04/05/2010 05:12 am ET Updated May 25, 2011

Why Did Countries Lend to Haiti?

In the wake of the recent earthquake, groups like Oxfam International and politicians like Rep. Maxine Waters (D-Ca.) have been calling for Haiti's public debt to be canceled by its international creditors. In fact, most of Haiti's debt was already forgiven or renegotiated last year, long before the earthquake, as part of an ongoing international program. So why do rich countries lend to poor countries like Haiti at all?

Let's start with some context. In the past several years, there has been a movement among the governments of rich countries (and their proxies, such as the International Monetary Fund and the World Bank) to reduce the debt of poor countries. Despite the fact that loans to poor countries typically have low interest rates and lengthy grace periods before repayment, they still become burdensome for many countries. Some countries lack the political or economic stability needed to consistently honor their obligations; others do not have the legal means to collect enough taxes or other revenue in order to make their payments.

One manifestation of this movement is the Highly Indebted Poor Countries (HIPC) initiative, whose purpose is to erase debts of poor countries that have a chance to grow but are being held back by their debts, many of which are decades old. As part of this initiative, a huge share of Haiti's debts were canceled or refinanced in 2009. Its annual payments of interest and principal were cut to less than one percent of gross domestic product for the foreseeable future.

With Haiti's economy in ruins and its ability to pay clearly reduced, there is little reason not to forgive its remaining public debt; trying to collect would be draconian and probably futile. The amount outstanding is less than half a billion dollars, which is also less than the total pledges of aid that Haiti received from around the world -- including from some of its creditors -- in the wake of the earthquake.

There is a deeper question here, however: why did countries lend to Haiti in the first place, if poor countries have such a hard time repaying their debts even without natural disasters -- and should they lend again? The answer comes down to arithmetic and politics.

First, the arithmetic. Let's say that you want to extend some aid to a poor country. The country can't afford to borrow money on the financial markets; investors see it as a risky proposition, so it would have to pay a very high interest rate, say 15 percent. To help this country get the money it needs to grow, you have two options: 1) give a donation that you never expect to be repaid, or 2) offer a loan at a below-market interest rate, say 5 percent, that you do expect to be repaid over time. Because the second option involves a below-market interest rate, it is also a kind of donation; you are voluntarily forgoing the extra 10 percent worth of interest that the market would pay for an equally risky investment. To make your decision, you can compare the cost of the donation and the cost of the loan (in terms of foregone interest). For example, if we discount future dollars by 3 percent per year, then a 10-year loan of $117 million costs you the same in today's dollars as a one-time donation of $100 million.

Now, look at the situation from the point of view of the poor country's government. They can take $100 million as a donation, or $117 million as a loan. If the country suffers from a lack of political or economic stability, the chances may be pretty low that 1) the same government will be around when the loan needs to be repaid and/or 2) the government will actually be able to repay it. So, for the current government, there is much more incentive to take the loan -- it's another $17 million to play with, with almost no strings attached.

Not surprisingly, politicians in poor countries were happy to take billions of dollars in loans for decades. Governments in rich countries liked this arrangement, too, as it seemed to suggest that the poor countries could become responsible citizens in the global economy, receiving credit rather than just handouts. They also liked it because loans didn't look as big as donations in their foreign aid budgets. The folks at the proxy institutions liked it as well -- some of their jobs depended on the loan business, after all.

Clearly, decision-makers in both rich and poor countries have an incentive to arrange loans instead of donations, yet loans are bad for both sides in the long term -- hence HIPC. It makes sense to bury these old loans, including Haiti's. The perverse incentives are still in place, though, so there's no guarantee that countries will learn from their mistakes.