Can public debt enhance democracy?

• Author: Gillette, Clayton P.
• Position: Italy

ABSTRACT

This Essay draws on historical and current examples to examine the extent to which public creditors can enhance democracy by monitoring public officials in a manner that compensates for the failures of the government debtor's constituents to monitor public officials. Creditors and constituents may share significant interests, depending on the structure of security arrangements for public debt and the identity of the debtors. Where interests overlap, the capacity of creditors to overcome collective action problems suffered by constituents may transform creditors into surrogates for constituents. Whether creditors are willing to play this role, however, may depend on the existence of alternatives to creditor monitoring, such as diversification and market constraints on default. The Essay concludes with an examination of the plausible scope of creditor monitoring in contemporary settings of sovereign and state and local debt.

TABLE OF CONTENTS INTRODUCTION I. THE IDENTITY OF CREDITOR AND CONSTITUENT INTERESTS II. PUBLIC CREDITORS AS PUBLIC MONITORS A. The Limits of Monitoring: Shareholders and Constituents B. Creditors to the Rescue? III. WILLINGNESS To MONITOR IV. THE PLAUSIBLE SCOPE OF CONTEMPORARY CREDITOR MONITORING CONCLUSION INTRODUCTION

In the early fifteenth century, the Republic of Genoa was teetering on the brink of financial disaster. Plague, war, and internal dissent had increased Genoa's debt to the point that 90 percent of the Republic's ordinary income was required to service interest obligations. (1) Creditors of the Republic recognized the situation as unsustainable, and acted to protect their interests from what must have seemed like imminent bankruptcy. (2) In 1407, they founded the Casa di San Giorgio ("San Giorgio"), an institution that was nominally a private association, but the function of which was to bring order to the Republic's finances and reduce the risk of debt repudiation. (3) San Giorgio began its operations by exchanging Genoa's massive debt for equity shares in the new association. (4) San Giorgio then made "grants" to fund the Republic's governmental activities. In return, San Giorgio received the right to collect taxes, to operate the Republic's profitable salt monopoly and mint, and to govern some of the Republic's overseas territories. (5) Thus, although San Giorgio's 11,000 shareholders, governed by a corporate structure that involved several councils and an eight-person board of directors called "The Protectors of San Giorgio," were nominally equity holders, they were effectively lenders secured by payments from dedicated revenue streams of the Republic. (6)

San Giorgio was, in some ways, a beneficent creditor. It distributed large sums to Genoan charities, (7) forgave many of the Republic's debts during times of excusable fiscal distress, and dedicated substantial contributions to the operation of the state. (8) This beneficence may have been motivated largely by the self-interest of the shareholders, who also tended to be residents of Genoa. (9) Thus, imposing unduly harsh conditions on the Republic would mean imposing such conditions on themselves. (10) But most importantly, San Giorgio regularized access to credit, attracted shareholders by reducing the risk of default, and--by assuring repayment of loans--brought political stability to a state that had previously so abused the financial wherewithal of its constituents (11) through policies such as forced loans that, in 1339, the enraged constituents burned the Republic's tax and debt records in a popular revolt. (12) Machiavelli so highly regarded the subsequent effect of San Giorgio on the finances and governance of Genoa that he referred to the association as "the preserver of the country and the Republic." (13)

It would be inappropriate, however, to think of San Giorgio as a crucible of democracy. Although a "state within a state," (14) San Giorgio was primarily interested in protecting creditors' rights and reversing Genoa's reputation for debt repudiation. (15) In doing so, San Giorgio arguably enriched its own shareholders by transforming the Republic into a mere pensioner and shifting the obligation to support the state from the merchant beneficiaries of the state's commercial ventures to the general public. (16) Moreover, San Giorgio enforced its contractual rights in ways that might be seen as inconsistent with democratic values. San Giorgio had the right not only to prosecute tax evaders, but to torture them, excommunicate them, and sentence them to death. (17) There is, however, no indication of the use of waterboarding.

Even if San Giorgio was undemocratic, its role in creating more widespread wealth, diluting the authority of the few autocratic families that had theretofore ruled Genoa, and constraining the exercise of political power by controlling financial affairs suggests that its policies greatly facilitated the growth of democratic values. (18) San Giorgio certainly did not intend the fomentation of democracy to be one of its objectives, but governance through structures more likely to align the interests of officials and constituents may have been an inevitable byproduct of its activities. It was not simply that San Giorgio involved a complicated governance structure--a General Assembly of 480 shareholders and an elected protectorate of 8 members with financial expertise (19)--that reduced concentrations of power by giving rise to a large pool of prospective public officials. It was also the case that the control that creditors exercised over the Republic's access to credit constrained those who sought political control over Genoa from attaining power through the abuse of constituents' rights. (20)

San Giorgio, then, stands as an exemplar of an interesting but underanalyzed phenomenon of public finance. It has become commonplace to suggest that the institutions that support public credit simultaneously create incentives for democratic governance within constitutional constraints. (21) According to this theory, public creditors will condition their loans on the sovereign's creation or toleration of institutions that increase the probability of payment by constraining the capacity of the debtor either to use loaned funds for unanticipated objectives (the moral hazard problem) or to repudiate or unilaterally alter the repayment obligation. (22) Frequently, these institutions take the form of representative bodies--at least representative of creditors--that are able to control tax collection and sovereign expenditures. (23) Through these footholds in the political process, creditors arguably set in motion the forces that have emerged into full political participation in advanced democracies. Moreover, commentators now perceive these institutions as precursors to rapid commercialization, economic growth, and the general enforcement of contract and property rights. In short, the presence of public debt is seen as a catalyst for democracy and robust markets rather than simply a means of financing the self-interested objectives of political officials. (24)

In this Essay, I explore an additional mechanism that identifies public credit with democratic governance. I suggest that, notwithstanding some inevitable divergence between the interests of governmental creditors and debtors, public debt can enhance the representative nature of democratic governance to the extent that creditors engage in monitoring that transforms them into surrogates or virtual representatives for the debtor's constituents. To be specific, creditors may have the capacity to monitor government officials in a manner that both complements and improves the institutions that constituents at large utilize to constrain public officials. Indeed, creditors' incentives allow them to overcome collective action problems that frustrate constituent monitoring of their officials. It was just this form of monitoring that presumably allowed the members of San Giorgio to distinguish between threatened defaults generated by benign conditions and those that arose from opportunistic behavior of public officials. (25) Ostensibly, the creditors were willing to waive the former, but not the latter. Any such strategy, however, required that creditors actively monitor officials to determine the source of the threatened default. (26)

On reflection, the claim that creditor monitoring can enhance democracy should not be surprising. The capacity of creditors to constrain the activities of officials in private firms is the subject of a vast literature. (27) Creditors of firms presumably have interests that, to some extent, coincide with those of shareholders, insofar as profit-maximizing activities increase both the capacity of debtors to repay debts and the value of shares. Thus, although creditors provide financial advice to debtors or monitor fiscal behavior to constrain the firm's officers from misusing corporate assets in a manner that would threaten repayment, (28) they simultaneously confer a benefit on shareholders who lack either the capacity or the willingness to engage in similar monitoring. My objective here is to explore the extent to which a similar relationship exists between creditors of government and the constituents of government debtors.

My reference to democracy in this Essay is somewhat idiosyncratic. It does not necessarily entail direct participation by constituents in political processes. Instead, it entails any political system in which officials face significant institutional constraints to comport themselves in a manner that is consistent with the interests of their constituents. Typically, those constraints come from the constituents themselves in their role as voters, or from designated third parties, such as courts, that are charged with enforcement of constitutionally dictated restrictions on governmental authority. Thus, my use of the term "democracy" necessarily embraces the concept of virtual...