Lending to the Borrower from Hell: Debt, Taxes, and Default in the Age of Philip II (The Princeton Economic History of the Western World)

by Mauricio Drelichman

  Elliott emphasized that high real rates of return on government bonds diverted capital away from trade and production, and created a rentier class. Warfare, in his view, was responsible for the continuously high interest rates. This created what amounted to a siren song for Spanish entrepreneurs. This argument, while plausible, does not stand up to scrutiny. Spaniards often held long-dated debt, but much of it was also placed abroad; entrepreneurs everywhere in Europe should have been equally tempted to become rentiers. After 1610, interest rates on public debt also were progressively lowered, declining to 2.75 percent by the eighteenth century (Alvarez Vázquez 1987). There is therefore no reason to think that the crowding-out effects west of the Pyrenees should have been greater than elsewhere.

  The leading interpretation of Spanish decline—put forward by economists working in the new institutional economics tradition—highlights the overwhelming strength of the Crown. According to this view, Spain’s rulers were already more powerful than other monarchs by the time the Americas were discovered. The influx of silver revenues then strengthened their position further. Ruinously costly and unnecessary wars, the high-handed breaking of contracts, frequent defaults and payment stops, and a disregard for the sanctity of property eventually undermined growth and prosperity.3 In contrast, where rulers in 1500 were initially weaker—such as in England—Atlantic trade strengthened the merchant class, which eventually wrested power from the rulers, improving the institutional quality and facilitating growth (Acemoglu, Johnson, and Robinson 2005).

  Remarkably, the leading interpretation of Spain’s “failure” is a blend of the same ingredients typically invoked to rationalize British success. In both cases, there is a focus on many wars fought, territories acquired, fiscal resources directed toward the military, preferential trading agreements, and the exploitation of colonies. According to Patrick O’Brien (2001), Britain’s bellicose policies and aggressively mercantilist strategy propelled its rise as an economic power. John Brewer (1988) underscored the importance of the English Crown controlling ever-greater resources through the tax system in an effort to finance more wars. Philip Hoffman (2012) has argued that efficiency improvements in weapons spilled over into production processes. Even the mountain of debt accumulated by Britain during the eighteenth century apparently had surprisingly few negative effects, as some of the literature observes.4

  Seemingly, what was good in one case turned out to be poisonous in another situation. Some of the contradiction can be explained by the way in which the writing of history is organized. Country specialists typically write history; they look for explanations in unique tales. As a consequence, the field as a whole has provided a deeply contradictory explanation of the rise and fall of Europe’s early modern empires. Here, we will first review Spain’s fiscal performance, together with that of other European great powers. We find little evidence of policy failure. Next, we offer an alternative explanation of Castilian decline. It was not excessive powers in the Crown’s hands that led to eventual doom but rather a failure to successfully centralize the Spanish administration, integrate heterogeneous territories into a larger whole, and pursue an “absolutist” agenda. The reasons for this failure were, according to our view, a greater initial level of political heterogeneity on the Iberian Peninsula than elsewhere and the deleterious effect of silver on state capacity.

  SPAIN’S FISCAL PERFORMANCE IN COMPARATIVE PERSPECTIVE

  A central part of the institutionalists’ indictment of Spain rests on that country’s seemingly disastrous fiscal performance. Spain defaulted time and again between 1550 and 1913 (Reinhart, Rogoff, and Savastano 2003). There is also no doubt about the country’s economic decline in the seventeenth century, during and after a string of payment stops. Whether defaults can be regarded as a sign of imprudent fiscal policy and the violent breaking of property rights is at least debatable from a theoretical perspective.5 It also bears repeating that the first four of Spain’s “defaults” only affected 15 percent of total borrowing—the short-term debt. As chapter 7 argued, these defaults were excusable and in all likelihood anticipated by the lenders. Hence, they did not violate the initial implicit contract struck between the Crown and lenders. Nothing demonstrates this more clearly than the fact that Philip II never lost access to credit, except for brief periods during the payment stops; in other words, the ultimate test of the sustainability of his debts was that he managed to sustain access to debt markets.

  In addition, we show here that Spain actually conducted its finances before 1600 in a more prudent manner than many other early modern European powers. This reinforces our conclusions in chapter 4, arguing that debts were sustainable and the payment stops reflected liquidity shocks. Our comparison does not look at various powers at the same point in time. Instead, we try to make our comparison more appropriate by examining a set of European states at the height of their power (during the early modern period), comparing sixteenth-century Castile with the imperial incarnations of Holland, France, and Britain in later centuries. The date ranges are mostly determined by data availability. This does not bias our comparisons; France, for example, would arguably look even worse if the final years prior to the revolution had been included (White 1989).6

  In table 28, we use a variety of fiscal indicators.7 Two measures frequently used in assessing the strength of fiscal systems are the debt-to-revenue and debt-service-to-revenue ratios (Sargent and Velde 1995). The Netherlands marks one extreme with an average debt-service-to-revenue ratio of 68 percent; fully two-thirds of tax revenue was spent on the Low Countries’ debts.8 France is at the opposite end of the spectrum, with a relatively low debt-service-to-revenue ratio of 38 percent in the eighteenth century.9 The figure for France may be too low; the average excludes the period prior to the 1720 rescheduling, when debt service accounted for more than 80 percent of revenue. Sixteenth-century Castile falls in the middle of the range, with a ratio of 51 percent. This makes it more similar to the United Kingdom than to the Netherlands.10 Compared to the other great powers in early modern Europe, Castile was not spending an especially high proportion of its revenue on debt service.11

  Table 28. International comparisons

  Note: Data taken from the “European State Finance Database” (Bonney 2007).

  + per capita tax as a percentage of income of an unskilled laborer, as calculated by Jan De Vries and Ad Van der Woude (1997)

  ++ based on data used by Francois Velde (2007), as kindly provided by the author

  +++ Sargent and Velde 1995, table 1

  * GDP based on the lower bound in Alvarez Nogal and Prados de la Escosura 2007

  ** GDP from Carreras 2003

  *** Based on data analyzed by David Weir (1989), as compiled by N.F.R. Crafts (1995)

  **** GDP data from Crafts 1995; fiscal data from Mitchell 1988

  The same conclusion emerges from the maximum debt-service-to-revenue ratio. This ratio peaks at 75 percent for Castile, the second-lowest value among this set of competitors—and only marginally higher than the 70 percent registered in Britain.12 France saw a maximum of 81 percent.13 The Netherlands sustained high levels of close to 200 percent for a short period while accumulating debts during the War of the Spanish Succession.

  During Philip II’s reign, Castilian tax revenues grew quickly—more quickly than in the United Kingdom, France, or Holland. Fiscal pressure increased approximately twice as fast as in the United Kingdom during the eighteenth century. This is all the more remarkable since historians have long held up Britain’s willingness and ability to raise taxes as one of the key factors for its success in both the wars with France and avoiding default (Brewer 1988; O’Brien 2009). Admittedly, the Castilian figures are for a shorter period than in the case of Holland or the United Kingdom, but the time span is similar to the one available for France.

  The maximum fiscal pressure relative to the GDP in Britain and Castile was also broadly comparable. Even when we use the (pessimistic) GDP estimates from Carreras (2003), the Castilian Cro
wn extracted a much smaller proportion of national income than Holland, where the government revenue reached more than 20 percent of the national income. By this measure, both the United Kingdom and Castile collected a little less than a tenth of national product in taxes and contributions. Since a significant share of Crown revenue in Castile was effectively a tax on foreign mining, the actual fiscal pressure on the domestic economy was even lower than what the raw numbers imply. If we use the GDP figures by Alvarez Nogal and Prados de la Escosura (2007), which are more optimistic than Carreras’s, the Castilian revenue-to-GDP ratio was half the British figure and markedly lower than in Holland.

  Debt-to-GDP ratios (tentative as they are) tell a similar tale. Relative to the economy’s total output, government debt in Castile was low—lower than in France or the United Kingdom. Scaling by revenue does not alter our conclusions. In 1801, for example, Britain’s debt stood at 13.7 times annual fiscal revenue (Mitchell 1988). In 1822, the ratio still stood at 12.96, while the Castilian number fell in the range of 5 to 6.

  Castile’s primary surpluses were also high, even by elevated English and French standards.14 Castile under Philip II actually allocated a higher proportion of its revenue to paying interest and repaying debt than either the United Kingdom or France. It could be argued that this is stacking the deck in Castile’s favor; the high primary surpluses were partly necessary because of the markedly higher interest rates paid by Castile compared to eighteenthcentury England. Keeping the debt from exploding thus required a greater effort. Low borrowing costs in England were indeed important for debt sustainability there, but they did not reflect the market’s fair assessment of risk. Instead, there is ample evidence that fiscal repression—forcing private lenders to underwrite government debt at below-market prices—was critical for the United Kingdom’s debt management.15

  So far we have examined a range of indicators and pointed out the relative position of the different powers. There is not a single indicator of fiscal probity on which Castile emerges as worst among the competitors; on several, it is at or near the top. If there is another state that looks broadly similar—in terms of average debt service, maximum debt service, and the revenue-to-GDP ratio—it is Britain, which has long been regarded as the benchmark for responsible financial management.

  While there is no single measure of fiscal behavior that can serve as a summary measure of policy, there is an indicator more powerful than the mé-lange of different measures we already discussed. One crucial factor for debt sustainability is the reaction of fiscal policy to a buildup of debt. For debts to remain sustainable, a higher debt burden must be met with a greater primary surplus—if not immediately, then not too long thereafter. This insight is at the heart of the literature on fiscal policy functions (Bohn 1998). For example, the United States during the twentieth century accumulated enormous debts—essentially during World War I and II, and again after 1980. After these debt buildups, it ran large primary surpluses over a long time, bringing down the debt burden gradually.

  Typically, scholars estimate fiscal policy reaction functions econometrically to determine how much the primary surplus rises as debt accumulates. Because of the logic we used in compiling annual fiscal accounts for Habsburg Spain, this is not feasible.16 Instead, we can examine how different powers performed according to the basic logic of fiscal reaction functions. In figures 31 and 32, we plot primary surpluses and debt stocks for Castile and Britain. Both powers show debt accumulation at a fairly rapid pace—with Britain going from a debt of 14 million pounds sterling in 1700 to 244 in 1790, while Castile saw an increase from 25 to 72 million ducats between 1566 and 1595. Britain produced higher primary surpluses to pay for this growing mountain of debt, but it did so in a particular fashion. During each war, primary surpluses turned negative, with the government borrowing just to pay interest. It is only during select years of peace that the primary surpluses grew.

  FIGURE 31. Primary surpluses and debt stock in sixteenth-century Castile

  FIGURE 32. Primary surpluses and debt stock in eighteenth-century Britain

  Castile showed a different cyclical behavior from the United Kingdom’s; at war in every single year of his reign, Philip II nonetheless almost never ran a primary deficit. There are only four years when Castile had to borrow to cover interest payments. The growing burden of debt coincided with greater and greater surpluses, rising from a little over 1 million ducats at the beginning of the period to more than 5 million by 1595. The consolidation was strongest in the years prior to the Armada, when high primary surpluses accumulated for years in a row. Therefore, it can be argued that Habsburg Spain adapted successfully in fiscal terms to the bellicose environment of early modern Europe. Rather than sharp swings in the primary surplus, it met rising debts with greater primary surpluses. Only extraordinary emergencies—such as the Dutch Revolt in the mid-1570s and the Armada—caused Castile to violate the first rule of fiscal probity (never to borrow to pay interest). By the standard of fiscal policy reactions, Castile was every bit as prudent as Britain, if not more so.17

  The conclusion from these international comparisons has to be that Castile’s finances in the second half of the sixteenth century were not in worse shape than those of other major European powers in their respective heydays. There was ample room for Castile’s tax-to-GDP ratio to grow, and grow it did. To a striking extent, ordinary expenditure did not catch up with revenue, producing large surpluses that were used to service the debt. While Castilian fiscal infrastructure was not as highly developed as Holland’s or Britain’s, revenue growth provided the breathing room to cope with high debts. On average, the Castilian Crown in the 1580s and 1590s commanded financial resources that were on the same scale (relative to the size of the economy) as Britain’s in the eighteenth century.

  STATE CAPACITY VERSUS CONSTRAINTS ON THE EXECUTIVE

  If fiscal recklessness and imperial overstretch are not to blame for Spain’s decline, what is? We argue that the problem was not despotism but instead weak, incompetent, incoherent governance. Rather than the new institutional economics’ emphasis on too much power in the hands of an absolute monarch (Acemoglu, Johnson, and Robinson 2005; De Long and Shleifer 1993), the key shortcoming was almost exactly the opposite: a lack of state capacity, of a government’s ability to successfully assert a monopoly of violence, defend its borders, impose uniform taxation, administer justice, and obtain resources for carrying out these tasks.

  In early modern Europe, constraints on the executive were not a key determinant of economic performance—otherwise Poland, where a single noble in the Sejm, the national assembly, could veto policy, should have grown faster than the rest of Europe (Mokyr and Voth 2011). Instead, it languished economically before being carved up by its neighbors and disappearing from the map altogether. Predation—the despotic breaking of contracts and seizing of property—was exceedingly rare in Europe ever since the High Middle Ages (Epstein 2000; Clark 2007). Spanish kings sometimes seized American silver in times of distress (as discussed in chapter 3), but compensated the owners with long-dated debt of equivalent value. This behavior of the Spanish Crown is broadly comparable to the infamous raid on the Tower of London in 1638. Normally the wrong was acknowledged and attempts at righting it were made.18

  Nor were the poor defenseless in any sense. Courts often sided with the underprivileged against magnates, rulers, and rich burghers (Grafe 2012). At the same time, corruption limited the extent to which laws were actually applied. The Duke of Alba, writing in 1573, argued that decisions in court cases were frequently sold “like meat in a butcher’s shop” (Braudel 1966, 693). While many European powers suffered from corruption on a vast scale before the nineteenth century (Mokyr and Nye 2007), Spain was widely acknowledged to be particularly poor because of the weakness of its central ruler. Throughout much of early modern European history, constraining princes was not crucial; building an effective state whose writ ran to the furthest corner of the land was, as Stephan R. Epstein (2000, 15) arg
ued in Freedom and Growth: “Jurisdictional fragmentation … gave rise to multiple coordination failure. [R]ather than autocratic rule[, it] was the main source of institutional inefficiency of ‘absolutism’ before the 19th century.” Our interpretation also connects with recent developments in political economy. Instead of the simple dichotomy of absolutist versus constrained governments, it is increasingly recognized that strong states can be good for growth and that weak states struggle to provide the conditions for economic development (Acemoglu 2005; Besley and Persson 2009, 2010).

  There is no doubt that Spain scored poorly in terms of governance. Contemporaries already saw administrative reality for what it was. An English observer commented in 1681: “Spain is a clear example that misgovernment … will soon bring the mightiest Kingdoms low” (Bethel 1681, cited in Elliott 1989). Similarly, Thomas Babington Macaulay (1833, cited in Elliot 1989) remarked that “all the causes of the decay of Spain resolve themselves into one cause, bad government.” The problem of state capacity was acute throughout early modern Europe. This is because states as we know them today did not exist in 1500. Instead, there was a collection of minor and major territories, ruled by princes subject to multiple feudal allegiances; local power holders frequently acted as judges, often commanding bodies of armed troops and controlling major fortresses. Exemptions from taxation and other duties for large segments of the population, based on ancient rights and traditions, created highly uneven tax burdens. Taxes were rarely collected directly; rather, they were either farmed out or their collection was delegated to cities in exchange for lump-sum payments. Out of this system of weak, fragmented, unsystematic governance emerged a handful of powerful, consolidated, centralized nation-states by the nineteenth century. These successfully tore up the spider web of ancient “liberties” and exemptions, monopolized military power, and collected significant amounts of revenue by applying the same taxation rules to every citizen.