Why Innovate? Founding the Bank for International Settlements

Abstract

One of the concerns of international political economy in the past several years has been to theorize about the conditions conducive to the development of international cooperation and institutionalization. This article explores the usefulness of economic theories of dynamic contracting, which are essentially functionalist in nature, to understand international financial innovation in the 1920s. It interprets the founding of the Bank for International Settlements as an important effort to overcome the problems of contract enforcement and information asymmetries in international lending that had contributed to capital market inefficiencies as the 1920s drew to a close. Dynamic contracting theories suggest reasons why borrowers and lenders have a strong interest in developing cooperative international institutions that help establish a borrower's credibility. This approach is supplemented with a multilateral bargaining model between debtor, private lenders, and creditor governments to explain international financial innovation during the interwar years. The evidence suggests that the BIS was created primarily to enhance Germany's incentives to repay its debts and that it was part of a deal between private creditors and creditor governments to reduce and commercialize German reparations. By looking not only at interstate bargaining but also at public/private bargaining, it is possible to understand the paradox of cooperative international institutional development in a period otherwise marked by conflict.