Foreign Loans and State Weakening

Why is state capacity weaker in the Global South than in the West? In my new book Pawned States: State Building in the Era of International Finance (Princeton University Press 2022) I argue that early access to external public credit in the first globalization of international capital derailed state capacity building in the Global South. Beginning in 1816, new independent nations and old but traditionally isolated countries gained access to virtually unlimited funds in European capitals. The rapid growth of public external indebtedness was not accompanied by advances in fiscal capacity (i.e., the state’s ability to assess wealth and enforce tax compliance), pushing sovereign nations into debt traps. Pawned States characterizes the domestic politics and geostrategic considerations of the first globalization of public finance and sheds light on the unintended consequences of early access to external capital for long-term state capacity.

A culture of cheap credit

Before the Napoleonic Wars (1803‒1815) the international credit market was limited to a handful of European powers; in fact, loan emissions were issued in Amsterdam and were mostly destined for Great Britain . After the Napoleonic Wars London became the new financial capital of the world, and private investors based in the City lent to dozens of countries in the periphery, first in Latin America and Southern and Eastern Europe, then Northern Africa and Asia, too. Drawing on data I collected from 90+ countries, I show that the entry of new borrowers into the credit market in 1820s carried no structural break in interest rates relative to those paid by European countries before 1800. In other words, the favorable conditions forged by European sovereigns over five centuries were offered to countries with high political instability, weak fundamentals and no reputation in international markets.

The puzzle

Perhaps not surprisingly, external default (i.e., the interruption of external debt service) became quite common in the nineteenth century. Why did investors keep lending to countries with high probability to default? I argue that foreign bondholders imposed “extreme conditionality” on loan contracts, namely the practice of collateralizing specific domestic assets (e.g., state-owned firms) to access fresh capital. In case of default, private investors foreclosed the pledged asset(s) and managed them until the debt was liquidated. Consistent with the idea of extreme conditionality, a statistical analysis of the provisions of 700+ loans floated in the London Stock Exchange between 1858 and 1914 confirms that collateralization of public assets reduced the premium paid by borrowers in the Global South.

The politics

 Pledging public assets was not popular for incumbents in the Global South—and they did their best to hide doing so from the public—but in accepting extreme conditionality they also accessed capital at favorable terms. That is, the hypothecation of public assets offered rulers a powerful lever to finance deficits and fiscal shocks in the short run—the hook—but exposed their countries to foreign control in the long run—the catch.

Incumbents in the Global South were not obliged to issue loans overseas (Menelik II in Ethiopia and the Chakri dynasty in Siam are good examples), but the alternative involved investment in the tax administration (e.g., recruiting tax officials and fiscal centralization) and, depending on initial conditions, granting taxpayers a political say. In the book I show that incumbents of countries with high political instability, loose executive constraints and weak fiscal capacity were more likely to prefer external debt over taxation. In other words, poor political and economic conditions led to poor fiscal policy.

Paths of State Building

The second part of Pawned States focuses on the long-term consequences of early access to external capital for state building. I delineate five possible paths (see figure 1.3 in the book, reproduced below). Prior to 1800 Great Britain and France as well as other European sovereigns followed paths A and B. When a government’s creditors are domestic, interrupting debt repayment is costly to the sitting ruler. Creditors can easily coordinate and deny fresh funds to the incumbent or even worse, sponsor an alternative monarch. In anticipation rulers have strong incentives to invest in tax institutions, secure tax proceeds and repay domestic debt.

Fiscal Shocks and State Building Trajectories
Fiscal Shocks and State Building Trajectories (Figure 1.3 in Pawned States, PUP 2022)

Paths C to E became widely available only after 1816. Along paths C and D public debt leads to investment in tax capacity sooner or later. In the nineteenth century, Meiji Japan exemplified path C of state building. Crucially, this country kept external finance under control because it had strong preexisting domestic credit markets—a statistical rarity outside the West. Path D illustrates the type of ordered sovereign default common in modern time, but this trajectory was infrequently followed before the creation of the IMF in 1944. Numerically, most countries in the Global South followed path E in the first globalization of finance. They borrowed overseas, interrupted debt service, and paid back in specie, not tax money, breaking the often-presumed long-term equivalence between debt and taxes. If any, payment in specie did the very opposite for state capacity. By putting key sources of state revenue in the hands of foreign bondholders, the tax base grew thinner and thinner over time, pushing countries into a debt trap.

Pawned States illustrates paths A‒E with a series of vignettes from all around the world and elaborates ways in which countries may switch from one path to another. The case studies are accompanied by a battery of statistical analyses that lend support to various parts of the argument. I document the short-term, intermediate, and long-term effects of international finance on fiscal capacity, plus two mechanisms of persistence—one focusing on the ratchet effect of bureaucratic strengthening on tax ratios, another on advances in quasivoluntary tax compliance in the presence of power-sharing institutions.


The book offers a cautionary tale about external finance, which certainly offers opportunities for economic growth to developing nations but carries risks, too. Both costs and benefits must be factored in to fully understand the effect of external finance on state building. The findings of the book contribute to various literatures: First, an old debate in economic history and historical International Political Economy involves financial imperialism, also known as the Hobson‒Lenin thesis. I find it one-sided. Foreign investors were no angels. They seized every opportunity they encountered to fill their pockets even at the expense of the well-being of multiple generations in foreign nations. We must, however, also recognize the domestic politics of borrowing countries. External funds were tempting for rulers with short time horizons, a predilection for collecting summer palaces and a dislike for sharing powers with taxpayers. Even when the field was not level, our understanding of state building in open economies must account for ways in which cheap credit weakens incentives of local rulers to build strong tax bureaucracies and share fiscal powers with taxpayers.

Second, Pawned States revisits the so-called bellicist hypothesis and updates it to a context of global credit markets (largely nonexistent in premodern Europe). I show that war was commonplace outside Western Europe in the nineteenth century, but it did not translate into stronger states because it was largely financed with foreign capital. European rulers in premodern times were no more and no less public spirited than those in the Global South after 1816. They simply faced stronger political incentives to repay debt because it was issued domestically, not abroad, hence their continued efforts to build a strong tax apparatus to repay war debt.

Third, the study of history in political science might be of interest per se or because of the legacies of historical events on current phenomena. Contemporary sovereign loans do not include extreme conditionality—whether this is true for some loans issued by China is still to be determined—but the consequences of old lending practices still shape fiscal and political institutions in the Global South today.

Pawned States: State Building in the Era of International Finance is featured in the Princeton Economic History of the Western World Series. For a 30% discount, use code P289 at


  • Didac Queralt

    Didac Queralt is Assistant Professor in the Department of Political Science at Yale University. His research examines the historical political economy of fiscal institutions from three different angles: war, trade, and external finance. He is the author of Pawned States: State Building in the Era of International Finance (Princeton University Press, 2022). His research has been featured in the American Journal of Political Science, International Organization, Explorations in Economic History, Quarterly Journal of Political Science, and Comparative Political Studies, among other.

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