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Lending to the Borrower from Hell: Debt, Taxes and Default in the Age of Philip II

0 Comments 🕔23.Oct 2014

The famous and recurrent defaults of Habsburg Spain during the sixteenth and seventeenth centuries have typically been analyzed as the paradigm of an inefficient public financial system that led the Spanish superpower from global hegemony to political and economic decline. In Lending to the Borrower from Hell: Debt, Taxes and Default in the Age of Philip II, Mauricio Drelichman and Hans-Joachim Voth offer an alternative analysis of the finance of Philip II that challenges this traditional but widely disseminated interpretation. In their view, the system of government borrowing developed by Habsburg Spain was remarkably effective. Furthermore, they argue that its reconsideration provides interesting lessons that contribute to a better understanding of the origins and the nature of sovereign debts and defaults. In the context of the current financial and debt crisis, they even consider that the case of Philip II offers an alternative model for keeping economies safe in times of financial troubles.

As the authors observe in the prologue, the interesting fact of this story is that, even if Philip II defaulted four times during his reign (1556–1598), he never lost access to capital markets. Few years after defaults, the same bankers – particularly the Genoese ones – continued lending money to finance the military expenditures for the Spanish Monarchy. The main question issued in the study results from this initial contradiction: “How could Philip II borrow so much and default so often?” (p. 19). This question is obviously relevant in the context of the 2008 financial crisis, which exhibited the incapacity of political institutions to counteract the negative effects of sovereign debt crisis in an efficient way. Had the Castilian administration and its bankers resolved this problem four centuries ago? And in that case, what does it mean for our understanding of the finance of the Spanish empire and, more generally, about the nature of sovereign debt and default?

In order to solve and analyze the implications of this puzzle, the book is structured in eight chapters that can be summarized as follows: After a prologue that presents the subject and advances the main arguments, there are introductory chapters. The first chapter introduces the financial system of Castile in the light of early modern European warfare, while the second chapter continues with an overview of the Spanish Empire (political foundations, military expansion, and economic performance). The third chapter describes the political institutions and fiscal revenues. It focuses on the composite character of the Spanish institutions and on the fact that government borrowing was constrained (in essence, by the Kingdom Assembly, the Cortes). It then follows with the introduction of the two main series of data used for the study. The first one is based on secondary sources and consists on the reconstruction of yearly revenues of the Crown between 1555 and 1596. The second one relies on archival data compiled from the Archivo General de Simancas that provides a new series of 438 short-term loans (asientos) contracted by the Crown with lenders to finance its short-term debt (1566–1598). The book mainly pivots on this new database. The coding of the contractual clauses aims to assess the evolution of short-term borrowing under the reign of Philip II, as well as both the rates of return for lenders and costs of servicing such short-term debt.

The main arguments are developed in chapters 4 through 7. Each of them addresses one of the four key questions that the study aims to answer: Did the Crown have enough resources to service the debt? If that was the case, which incentives made the Crown pay back its lenders? Why did bankers continue to lend while the borrower recurrently ceased its payments? Finally, what was the nature of the defaults of the Crown and how can these be interpreted?

The core issue could be summarized as follows: in contrast with the traditional argument, the Crown was not insolvent. Philip II had enough revenues to pay back his lenders. In other words, Castile’s debt was sustainable. Compilation of revenues, expenditures, debt service, and stock of debt allows the authors to assess the health of Spanish public finance using the International Monetary Fund’s methodology. The results show that the difference between revenues and expenditures (without the cost of debt) produced a positive primary surplus that was enough to service the debt almost every year. This primary surplus was due to the sustained increase of the fiscal revenues and the arrivals of American silver. In this context, defaults were caused by liquidity crises but not by insolvency.

The fact that Philip II was able to pay back his debt does not mean that he was interested in doing so. The authors argue that the main incentive that made the Castile’s Crown to pay back bankers was based on reputation and market power matters. The Genoese bankers (who controlled more than two thirds of the short-term debt issued by the Crown) acted as a private coalition. As a consequence, their market power induced the King to repay them and, in times of crisis, to grant them acceptable conditions. Because he did not have any viable alternative, Philip II was forced to settle with the Genoese network to preserve his access to credit.

As far as bankers are concerned, what where the incentives for them to continue lending to the Crown? The book justifies this decision by the high rates of return that lenders enjoyed during “good times.” The calculation of cash flows indicates a particularly high gross rate of return when the Castilian administration paid them. The same type of estimation including the default impacts suggests that the rescheduling reduced the profitability, but that the majority of lenders continued to make money if they continued to invest ex post. High profitability in ordinary times was a kind of premium that compensated lower rates of return in case of non-payment. According to the authors, the evaluation of the net rate of return (including bankers’ cost of funds) does not alter this result.

The authors answer the fourth question through the explanation that the nature of the defaults of Habsburg Spain came from the peculiar form of the contracts, and especially, from their contingent character. Contractual clauses foresaw any kind of circumstances that provided the government the possibility to adjust reimbursement in function of its momentary payment capacity. From the authors’ perspective, defaults were part of this flexible practice. In the case of external shocks unforeseen in the contracts, default (followed by a quick settlement and moderate rescheduling) was a powerful method that gave the government the possibility of sharing the risks with the bankers. This practice prevented the disadvantages of the non-contingent sovereign debt. According to the authors, this is the main reason behind the success of Spanish borrowing.

In the last section, the book uses its prior findings in order to reconsider the main determinants of the economic Spanish decline of the seventeenth century. The authors reject the arguments of New Institutional Economics scholars who usually consider the lack of constraints on the government as the key factor that would have led Spain to imperial overstretch. In their opinion, the new data provided show that Spain’s fiscal and financial performances in the sixteenth century were equivalent or better than those of the successful Atlantic models of the eighteenth century such as England. Lack of state capacity would have been the main reason for Spanish decline. Due to major territorial heterogeneity and to the role of American silver, Spain would not have succeeded in unifying and centralizing its fiscal, legal, and political systems. Finally, unlucky military defeats would have worsened this tendency.

This ambitious monograph provides a powerful and well-structured narrative about the fascinating question of sovereign debt and default in historical perspective. It relies on impressive archival and bibliographical quantitative data, recent historiography, modern economic theory, and methodology. The reconsideration of fiscal performance, sovereign debt, and defaults during the reign of Philip II has great implications from the Spanish historiography’s point of view. Furthermore, it provides new insights for the current debates relative to the comparative history of economic institutions in pre-industrial Europe. In contrast with the New Institutional Economics pessimistic interpretation, the authors’ assertion about the efficiency of Castile’s government borrowing is convincing and very suggestive.

Nevertheless, the book is also characterized by some limitations and questionable positions. First, the fact that defaults of Philip II were much less catastrophic than the Spanish black legend has traditionally presented has been well known by Spanish historians since decades ago. In this sense, the main thesis could be seen as less innovative than it could initially appear. In addition, key arguments remain unproven. For instance, the interpretations of Philip’s defaults as illiquidity crises, the argument that lenders acted as a unified coalition and were not surprised by the Crown’s defaults, or the calculation of their net rate of return remain hypothetical. Even if the examination of contracts and the reconstruction of Castile’s revenues and expenditures represent a relevant contribution, it could remain insufficient to obtain conclusive results about the nature, causes, and implications of these defaults. The documentation of the Castile Council of Finance (Consejo de Hacienda) would have allowed for the contrast of quantitative data. In addition, the study is very affirmative about Habsburg Spain defaults, but the monograph is limited to only two of them (1575 and 1596). While the last chapter concludes with the seventeenth-century decline of the Spanish Empire, nothing is said about the defaults that occurred in that period (1607, 1627, 1642…). Finally, scholars could regret omission of the data of the asientos in an appendix, which could have been very useful for future research.

Notwithstanding these shortcomings, this innovative monograph substantially enriches our understanding of Castile’s government borrowing, as well as the nature of sovereign default in early modern Europe. And it will most certainly conquer a central place in the literature and future debates on public debt and finance from a historical perspective.

 Reviewed by Benoît Maréchaux, Carlos III University, Madrid

Lending to the Borrower from Hell: Debt, Taxes, and Default in the Age of Philip II
by Mauricio Drelichman and Hans-Joachim Voth
Princeton University Press
Hardcover / 328 pages / 2014
ISBN: 9781400848430

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