported above does not support this argument, however. The value of debt outstanding is a significant determinant of




what countries actually pay. Banks' ability to extract resources appears to increase

with the face value of the debt. Whether this relationship between transfers and the

face value of the debt will continue to apply after debt is written down as part of the

Brady package is uncertain. A second implication is that, if private creditors' enforcement power rises with the

debtor's resources, as is often assumed, then private creditors can appropriate some of

any public transfer to a debtor by extracting larger transfers to themselves. At the

extreme, if the maximum resource transfer to both public and private creditors is

constant, then private creditors appropriate 100 percent of any public transfer.

Commercial lenders may have already extracted a considerable amount from the

governments of developing countries. One reason why banks may have stopped

lending to debtor nations in the early 1980s was that they hoped to draw in funds

from public sources.

Whenever a borrower owes more than the most it will transfer, the creditor can

either: (i) lend the difference (which can mean rescheduling, tolerating arrears, or

lending "new money"), (ii) find others to lend the difference, (iii) forgive payment, or

(iv) declare the borrower in default and seek a legal remedy. During the 1970s,

borrowers were usually able to meet debt-service obligations with new borrowing from

private sources, since interest rates then were below many growth rates. Indeed, the

debt crisis began in the early 1980s, when the world economy stopped providing the

conditions for a viable Ponzi scheme. Creditors became unwilling to lend enough new

money to service existing debt, and debtors were unwilling to make the resource

transfers that were consequently required. Since there is relatively little to attach in

the event of sovereign default, declaring default is less rewarding internationally than

domestically. Hence the commercial banks still lent some rather than declare default.

Domestically, a lender has little hope of finding others to finance debt service

payments to it when it is not in its own interest to do so. But commercial creditors had

reason to think that creditor governments would lend more to avoid the externalities

associated with sovereign default. Official exposure to the HICs has in fact grown

while the exposure of commercial banks has fallen since 1983. The regression result

reported above indicates, however, that those HICs transferring the most to private

creditors appear to be those receiving the least from public lenders.

A third implication of the enforcement problem is that handing over the debts to

a public institution, a component of the Kenen plan, is likely to reduce net transfers

from debtor countries. If imposing sanctions is costly to the creditor community as a

whole, how can a public institution acting in the interest of this community enforce

more repayment? Although the IMF and, to a much lesser extent, the World Bank,

have collected net transfers from foreign debtors, the amounts have been much less

than what private lenders have collected. Bargaining models of debt repayment

indicate that, even if sanctions for default are costly to impose, there are circumstances

under which they are credible. The outcomes may be messy, however. The borrower

may delay paying, and the creditor may actually have to implement the sanctions

(Eaton and Engers, 1989). The Kenen plan calls for a public purchase of bank debt at




a price well below its face value, but often above its secondary market value. If the institution cannot collect as much as the secondary market thinks private creditors can collect themselves then the institution is going to lose money.

A fourth implication of the enforcement problem, which does not play a role in any of the plans, is that, if the enforcement capacity of creditors influences resource transfers from debtor countries, then lowering the apparent cost of default will reduce these transfers. The IMF recently took a small step in this direction by allowing the disbursement of loans to countries in arrears to private creditors. As the Allied case suggests, any signal that the U.S. government will not enforce debt contracts as they currently stand would do much more.

Government vs. Private Borrowing

The enforcement problem has contributed to one of the most negative features of commercial bank lending to developing countries: In contrast to portfolio investment before World War II, which was primarily to firms or to local governments, most commercial bank loans are now to central governments. Given the frailty of the tax systems of many of the HICs, raising the resources to repay debt is imposing large administrative costs and excess burdens. The high inflation in many of the HICs reflects this problem.

So why is developing country debt now overwhelmingly public or publicly- guaranteed rather than private and nonguaranteed? One reason is the heavy involvement of many debtor governments in their domestic economies. But even countries that were pursuing laissez-faire policies, like Chile, have little private, nonguaranteed debt relative to government debt.

Diaz-Alejandro's (1985) account of commercial nonguaranteed loans to private Chilean banks suggests another reason why a government can end up owing most of the debt even if it didn't intend to: The private Chilean banks invested the money they borrowed recklessly. When they failed, the foreign lender banks threatened to worsen the Chilean government's own credit terms if it did not assume these debts. It did.

What this episode illustrates, aside from commercial banks' willingness to play hardball, is how, even in a laissez-faire country, banks did not distinguish private commercial risks from general sovereign risk. Since they could ultimately force the government to make good on the loans, there was no need to oversee how the private borrowers invested. The foreign lenders may have felt unable to monitor the borrowers' activities anyway, or did not trust how they would fare in a domestic bankruptcy proceeding.

The basic lesson is that, as long as governments enforce property rights and contracts and administer bankruptcy proceedings, the risks associated with private lending abroad are not separate from general political risk.



Jonathan Eaton 53

The Debt Proposals

Given the origins of the debt crisis, how much would the various plans for restructing debt alleviate it? They can be evaluated at various levels.

One issue is whether they correct defects in the terms of the loan contracts themselves. Bad luck and bad management could have plagued any realistic loan arrangement, although better-designed loan contracts would have allocated risks more efficiently and reduced the incentive for mismanagement. In particular, the floating interest rate on commercial bank credits forced the borrowers to absorb all the risks of shifts in real interest rates. The short term of the loans reduced the incentive to invest borrowed funds in longer-term projects that might have yielded higher returns. Finally, putting the government in the role of borrower or guarantor added fiscal burdens and created an incentive for capital flight as domestic investors placed funds abroad to avoid the tax obligations that the debt implied.

A positive feature of the various proposals for reform is that they do improve on some of these defects in current loan contracts. Nevertheless, it is not clear that public spending or public assumption of the debts is necessary to restructure the loans. Furthermore, since the proposals concern the disposition of current debts, they do not address how to remove these deficiencies from future lending.

The debt Laffer curve has provided a second reason for public involvement. As argued, its empirical validity is doubtful. But if it does hold, then the solution is to overcome the private creditors' failure to coordinate. It is not clear why an international agency is needed to accomplish this. It could be done by jawboning, changes in bank regulatory procedures to facilitate a private buyout of the debt, or perhaps an announcement that the U.S. government will not support banks' attempts to enforce their original claims in U.S. courts. A cost of the jawboning approach is that it could be seen as an implicit government guarantee to those who go along. This may have been a problem with the Mexican negotiations in 1983, when private lenders were cajoled into providing "new money" for Mexico.8

A third justification for public involvement is to reduce transfers from developing countries, just the opposite of the Laffer curve argument, which holds that debt should be relieved or restructured to increase transfers. Transfers at current levels do appear to impose a cost on the U.S. public, in the form of a loss of export markets and of hemispheric political unrest. This justification admits that the purpose of public involvement is to reduce what banks will collect, or else to use public money to pay the banks.

The case for having the public, rather than the banks, shoulder the burden of

reducing the transfers is a poor one, however. The banks initiated the lending, and the

loan contracts were badly designed. The proposals do call for the acceptance of a loss

In Eaton (1987), I develop a model which relates capital flight to the fiscal burden imposed by national debt. tJoseph Kraft (1984) provides a lively account of the effort to coordinate private lending to Mexico in 1983.




by the banks compared to the current face value of the debt, but not compared to its secondary-market value.

The case for reducing transfers is not uniform across the HICs. Some have made serious, if belated, efforts to eliminate inefficiencies, to repatriate flight capital, and to raise taxes on the wealthy. Continuing to force these countries to pay what they now owe to commercial banks does not seem compatible with the overall interests of creditor countries. Other debtors have done little to restructure their economies, to eliminate corruption, or to tap the substantial resources of very rich nationals. It is not clear why creditor countries should let these countries off the hook.

A final issue is what the proposals imply for the long-term operation of international capital markets. The current plans fail to address the more basic problems of enforcement and political involvement in the economy.

The Legal Environment and Macroeconomic Mismanagement

Encouraging future private investment in developing countries without inviting another crisis requires establishing an international legal environment that does not put either the lender's or the borrower's government in the role of implicit or explicit guarantor. Contract enforcement, bankruptcy procedures, and the protection of property rights need to be distanced from political decisions.

Many debtor countries may take some time to develop legal systems with the transparency, independence, and dependability necessary. One alternative is to estab- lish a supranational judicial system to assume these adjudication and enforcement functions. National governments would have the option of transferring their own authority in these areas, at least when foreigners are involved, to this system. The system would need the trust of both governments and potential investors, and a decision to relinquish authority would have to be seen as irreversible for some time. There are precedents for a country relinquishing rights of adjudication and enforcement. Several developing countries, in response to corruption in domestic customs collection, contracted a Swiss firm, Societe Generale de Surveillance, to assess tariffs (Business International Corporation, 1986).

A second task is to wean the HICs away from their reliance on borrowing and inflation to finance expenditure. This will require more new taxes. To use Indonesia as an example again, it was faced with both a large debt-service burden and a drastic fall in oil revenues, but averted a fiscal crisis by introducing a value-added and a property tax.

Switching taxes to resources in nationally inelastic supply-real property, for example-will reduce the fear of taxation that has frightened so much mobile capital into flight, thereby increasing reliance on foreign borrowing. Developed countries and commercial banks can help by providing more data on investments by foreigners and by assisting developing country governments in collecting taxes on national assets abroad.




Conclusion

The case for spending more public money on the debt problems of the HICs is a poor one. These debts have already used up a great deal of public money, and the resolution of the crisis should not set a precedent for converting privately-initiated lending into foreign aid. Banks or middle-income debtors are not the most deserving recipients, especially since there is no assurance that this form of aid will benefit the poor in the countries in question.

If more public money is to be spent, however, a benefit of having a new institution take over these debts is that the cost of bailing out the HICs and their creditors would at least be more visible, and separated from the foreign aid expendi- tures of creditor countries, the IMF, and the World Bank. Fewer resources might then be diverted from worthier causes.

If the goal of debt relief is to make private lending to middle-income countries more rewarding and less crisis-provoking, adding to the set of organizations participat- ing in the international financial system, by itself, will not help. The legal context in which such organizations operate must be clarified, and the enforcement mechanisms at their disposal made more effective, before lending to developing countries can be more rewarding than Keynes found it to be in the 1920s.

* I am grateful to the editors for their detailed and insightful comments on previous drafts and to Carmeni Luther for research assistance.




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Documents

Debt Relief and the International Enforcement of Loan Contracts