April 8, 2003


Odious Debt (Michael Kremer and Seema Jayachandran, June 2002, Finance & Development)
Many developing countries are carrying debt incurred by rulers who borrowed without the people's consent and used the funds either to repress the people or for personal gain. A new approach is warranted to prevent dictators from running up debts, looting their countries, and passing on their debts to the population.

Under the law in many countries, individuals do not have to repay if others fraudulently borrow in their name, and corporations are not liable for contracts that their chief executive officers or other agents enter into without the authority to bind the corporations. The legal doctrine of odious debt makes an analogous argument that sovereign debt incurred without the consent of the people and not benefiting the people is odious and should not be transferable to a successor government, especially if creditors are aware of these facts in advance.

The doctrine of odious debt originated in 1898 after the Spanish-American War. During peace negotiations, the United States argued that neither it nor Cuba should be held responsible for debt the colonial rulers had incurred without the consent of the Cuban people and not used for their benefit. Although Spain never accepted the validity of this argument, the United States implicitly prevailed, and Spain took responsibility for the Cuban debt under the Paris peace treaty. Soon after, legal scholars elaborated a similar doctrine. [...]

What can be done to eliminate odious debt? In a recent study, we argued for the creation of an independent institution that could assess whether regimes are legitimate and declare any sovereign debt subsequently incurred by illegitimate ones odious and thus not the obligation of successor governments. If structured correctly, such an institution could restrict dictators' ability to loot, limit the debt burden of poor countries, reduce risk for banks, and lower interest rates for legitimate governments that borrow. This policy can be viewed as a form of economic sanction that no one would have an incentive to evade.

As it stands now, countries repay debt even if it is odious because, if they failed to do so, their assets abroad could be seized and their reputations would be tarnished, making it more difficult for them to borrow again or attract foreign investment. However, if there were an institution that assessed, and announced, whether regimes were odious, this could create a new equilibrium (that is, market outcome) in which countries' reputations would not be hurt by refusal to repay illegitimate debts, just as individuals' credit ratings are not hurt by refusal to pay debts that others fraudulently incur in their name. For example, if the world's leading powers, international organizations, and financial institutions declared a regime odious and announced that they would consider successor governments justified in repudiating any new loans the odious regime incurred, a private bank-even an unscrupulous one-would think twice before lending to the regime. This argument draws upon a well-known result in game theory that repeated games have many possible outcomes and that simply making some information public can create a new-and, in this case, better-one.

There is no guarantee, however, that everyone would coordinate on this new equilibrium. We propose two mechanisms to ensure that lending to odious regimes is eliminated. First, laws in creditor countries could be changed todisallow seizure of a country's assets for nonrepayment of odious debt. That is, odious debt contracts could be made legally unenforceable. Second, foreign aid to successor regimes could be made contingent on nonrepayment of odious debt. In other words, donors could refuse to aid a country that, in effect, was handing the funds over to banks with illegitimate claims. If foreign aid is valuable enough, successor governments will be compelled to repudiate odious loans, and banks to refrain from originating them. (Interestingly, the same reasoning suggests a potential way to solve the moral hazard problem associated with foreign aid. [...]

In short, the international community or even a few major countries, possibly in concert with nongovernmental agencies, could create a new norm under which a country would not be responsible for odious debt. Creditors therefore would not issue odious debt in the first place. This new approach would be in line with the growing recognition in international law that some uses of power by government officials might be illegitimate or criminal, the prosecution of Slobodan Milosevic for war crimes being just one example of this trend.

The policy we have laid out would help legitimate creditors and debtors. Creditors would benefit from knowing the "rules of the game" in advance. Currently, there is a movement to nullify some debt on the grounds of odiousness, but it is hard for creditors to anticipate which loans will be considered odious in the future. If odiousness were declared in advance, banks would avoid lending to odious regimes in the first place and no longer face the risk of large losses if a successful campaign nullified their outstanding loans. Less uncertainty has the added benefit that interest rates for legitimate borrowers would be lower. But most important, dictators would no longer be able to borrow, use the proceeds for illegitimate purposes, and then saddle the people with their debts.

Very cool--I no sooner rant about this than NPR's Marketplace interviews a guy who's written seriously about it and it turns out to have a history and theory behind it. This concept, of odious debt, seems like an important thing to pursue if we are really going to bring pressure to bear on unelected governments and those who truckle with them. Posted by Orrin Judd at April 8, 2003 6:49 PM

The Economist had an article describing the concept of 'Odious Debt' two or three weeks ago. This was specifically with regard to Iraq.

The idea seems eminently sensible to me. I just hope a fair way of enforcing it can be worked out, one that is recognised worldwide. It would be good to hope that it makes people think twice before crediting the common or garden murderous dictator. It's time we all stops making rods for our own back.

Posted by: Alastair at April 8, 2003 8:16 PM

A lot of the odious lenders --- most of them, in fact --

are Americanos.

Posted by: Harry Eagar at April 8, 2003 11:44 PM

Guys, let's not get too exhuberant. I lay good odds that the cabal that would adjudicate on this issue will declare all debt incurred by the US from January 21, 2001 onwards and for the time being, odious. Then they will address North Korea...

Posted by: MG at April 9, 2003 3:46 AM

Mr. Judd;

The real lesson here is the benefits of American unilateralism. Note that the very concept in international law was invented to retcon the American action. One wonders if whatever we do in Iraq will have a similar effect.

Of course, the fly in the ointment has been pointed out by MG – an “international institution” would likely be captured by precisely those who would use the designation for parochial political purposes. I suggest that the US or the Anglosphere simply use the designation “unilaterally”. If, as Mr. Eager claims, most of the odious lenders
are US based this would be almost as effective and far less subject to decay.

Posted by: Annoying Old Guy at April 9, 2003 10:05 AM


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