Friday, April 3, 2009

John Stewart, Sovereign Default, Sovereignty and the Treaty of Westphalia

John Stewart noted on The Daily Show that countries that default on loans are treated differently than regular people (got a link Anthony?).

A (loan) default by a country is known as a “sovereign default”. (If you don’t know it, type “define sovereign” into Google.)

This goes back to the point in history when the sovereign and the government were basically the same thing. Now that most countries don’t have sovereigns, we personify the government as the sovereign.

This is actually really convenient for unscrupulous politicians and bureaucrats because it allows them to avoid personal responsibility by saying the government did it, not themselves.

Sovereignty is a complex idea that came out of the Middle Ages. (You only need to briefly skim the linked article.)

Sovereignty was codified in the Treaty of Westphalia that ended the Thirty Years War. That codification is important enough to be known as Westphalian sovereignty. There are 3 basic principles:

  • Within countries, only members of those countries can make decisions about the country.
  • Countries are equal.
  • Countries shouldn’t interfere in the internal affairs of other countries.

In some sense, the story of the last century has been the continued application of the principals of Westphalian sovereignty to countries that should be excluded from that privilege on moral grounds:

  • Communist countries didn’t violate the letter of the first principle because they claimed that only the party members were the real members of the country, and the previous stakeholders were all imposters.
  • The UN is such a basket case because it isn’t clear that countries are equal. Nuff said. It’s also a problem when you create new countries: you can’t just make them equal by saying they’re equal. There’s also an issue with imperialism here: the Europeans were clearly not treating other countries as equal when they went out and added them to their colonial empires.
  • This is why the allies didn’t do much to save the Jews in Nazi Germany. It’s also why some people didn’t like Bush invading Iraq.

It was difficult to envision these problems in advance though. Potential political leaders prior to 1900 were heavily steeped in a sense of entitlement (that they could make decisions), basic decency (so others in the same position were treated well), and integrity (to respect the decisions of others’ countries). For all the faults of leadership by the elite, consistency with these principals wasn’t one of them.

This issue of Westphalian sovereignty is of specific importance in macroeconomics right now because it means that when an international agency loans money to a country:

  • Once the money enters that country, only the members of that country can decide whether to repay it or not.
  • The position of a borrowing country is legally equal to that of a lending country, so a sovereign default often devolves into a diplomatic version of “he said, she said”. Loans through the IMF or World Bank are perhaps worse, because it isn’t clear that they have any legal standing against countries. They certainly can’t enforce any standing that they do have.
  • You just can’t invade another country because they borrowed from your citizens and didn’t repay them.

These are all OK as long as leaders are trained to play by these rules. But they’re not any more: now they play by a different set of rules and then use these as cover.

So, the difference between a person defaulting and a country defaulting boils down to the country being treated differently on the middle count (where bankruptcy court does make lenders and borrowers unequal) and the last count (where there is some limited ability to use force or the threat thereof against individuals).

An economic take on this is that we created big moral hazard problems when we responded inappropriately to violations of the underlying foundation that makes Westphalian sovereignty workable. When confronted by countries that morally violated those foundations – like the Soviet Union for the first one, Belgium in the Congo for the second, and Nazi Germany for the third – we didn’t address the problems with Westphalian sovereignty, or throw the whole idea out the window. Instead, we 1) grafted kind--hearted ideas (e.g., the U.N, the IMF, or the World Bank) on to the system of Westphalian sovereignty without clarifying their position in the framework, and 2) hugely diluted the club of nations that were supposed to abide by Westphalian sovereignty with new members uneducated in its successes who had been recently exposed to violations that were weakly punished. We shouldn’t be surprised that there have been problems.

Our response to that has been to complain a lot and to stop teaching high school students about all this because it isn’t amenable to multiple choice exams.

John Stewart is a bright guy, with smart writers, who probably know most of this. But … it’s a comedy show … and most of the viewers can get the joke while puzzling over the irony.

ADDENDUM: I did mention, but forgot to put in the first draft of this post, that developed countries used to violate the sovereignty of less-developed countries quite routinely. This probably discouraged defaults! There isn’t an easy to way to convey how frequently this was done, but one thing that you can do is go to the Wikipedia page entitled “List of United States Military History Events” and search for the word “interests” as a polite way of saying it was all about money. You’ll only find one example after 1932.

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