There is an interesting dichotomy in the dialogue about the use of foreign assistance in the pursuit of domestic economic and strategic interests. It is clear that self interest and security arguments have often represented little more than cynical efforts to generate support for the foreign assistance budget. There have been serious efforts to examine the theoretical foundations of the economic self-interest argument. There have also been increasingly serious attempts to evaluate the economic and social impacts of economic assistance in developing countries. In addition to a large professional literature, the U.S. Agency for International Development has conducted and published more than 100 Project Evaluations, Evaluation Special Studies, and Program Evaluation Reports. The World Bank has an Operations Evaluation Department that engages in a major program of project completion evaluation studies.

The security rationale has not, however, been subject to nearly as rigorous theoretical or empirical analysis. 1 8 The single background paper on the effectiveness of military assistance prepared for the Carlucci Commission asserted a positive linkage between U.S. security assistance expenditures and security interests while admitting that the evidence to support the assertion is "elusive."19 This is not to suggest that empirical support cannot be provided to support the political and strategic self-interest arguments. It is simply to argue that, in spite of Huntington's assertion that the results of security assistance have been at least as successful as efforts to promote economic development,20 little convincing evidence has appeared in the professional literature on development assistance.

Scholarly historical research and common-sense discussions of world affairs often emphasize foreign intervention as a major determinant of the dynamics of political institutions. For example, Theodore Roosevelt advanced in May 1904 that the U.S. had a “moral mandate” to enforce proper behavior among the nations of Latin America (this came to be called the Roosevelt Corollary to the Monroe Doctrine). Subsequent attempts to enhance “proper behavior” lead shifting U.S. governments to intervene in favor of dictatorships, to sponsor coup d’états, to support weak democracies and to encourage democratization. Foreign intervention was neither limited to Latin America, nor was it exclusive to the United States. Behind most examples of foreign intervention looms economic goals such as providing a better and more secure investment environment. Yet, the fast growing economics literature on endogenous political institutions has not provided a framework in which the role of economically motivated foreign intervention in the rise, fall and establishment of different forms of democracies and autocracies can be analyzed.

Our theoretical model provides economic foundations for political institutions in situations where international capital flows are important and where investments in other countries are of strategic significance to foreign governments. The main contribution of the paper is to inquire into the incentive of a foreign government to influence regime transitions in another country. We derive conditions under which foreign intervention plays an important role in explaining why certain forms of democracy and autocracy emerge, breakdown or consolidate.

Financial contracts typically do not specify repayments to investors as a detailed function of all payoff relevant variables. For example, debt contracts normally do not specify repayments as a detailed function of the financial state of the firm, but rather puts some easily describable liability on the firm’s cash flow through a fixed repayment obligation. One focal approach in the literature that attempts to model this feature of financial contracts is the Costly State Verification (CSV) approach. The core of this approach is that, upon the date of repayment, inside investors have superior information to the outside investors about the profitability of the firm, and therefore may try to divert cash from outside investors by underreporting the true cash-flow. Of course, this may in turn create an ex-ante governance problem in that external investors may be reluctant to finance the firm.

The weapon outside investors can use to mitigate the cash diversion problem is to partially or fully verify the true profitability of the firm, by e.g. demanding an audit, declaring bankruptcy, or even discharge management and take control of the operations of the firm. Such a leveling of information can only take place at a certain cost of verification. Celebrated papers by Townsend (1979) and Gale & Hellwig (1985) derive debt contracts as optimal under such circumstances, i.e., contracts which promises a fixed repayment, and where the creditor verifies whenever the offered repayment falls below the promised repayment.

The expected loss on corporate debt is an important input to many financial decisions, including lending, bank regulation, portfolio selection, risk management, and valuation. Starting with Altman (1968), various methods of forecasting default losses using characteristics of individual firms or rating classes have been proposed. These include discriminant analysis, approaches based on rating transitions (Elton et al., 2001), structural models of risky debt (Leland, 2002), and various proprietary models, of which the KMV model is probably the best known (Crouhy et al., 2001).

The extensive development of bond markets offers another opportunity, which we pursue in this paper: to extract the expected default loss on a corporate bond from its yield spread. We calibrate the Merton (1974) structural model of risky debt using observed bond spreads in conjunction with information on leverage, equity volatility, and equity risk premia to yield an estimate of expected future default losses incorporated in current market prices.