Philip II’s debts are often invoked as an egregious example of financiers’ gullible optimism and fiscal recklessness. The editorial from the Economist cited above (September 23–29, 2006) used the Genoese loans to Philip II to argue that “lending is a sober business punctuated by odd moments of lunacy.” Philip failed to honor his debts four times. Many earlier scholars have attributed Philip II’s continued access to funds to cunning manipulation, starry-eyed bankers, and the general novelty of lending to powerful princes.
In addition, Habsburg Spain’s defaults have typically been regarded as catastrophic financial events, causing major economic disruptions while ruining scores of bankers and small investors. Philip II, to exaggerate only a little, is usually cast as the villain of a morality play—an absolute monarch who squandered the wealth of his realms on fanciful dreams of European hegemony. Spain’s decline and eventual fall as a European great power is generally linked with imperial overstretch—the excessive ambitions and financial irresponsibility of the Habsburg monarch whose courtiers flattered him with the moniker “the biggest brain in the world.”
This book draws on new archival documents, advances in sovereign debt theory, and fresh insights in early modern historiography to offer a reinterpretation of Philip II’s finances. Taking our lead from earlier scholars—such as Thompson—who already argued that default cycles must have been anticipated, we show that Castile was solvent throughout Philip’s reign. A complex web of contractual obligations designed to ensure repayment governed the relationship between the king and his bankers. The same contracts allowed great flexibility for both the Crown and bankers when liquidity was tight. The risk of potential defaults was not a surprise; their likelihood was priced into the loan contracts. As a consequence, virtually every banking family turned a profit over the long term, while the king benefited from their services to run the largest empire that had yet existed.
We began with a historical overview of sixteenth-century Spain, with particular emphasis on the origins and evolution of state institutions as well as the distribution of political power. Philip II was not an absolute monarch by any standard; neither Cardinal Richelieu nor the famous theorists of absolutist rule, Bodin and Pufendorf, would have recognized him as such. Raising taxes and issuing long-term debt required the consent of Castile’s representative assembly, the Cortes. In contrast to the arguments in some of the new institutional economics literature, the rulers of Castile were every bit as constrained in the sixteenth century as, say, the kings of England, if not more so. The dynamics of bargaining between the king and Cortes resulted in a safe, tax-backed system of long-term debt (juros), on which Philip never defaulted. It was underpinned by rapidly rising fiscal revenue, which increased with the consent of the principal cities of Castile.
In addition, the king had access to several revenue streams not controlled by the Cortes. The most important of these was a tax on silver remittances from the Indies. These resources were used to back short-term loans, called asientos. At their peak, they accounted for a quarter of total borrowing. Philip II only ever defaulted on this relatively small share of total debt. To understand these defaults, we constructed a database using information from every single short-term contract subscribed during Philip II’s reign preserved in the Archive of Simancas. Earlier research never used all the information in these lending contracts. For each loan we transcribed every single contractual clause, reconstructed the associated cash flows, and coded up to ninety additional variables.
Based on these new data, we first examined the king’s ability to pay. If the Crown was insolvent—with no hope of bridging the gap between unavoidable expenditures and available revenues—lending would have been either irrational or naive. Using our new borrowing series along with a combination of primary and secondary sources, we reconstruct the fiscal position of Habsburg Castile on an annual basis between 1566 and 1596—the earliest such series for a sovereign state in history. With these data in hand, it is easy to show that Castile passes several key tests of fiscal sustainability. The king’s ministers—without knowing even the exact quantity of money received or borrowed—managed to run a primary surplus in almost every year of Philip’s reign. This means that the Castilian Crown almost never had to borrow to pay interest; it serviced debt out of regular revenue. Equally important is the fact that as debt levels increased, the primary surplus on average rose as well; the more debt had to be serviced, the greater the amount of money made available to this end. The final proof of probity is the long-run outcome. At the time of Philip’s death, the debt-to-revenue ratio was broadly unchanged from the one he had inherited from his father.
The defaults reflect illiquidity—and not an unsustainable debt burden or insolvent borrower. Cash could run out for several reasons; typically, a combination of adverse military developments—boosting required spending—and revenue shortfalls was necessary to send Castile’s treasury over the edge. This confluence of negative factors was generally counterbalanced by increases in revenue and adjustments in expenditure thereafter. During Philip’s long reign, his resources were both large and increasing, and he ran a tight fiscal ship. Lenders had little risk of facing an utterly bankrupt monarch who could not pay even if he wanted to.
The king could service his debt. But what were his incentives to do so? The sovereign debt literature argues that repayment must be enforced either through reputational concerns, economic disruptions, or the threat of sanctions above and beyond the loss of access to credit. We use the contracts in our database to document the legal and economic environment in which lending took place. Borrowing and lending in the age of Philip II took place under “anarchic” conditions—neither the king nor bankers could credibly commit to honor contracts to the letter. The king sometimes defaulted on or postponed payments; bankers also took deposits and then declared bankruptcy, leaving the king with losses, or made promises of loans that were not fulfilled.
The majority of Philip II’s bankers were Genoese. They engaged in a particular form of syndicated lending. They issued joint loans in overlapping constellations, and used cross-collection and cross-posted collateral to further strengthen the bonds between members of these informal syndicates. In addition to the manifold linkages of blood and marriage between these banking dynasties, there was a near certainty that they would act in unison during a crisis. Despite numerous, often-desperate attempts to strike side deals with powerful lenders, this arrangement prevented the king from negotiating separate terms with any of his Genoese financiers. Unable to break the coalition of lenders that provided over 70 percent of his funds, Philip in the end had to repay his loans in full most of the time. After each default, he also had to offer a settlement acceptable to the lenders to regain access to credit. The lenders’ coalition was a private-order institution in the sense of Avner Greif (1993). Our case study of what sustained sovereign lending in its earliest days lends powerful support to models of sovereign debt stressing the importance of lenders’ market power in combination with reputational concerns. It is also one of the first studies that can provide empirical support for reputation-based approaches, which are by their very nature hard to verify.1
In contrast, we find no support for the sanctions-based view of sovereign debt; the threat of cutting the king off from further lending was sufficient to align incentives and ensure the operation of a successful, sustainable system of sovereign borrowing. Conklin (1998) had concluded that a transfer moratorium by the Genoese, caused by the 1575 bankruptcy, directly led to a mutiny in the Army of Flanders. The unpaid soldiers then sacked and plundered the loyalist city of Antwerp, dealing a major blow to Spain’s position in the Low Countries. In Conklin’s view, therefore, the penalty of a transfer moratorium could bring the king of Spain to heel. A close reading of the historical record, however, suggests that the transfer stop was never effective; other bankers filled the void and transferred funds (without ever lending). Mutinies were common in the Army of Flanders; the only reason this one got out
of hand was a power vacuum caused by the governor-general’s death. Penalties and sanctions played no role in convincing Philip II to pay his bankers.
The conclusion has to be that the king could pay his creditors, and most of the time had no choice but to pay merely to retain access to lending services. Yet defaults happened, and settlements featured significant reductions in principal and interest. Short-term loans were converted into perpetuities. Most contracts caught in a bankruptcy posted negative rates of return. Why did bankers continue to lend in the face of these repeated defaults? Our answer is simple: because it was good business. To assess the profitability of lending, we painstakingly transcribed every single clause in 438 contracts, reconstructed the agreed-on cash flows, and calculated the implied rates of return. Based on an assessment of the default’s impact, we calculated ex post rates of return. The losses suffered during the defaults were more than offset by the returns obtained in tranquil times. No banking family that maintained a long-term relationship with the Crown lost money overall during the period 1566–98; virtually all earned over 7.14 percent, the yield on safe perpetuities that we use as a benchmark. Over the long run, real returns on short-term lending averaged just over 10 percent after accounting for the effect of the defaults and reschedulings, leaving a healthy premium over the risk-free rate.
The key to understanding the nature of Philip II’s defaults lies in the peculiar structure of his loans. The contractual clauses show that lending was contingent on a wide variety of circumstances, including the timing of the arrival of the silver fleets and the performance of specific tax streams. The contracts also gave the king and his bankers several options for delaying repayment, or changing delivery locations and maturities. The clauses speak of a rich contracting environment. Both parties understood they lived under uncertainty, and tried to anticipate and price as many states of the world as possible. Defaults were nothing more than an extension of this uncertainty. Some shocks were large enough to be unanticipated or noncontractable. Examples include the opening up of two simultaneous war fronts, delay of several silver fleets in a row, or disastrous defeat of the Invincible Armada. Some of these events prompted an across-the-board rescheduling of outstanding debt. Bankers understood that these were one-off occurrences and that business would resume as usual as soon as the negative shocks had dissipated. Negotiations were thus swift, settlements were moderate, and lending resumed as soon as the Crown’s liquidity was restored. Philip’s defaults were hence excusable in the sense of the modern sovereign debt literature (Grossman and Van Huyck 1988).
Toward the end of Philip’s reign, primary surpluses were no longer sufficient to stabilize the debt-to-income ratio. By this relatively narrow standard, debts were no longer sustainable. This does not mean that Philip was insolvent; it merely implied the need for a fiscal adjustment. We calculate that the necessary changes were relatively small compared to the ones that had been carried out several times during his reign. Since four ducats out of five were spent on war, any reduction in the scale of the military effort could have quickly improved Philip’s fiscal position. The massive expenditure cuts and revenue measures implemented during the 1570s, for example, reduced the debt problem quickly. On average during Philip’s reign, higher debt levels had always been met with greater primary surpluses. Compared to other early modern European powers, Habsburg Spain conducted its finances in a highly responsible manner: it raised primary surpluses more in the face of mounting debts than England or France did at the height of their military ambitions. By this standard, sixteenth-century Spain was on a more solid financial footing than eighteenth-century England, often regarded as a paragon of fiscal virtue.
One key difference between England and Spain was military success on the battlefield. England frequently won; in contrast, Spain’s few victories failed to deliver major gains. The fog of war clouded Spain’s fiscal outlook, but it was not a reflection of military weakness as such; Philip II won glittering victories against France and the Ottoman Empire, for instance. The fact that victories did not translate into peace and defeats produced the need for further spending reflects the nature of great power politics at the time along with the severity of religious strife. None of the military outcomes is a fair judgment of financial probity. Spain could have easily coped with its fiscal situation had the Dutch War (or the Armada) gone slightly better.
We also argue that the long-run performance of Spain—typically interpreted through the lens of sixteenth-century fiscal turmoil—suffered more from an inability to strengthen state capacity than from financial ineptitude and serial defaults. All early modern monarchs faced the same basic problem: to outspend their military rivals required new, higher taxes. These were best collected with the consent of powerful magnates, cities, and the clergy—all to some extent “veto players” in the game of early modern politics. The absolutist strategy—as far as it existed—gradually hammered away at the ability of dispersed power holders to resist the monarch’s centralizing agenda. In contrast, some polities evolved a different strategy—one of compromise with the potential adversaries, allowing much higher taxes in exchange for power sharing. City-states had long pioneered such a bargain (Stasavage 2011); both the Dutch Republic and England (after 1688) found ways of combining strong state power with constraints on the executive (North and Weingast 1989).2
Such a grand bargain was never struck in early modern Spain. Why? We emphasize the political economy of the silver remittances. The king alone controlled silver revenue. It was not subject to oversight by the Cortes, the representative assembly of Castile. Time and again, when the king was under pressure to compromise, the Cortes offered bargains that would have increased its power in exchange for higher fiscal revenues for the king. In almost all cases, this came to naught. Philip II ultimately avoided compromise because American silver strengthened his hand. During one episode, a power-sharing and revenue-raising deal was almost implemented. The provisions for the millones tax allowed independent budget oversight of the royal finances by the Cortes. As the flood of American silver continued, the Crown gradually undermined the commission’s influence, co-opting key players and sidelining others. While this neutering of the budget commission meant that the same deal would not be on the table in the future, the king could afford not to care. Spain’s institutions did not gradually decline and degrade under hammer blows struck by bankruptcies and fiscal incompetence, as the serial default view would argue; instead, a resource windfall strengthened the executive at a crucial moment, when it would have been more beneficial for it to be constrained in the long run.
Our conclusions challenge two strands of scholarly literature. First, we find little evidence of financial folly. Rather than emphasizing animal spirits and crowd psychology, we argue that lending and defaults were not signs of bankers’ folly. This conclusion is based on a close analysis of the earliest and most famous case of serial default: the payment stops of Philip II. We show that lending to him actually made excellent economic sense. Occasional losses were more than compensated by rich pickings during the long periods when the king serviced his debts. Defaults were largely anticipated. Bankers de facto wrote insurance contracts that allowed the Crown to reduce payments in bad times, such as when military setbacks occurred. Despite all the hue and cry of bankers during the sixteenth-century crises, there was nothing irrational about either continued lending or the defaults of the Crown. In effect, at the dawn of sovereign borrowing, lenders and borrower evolved an effective system of risk sharing that offered attractive returns to the bankers, rapid access to funds for the Crown, and a quick as well as simple resolution mechanism in times of crisis.
The second strand of the literature that we challenge is the economic history version of Spain’s Black Legend—la leyenda negra. The term “Black Legend” refers to Protestant propaganda going back to the early 1500s that emphasized, exaggerated, and embellished willful cruelty along with lawless behavior by the conquistadores in the Americas and Spanish troops in the Net
herlands. While often containing a kernel of historical truth, it became a genre full of huge exaggerations—such as the caricature by Jean de Bry, a Dutch Calvinist, depicting a Spaniard feeding a murdered infant to his dogs. Challenged by historians a century ago, the Black Legend nowadays serves more as a case study in religious propaganda than as an organizing principle of historical analysis.3
The economic history version of the Black Legend emerged from a marriage of two narratives: a rich historical tradition analyzing the decline of Spain as an economic and military power from the seventeenth century onward, combined with new institutional analysis highlighting the unconstrained power of the monarch (and contrasting it unfavorably with England after the Glorious Revolution). Hamilton (1938, 170) famously emphasized “the abundant evidence that agriculture, industry and commerce declined sharply in the seventeenth century.” Later work by Jaime Vicens Vives (1959), Elliott (1961), and Kamen (1978) largely reinforced this conclusion.4
This research rests on a firm empirical foundation. And yet it also served as a basis for Spain’s Black Legend in economic history terms. With the rise of new institutional economics, Spain’s indisputable decline of the seventeenth century became increasingly seen as the just punishment for the country’s institutional weaknesses during its heyday. According to this view, imperial Spain was an absolutist monarchy that destroyed the country’s economic prospects as a result of poor institutions coupled with a blatant disregard for property rights and proper incentives. When comparing the performance of Spain with other European powers, Douglass North and Robert Paul Thomas (1973, 101) classify the country as an “also-ran,” and argue that “contrasting sets of property rights … on the one hand produced sustained growth in the Netherlands and England and on the other led to … stagnation and decline in the instance of Spain.”5 The executive, according to this view, was so strong that it could trample on ancient freedoms, ignore merchant interests, break contracts at will, and push through massive tax rises (Acemoglu, Johnson, and Robinson 2005). All this eventually crippled the Spanish economy.
Lending to the Borrower from Hell: Debt, Taxes, and Default in the Age of Philip II (The Princeton Economic History of the Western World) Page 33
