CHAPTER 1

Introduction

An extraordinary act in the history of the civilizednations, without precedent, without possible justification,a barbarous act because it is an attack on themost rudimentary principles of international law, anignoble act because it is the fruit of an immoral andcowardly collusion of force and betrayal.—Cipriano Castro, 1902

This is the great threat, the biggest threat that theplanet faces today. The Yankee empire.—Hugo Chávez, 2010

In 1900, Venezuelan president Cipriano Castro seized propertiesbelonging to the American asphalt trust. Venezuelantroops forcibly ousted the trust's employees and occupied its facilitieson the shores of Lake Bermúdez, one of the largest naturaltar pits in the world. The McKinley administration protested,and the Navy Department ordered three warships to the scene,but the United States did not intervene. Dissatisfied with theofficial response, the asphalt trust immediately set out arminga rebellion to overthrow Castro's government. American corporatesupport for the rebels led Castro to seize British-flaggedvessels carrying weapons for Castro's opponents. That in turnprovoked a confrontation between Castro and the United Kingdom,which caused the German government to get involvedon the British side. The Anglo-German alliance shelled La Güaira,sank two Venezuelan vessels, blockaded several ports, andthreatened invasion. The U.S. government was dragged backinto the dispute, where it brokered a state-to-state settlementat the International Tribunal at the Hague. The imbroglio wasconfused, politicized, and violent. But it was not unique. Fromthe confrontation between the Hawaiian sugar planters andQueen Liliuokalani in 1893 to the "dollar diplomacy" of the1920s, the U.S. government found itself drawn again and againinto disputes between American investors and foreign governmentsover their property rights.

In 2007, Venezuelan president Hugo Chávez seized propertiesbelonging to the American oil giants ExxonMobil andConocoPhillips. When asked, a State Department official stated,"The government of Venezuela, like any other government, hasthe right to make these kinds of decisions to change ownershiprules. The standard has always been that we want to see themmeet their international commitments in terms of providing fairand just compensation." The oil giants then sued Venezuela'sstate-owned oil company at the International Chamber of Commerce(ICC) and the Venezuelan government at the InternationalCentre for Settlement of Investment Disputes (ICSID). The U.S.government was not involved in the suits. The ICC decided thatVenezuela owed ExxonMobil $907.6 million in compensation.Chávez blustered, but paid. The dispute was legalistic and relativelyorderly. But it was not unique. By 2007, it was perfectlynormal for American companies to sue foreign governments ininternational tribunals over violations of their perceived propertyrights—and, at least sometimes, to win and to collect.

The Empire Trap is about the shift from politicized confrontationslike the imbroglio of 1900 to legalized disputes like themore orderly affair of 2007. It advances four basic findings. First,American government intervention on behalf of U.S. foreigninvestors was astoundingly successful at extracting compensationthrough the 1980s. Second, American domestic intereststrumped strategic concerns again and again, for small economicgains relative to the U.S. economy and the potential strategiclosses. Third, the United States proved unable to impose institutionalreform in Latin America and West Africa even whileAmerican agents were in place, let alone afterward. Finally, thetechnology that the U.S. government used to protect Americanproperty rights overseas changed radically over time—and ultimately,in a case of unintended consequences, gave U.S. investorsa set of tools that they could employ against foreign governmentswithout explicitly calling on the power of the Americanexecutive to protect them.

The first finding—that the U.S. government intervened oftenand intervened successfully on behalf of American overseasdirect investors from the 1890s through the 1980s—is particularlytrue for natural resources. State Department reportsprovide data on every investment dispute brought to its attentionbetween 1900 and 1987. For investors in oil and hardrocknatural resources, the number of cases in which countriesunequivocally managed to avoid paying full compensation—definedas the market value of foregone future income—wasalmost entirely limited to countries openly allied to the SovietUnion. In only six non-Soviet cases (out of 130) did investorsunambiguously receive less than the value of their investment asa going concern: Venezuela in 1900, Bolivia in 1952 and 1969,Ecuador in 1972, Kuwait in 1975, and Iran in 1979. In otherwords, once you look at the data, one of the major stylized factsabout the foreign expropriation of American assets disappears:investors in natural resources rarely suffered economic damagefrom expropriation. And this was because the U.S. governmentactively defended the owners and their interests, almost regardlessof the strategic situation or ideological preferences.

The implication is that domestic interests trumped strategicimperatives, over and over again—which is the second findingof this book. This result is surprising considering the relativeunimportance of foreign direct investment (FDI) to the Americaneconomy. FDI was never a significant part of total Americaninvestment, and the returns from FDI were never a significantpart of national income. The United States did have strategic interestsin securing foreign supplies of raw materials—but neverdid such security hinge on the de jure ownership of foreignwells and mines. Foreign portfolio investment was slightly moreimportant—but only beginning in the 1970s. From the 1890sto the early 1970s, American investment in sovereign debt wasneither a significant proportion of American overseas portfolioinvestment nor systematically important to the health of the financialsystem. Nevertheless, American administrations againand again went to bat for private interests in their conflicts withforeign governments. This held true even when the rise of theAxis and the Cold War with the Communists sent the potentialstrategic costs of such conflicts into the stratosphere. After theCuban Revolution of 1958, many within the State Departmentfeared that it was the American hard line on expropriation thatdrove Castro into the arms of the Soviet Union—yet the UnitedStates ran such strategic risks again and again and again, inIndonesia and Peru and Ethiopia and elsewhere. Simply put, noU.S. president could afford to take a Solomonic view and ignorethe immense pressures that private interests could bring to bearto insist upon the defense of their property rights.

To be sure, some presidents needed more persuasion thanothers. Theodore Roosevelt and Richard Nixon needed littleconvincing to punish foreign governments that threatenedAmerican-owned property. William Howard Taft and CalvinCoolidge did not require a great deal more persuasion to interveneon behalf of investors. Warren Harding, Harry Truman,Dwight Eisenhower, and John Kennedy, on the other hand,were relatively reluctant. Finally, some presidents needed to bedragged kicking and screaming into intervention. WoodrowWilson, Franklin Roosevelt, Lyndon Johnson, and Jimmy Carterhad little interest in using American power to protect wealthyAmericans from foreign governments—but did so nonetheless.

The third finding is that the United States proved incapableof fixing what it believed to be the underlying factors that madeproperty rights insecure in Latin America and elsewhere. Earlytwentieth-century economic orthodoxy held that political instability,insecure property rights, poor infrastructure, and whattoday would be called "underdevelopment" all stemmed from asingle, common root: poor revenue collection caused by internalcorruption. The inability to collect taxes and tariffs, in this view,trapped states in a vicious cycle. Governments needed to paytax collectors in order to collect taxes; so without the administrativecapacity to raise revenue there was no way to createthe administrative capacity to raise revenue! Low revenues, inturn, meant there were few resources to spend on public goods:armies to maintain order, courts to enforce contracts, and infrastructureto move goods and improve health. The result was politicalinstability: without the ability to tax, governments wouldresort to expropriating private property (including that of foreigninvestors)—which would in turn mobilize violent opposition.Foreign borrowing could in theory square the circle. Theproblem was that the borrowing states lacked the ability to taxany resulting increase in economic activity. The result would beat best a cycle of default. At worst, a country would find itselfcut off from foreign capital markets and plagued by rampantinstability. Neighboring countries could be destabilized as well,and promising investment opportunities would be lost.

The above diagnosis of the problem offered an obvious solution:appoint American officials to manage a country's revenueinstitutions. U.S. managers, with the power to hire and fire andenforce new administrative rules, could reduce corruption andenhance efficiency. Revenue would rise. Higher revenue wouldallow more expenditure on public goods. It would also decreasethe chance of default, thereby lowering borrowing costs—enablingeven more expenditure on public goods. That wouldreduce political instability and promote growth, which wouldin turn attract foreign direct investment, which would in turncreate more growth. The end result would be stable prosperouspolities in which American investment would be safe.

The only problem with the theory was that it did not work.The United States imposed eight "fiscal receiverships," most withthe cooperation (even enthusiasm) of the foreign government.Except for the first, in the Dominican Republic, none managedto raise more revenue than the country had previously collected.In the Dominican Republic, the receivership raised revenues notbecause the Americans reduced corruption, wrote better rules,or brought innovative management, but because Dominicaninsurgents stopped attacking the customhouses once Americanofficials were in place. Elsewhere, putting executive authority inAmerican hands (and in many cases rewriting legislation) wasnot enough to change entrenched cultures of corruption. Fiscalreceiverships failed even when the United States ultimately tookover all government functions, as in Cuba and Haiti. Moreover,with the exception of the first intervention, markets reactedbadly to the announcement of a receivership. Bond yields on thedebt of other Latin American nations jumped several hundredbasis points in the month a receivership was announced. Ratherthan showing reassurance that the Americans stood ready toimprove institutions, investors acted as if the receiverships remindedthem of what a risky place Latin America really was.

The fourth finding is that the technology of intervention tocompel compensation changed dramatically over time. In orderto defend the property rights of Americans (or at least the valueof the income streams those rights generated) in conflicts withforeign governments, the United States needed to do one ofthree things: bribe the foreign government, threaten the foreigngovernment, or change the foreign government. The most obviousway to protect American investors in foreign territory wasto make the territory no longer foreign—that is, bring the areainto the United States under the purview of the Constitution.That strategy ran into trouble when Americans began investingin areas with largely nonwhite populations: racist voters wouldnot accept full annexation, which the Fourteenth Amendmentensured would also bring citizenship. Hawaii was the exceptionfor a variety of special circumstances not to be repeated.

The first new "technology" to be introduced was annexationwithout the Constitution—as in, for example, imperial rule.The U.S. Supreme Court, in the infamous "Insular Cases," allowedannexation without citizenship or the full protection ofthe Constitution. Unfortunately for investors, that in turn alsoproved problematic. Democratic anti- imperialists in Congressdeliberately wrote rules that restricted private American investmentin the two largest and most economically important U.S.possessions: the Philippine Islands and occupied Cuba. That leftinformal imperialism: carrots and sticks to be rolled out againstnominally independent governments. From 1904 to the GreatDepression, the stick was military force (usually via the threatof blockades) and the carrot was access to the American creditmarket. In the 1930s the set of carrots and sticks broadened:Franklin Roosevelt added public loans, foreign aid, and accessto U.S. markets to the carrots, and the threat of denial became astick. Later, during World War II, the United States developed anentire branch of government dedicated to covert action againstforeign states. It became only natural that the new tool wouldbe repurposed to defend the private property rights of Americansabroad.

Beginning in the third quarter of the twentieth century, aseries of mostly—but not entirely—unplanned innovations removedthe concept of absolute sovereign immunity from legalaction and gave investors direct access to international arbitrationwithout the need to get their home governments to "espouse"the complaint. Other changes allowed the resultingdecisions to be enforced in national courts. The changes gaveinvestors a third option between cooperation with the foreigngovernment and convincing Washington to back them in confrontation.The new option had the salubrious side effect of depoliticizinginvestment disputes and freed the U.S. governmentfrom the domestic pressures that had dragged it again and againinto conflict with foreign states.

The Empire Trap

The above findings suggest the possibility of an "empire trap,"in which one American administration's promise to interveneon behalf of U.S. investors makes it harder for future administrationsto refrain from such intervention. If a president crediblycommits to use the power of the United States to defend propertyrights in a foreign country, the perceived risk of investingin that country will fall. More capital will flow in, increasingthe political pull of investors in that area. In addition, investors(as a matter of historical fact) will perceive that the promise appliesto similar countries—in fact, for such countries to becomemore attractive, investors need only perceive the possibility thatthe promise applies. More American capital will flow in. Futureadministrations can default on the implicit promise—butonly if they are willing to confront the owners of those investments.That entails political costs, the more so the more wealththat investors have at risk. In short, successful intervention onbehalf of overseas investors begets more overseas investment,which creates more pressure to intervene when those investmentscome under threat. The result is an "empire trap," whereU.S. administrations find it difficult to resist pressures to defendAmerican overseas property rights.

The rub for investors is that American presidents have multiplereasons to refrain from exercising American power on theirbehalf. Interventions bear domestic political costs. Voters do notnecessarily think that the interests of private investors are thesame as the national interest. Some may oppose intervention forideological reasons. Others oppose intervention because it failsa perceived cost-benefit test. After all, the benefits to voters fromoverseas investments are generally small given the immense sizeof the U.S. economy. The costs of getting involved in a foreignquagmire, on the other hand, can loom large. Such quagmiresdo not have to be military. For example, an economic confrontationwith an expropriating government might cause that governmentto collapse, requiring expensive aid flows to stabilizeits successor. Similarly, covert action can engender terrorism orother forms of blowback. Finally, the public might oppose interventionbecause it lacks sympathy for the co- nationals who losttheir property. For example, the bankers and bondholders whoheld Latin American debt in 1929 enjoyed little to no publicsympathy—and moves to support them incurred high domesticpolitical costs.