Balancing against Threats with Moral Hazard

In this paper we take a new approach to the study of alliances. Since at least 1648, an important group of alliances have involved one country pledging to the other some amount of aid in times of war. Taking a view of alliances as a form of decentralized insurance arrangements that indemnify targets against the cost of wars with potential aggressors, we develop a theory that explains why particular security agreements form and why the commitments look as they do. Our theoretical model considers both the effects of moral hazard on alliance partners and the deterrence possibilities against third parties. Our analysis explains why alliances tend to form between large countries, or between large countries and small countries, but not between small countries.