Depths of Debt: Debt, Trade and Choices Lapo Salucci PhD Candidate University of Colorado at Boulder Department of Political Science Presented at: Midwest Political Science Association (MPSA) Chicago, April 12-15, 2007Lapo Salucci – Depths of Debt MPSA 2007 2 Abstract This paper wants to explore the relationship between international debt and international relations. This research argues that international debt patterns, connected with trade, have an influence not only on economic relations, but on political ones as well. Reversely, political relations have an influence on how countries can use the instrument of debt for their own economic and political goals. The paper utilizes game theory models to explain debt/trade political relationship in two cases: the 1st Opium War between the UK and China, and the current economic relationship between China and the USA.Lapo Salucci – Depths of Debt MPSA 2007 3 "If you owe a bank $ 1 million, you have a problem. If you owe it $ 1 billion, the bank has a problem."(Anonymous) 1. Introduction Debt is a double-edged sword, as the quotation above reminds us. Individuals have debts and credits, and so do companies, as well as states. The management of debt has been one of the main financial activities since before the creation of currency. Businessmen have accumulated debt to build financial and commercial empires, and kings and queens have accumulated it to build their countries. History has seen bankers build the political fortune of royal families, financed armies and wars, and get ruined in the process. The Thirty-Year War is as much a story of bankers opening their wallets as it is of armies sweeping Europe. The Peace of Westphalia, the turning point in the creation of the European state system, is as much about the exhaustion of combatants as it is about the bankruptcy of losers (and of winners, almost). Debt relationships are inherently political. Why is it so? In theory debt relationship depend only on a strict cost-benefit calculation. In reality, they are imbedded in much less quantifiable types of concepts. Reputation is one of those. It is obvious to everyone that reputation has always been a fundamental requirement to get access to credit. The better a person’s reputation, the more likely he/she would be to get access to credit. In countries that have developed a modern financial system, the role of reputation might not seem as important as it was before, but it just has shifted shape, without really changing that much. Credit history, in the United States, is just a high-tech version of old-style personal reputation. In fact, it is just aimed at measuring how likely someone is to pay his/her own debts, which in turn tells financial institutions how risky it is for them to provide credit to that specific individual. That might not seem much political;Lapo Salucci – Depths of Debt MPSA 2007 4 however, if we take it to the next level, then we see how the picture changes. Let’s consider governments, for example. How can we assess how governments are likely to repay their debts? Through credit-rating agencies, the easy answer goes. The higher the credit rating, the more reliable a government’s debt is. In reality, it is easy to see that the criteria for those credit ratings are not entirely based on cost-benefit analysis, but also on prestige, political power, belonging to specific international ‘clubs’ such as the European Union, and so on. We also know very well that when things go bad, debt repayment is not equal for all. It is obvious that some actors in the market carry more weight than others, and therefore they are more likely to be saved from the bad choices that led them to bankruptcy (or on the verge of it). Examples abound everywhere: huge business conglomerates asking for extension of debt (i.E. FIAT in Italy), banks asking to be bailed out from their bad loans (Japan), entire countries saved by international institutions’ interventions (Asian Financial crisis of 1997). Bankruptcy, in those cases, would have entailed huge socio-political problems, at least in the short run, therefore those actors were saved from their debts, in a way or another, setting aside purely economic considerations. As the scholars that deal with moral hazard know very well, those bailouts do not make much sense from a purely economic standpoint, since they encourage a similar behavior in the future. However, political considerations trump economic ones and the cavalry comes to rescue. That for the dark side of debt and its political relevance. On a brighter note, a clever management of both internal and international debt allows government to have the resources they need for economic expansion. In this paper, we will investigate the political relevance of debt management. Part II will introduce the relevance of debt and trade analysis. Part III will introduce the first of the two caseLapo Salucci – Depths of Debt MPSA 2007 5 studies of these paper: the relationship between China and the UK at the times of the Opium War, whereas part IV will do the same for the current US-China situation, in a more formalized fashion than part III. Lastly, Part V will develop a game theory-based model of interaction to represent our two case studies and will draw conclusions on the analysis. 2. Debt/trade analysis and its importance The role of public debt in the building of a state is of paramount importance. As Michael Veseth reminded us in his comparative study of Florence in the 13-15th Century, Britain in the 19th and the United States in the second half of the 20th (Veseth, 1990), debt management is a cornerstone of statecraft. The skillful borrowing of resources from citizens and the management of their return was one of the features of successful state entities in all three cases the economic historian investigated on. Even though Florence was arguably on a much smaller territorial scale than the other two cases, it was the financial power of the time (also because of its banking facilities and inventions - double-entry accounting being one of those), so it deserved to be on the same league. Rather than focusing on the interesting features of debt management in those three historical cases, we are interested in drawing the practical lessons from Veseth’s analysis and in applying them to a different setting. The American and British cases are more interesting for us, since they applied to