This paper examines the lending by Genoese-led cartel to Phillip II of Spain in the 16th century from the viewpoint of sovereign debt. The Genoese linked specie deliveries from Spain to the Low Countries to lending in order to cartel created a penalty to enforce their loans. If the king tried to renege, the Genoese applied the penalty and the king eventually repaid.
Sovereign lending, throughout history, has been marked by occurrences of partial default and repudiation by governments of all kind; from medieval princes to dictators to democratic regimes. In the 1970s lending to lesser-developed countries led to the rescheduling and partial defaults in the 1980s. Even the sustainability of the debt of nations such as Belgium, Canada, Italy and even the United States is not free from suspect.
The reign of Philip II of Spain provides a good example to extend our knowledge of sovereign lending. Philip II fought wars through out his reign. To finance fluctuations in military expenditures, he had to borrow extensively. Repeatedly, Philip II’s Genoese lenders had imposed debt ceilings on the Crown. Once after reaching the debt ceiling, the Genoese suspended lending. They further punished Spain by executing a penalty in order to force payment of loans; an embargo on specie delivered to Spain’s armies. The military consequence of the embargo was severe. “Spain was the predominant military power of the age, and Philip II was the last sovereign to credibly threaten to dominate Europe until Napoleon.(Kennedy p30)”. This played a significant role in testing Philip II’s aspirations in Europe and eventually caused Philip II to cede to the lenders.
Sovereign debt theories first must assume the premise that there is no third party enforcers and that lenders must be able to enforce claims on their own. In addition these theories use reputation arising through repeated interaction to generate equilibria. It is only then that lending agreements are made and self-enforcing. Bulow and Rogoff (1989b) show that no lending will occur if the only threat is to cut off future lending. This is because merely the threat to withdraw credit is not a severe enough penalty to prevent the Crown from repudiating his debt. Lenders would then anticipate this, and consequently, they do not lend.
There are two classes of models that elaborate on Bulow and Rogoff’s result and provide environments where repudiation does sustain positive debt. The class most important to us is that of Bulow and Rogoff (1989a) and Cole and Kehoe(1994). These models support positive debt and assume that sovereigns have access to alternate vehicles of savings and expenditure smoothing. In addition, it assumes that lenders can impose additional and more costly penalties than those narrowly pertaining to the loan agreement.
II. Military Finances During the Reign of Philip II
Revenues and expenditures
The revenues the Crown depended on to meet volatile and increasing military expenditures were also volatile and increasing. This created two financial needs: to anticipate increasing revenues in the future and to cover the differences between the fluctuating revenues and expenditures. In addition, the Crown needed to transfer specie from Castile to it’s troops outside of Spain. The Crown’s revenues belonged to 4 categories: 1) “ordinary rents,” which included excise taxes, customs duties, and revenues from royal monopolies; 2) “extraordinary rents,” which included monies who renewal required a vote from some other body, such as a church; 3) revenues from the American colonies; and 4) “extraordinary expedients” which were revenues that were derived from measures of seizure of merchants silver, the sale of offices ad the sale or resale of on lands the Crown may have claimed. The first two revenue sources came largely from within Castile and were stable and increasing though there were many parts of the empire that only paid taxes. In many regions the revenues provided were much less than expenditures on war and administration in that kingdom.
The Crown contracted international credit through the asiento, a high interest, and short-term debt instrument lent by a Genoese-led cartel. The asiento was a general term that described a variety of contracts all thrown into the same agreement: an unsecured short-term loan, a transfer of payment and a currency exchange agreement. For example, the Crown might contract in Madrid for a certain number of gold florins to be delivered abroad and the crown would pay the banker in Madrid. When the crown paid, it paid in silver reales. Note the coin that had been delivered. Finally, the Crown would not have to deliver payment for a number or months or even more than a year. Many asientos were contracted for the purpose of “rolling over” earlier asientos that had matured and that the Crown could not fully retire. This only increased debt since interest rates on asientos were anywhere from 8-22 percent, with 12 percent being typical
The four royal “bankruptcies” of 1557, 1560, 1575 and 1596 were similar in most ways. When the bankruptcies were settled quickly, as they were in 1560 and 1596, the Crown emerged with both it’s finances and military prospects improved. On the other hand, when the bankruptcies were settled slowly and acrimoniously as in 1575-1578, the king’s armies floundered from lack of funds (Parker 1985).
In a typical bankruptcy, the Genoese would initiate the bankruptcy by cutting the crown from new asientos and refusing to roll over expiring asientos. The Crown would respond by announcing a suspension of payments on asientos and all other accounts payable. The Crown and its creditors would then negotiate to resolve the suspension. Creditors would slow or halt new lending and international transfers of payment until terms were settled. During the shorter negotiations of 1560 and 1596, it is not clear whether a freeze was imposed or whether the expedition of asientos was slowed in the confusion of negotiations. However, from 1575-1578, the freeze on lending and transfers were forcefully imposed. The two freezes were separate measures. Thus, the freeze on transfers could have been eased even if the loans were denied, since the King could have paid up front for the transaction. However, both measures were imposed and as a result the Crown’s capacity to make war beyond its borders were seriously impaired until it reached an agreement with its lenders.
III. Theories of Sovereign Debt
Bulow and Rogoff (1989b)
Bulow and Rogoff demonstrate a “no-lending” result. They assume perfect information where the only penalty is that the lender will cut off future lending. Under this model, the sovereign can smooth fiscal shocks without the help of lenders through savings deposits. Deposits offer an expected return equal to the international interest rate and do not give negative payouts under uncertainty. Under these assumptions, the sovereign will choose to repudiate debt in the future: once it has borrowed it can either repay or use any portion of the funds it is supposed to repay with to buy a saving deposit. Because savings are just as good as loans in smoothing over fiscal shocks, the Crown will find itself choosing to divert funds and build up savings instead of paying down past loans. To avoid this, lenders impose a debt ceiling of zero and, hence, do not loan.
Bulow and Rogoff (1989a)
In a second model, Bulow and Rogoff assume perfect information. They assume that sovereigns can smooth against fiscal shocks and lenders can impose additional and costlier penalties beyond cutting the sovereign off from future credit. They show that: 1) positive debt is sustainable, 2) lenders will impose a positive debt ceiling on the sovereign, 3) the debt ceiling increases with the severity of the punishment it can impose and decreases with the real interest rate lenders can get from lending to someone else. This model incorporates the fact tat the credibility factor is two-sided: just as the sovereign can not commit to repaying ex ante, lenders can not commit to just walking away and implement an inefficient sanction if by renegotiating, they can salvage more value from the contract. That is, lenders may be tempted not to impose penalties if in return they received compensation greater than they would receive from implementing the penalty.
Cole and Kehoe (1994)
Cole and Kehoe, like Bulow and Rogoff (1989a), explore an additional penalty model under perfect information. In their model the sovereign and the lender both receive benefits by cooperating in a strategic, non-lending relationship such as exploitation of a common non-excludable resource. If the lender links cooperation in the non-lending relationship with repayment of loans it effectively creates a penalty to sustain positive lending.
IV. Genoese Penalty
Evidently, by their actions during the bankruptcy of 1575, the Genoese possessed the ability to halt transfers of payment used to pay the king’s army. The halted transfers of 1575-78, was indeed a penalty and not a result of the Genoese inability to clear letters of exchange. This is evident because even when the king’s fleet arrived, enabling the Crown to pay, the Genoese still did not execute transfers for the Crown but did so for other clients. Their boycott inflicted appreciable losses on the Crown. The best measurement of this is the actual outcome in military terms. The sacking of Antwerp in 1576 by Philip’s own troops was a military disaster. This only spurred the Dutch opponents to a more aggressive offense and interrupted commerce and taxing in the Spanish Netherlands. Shortly after this, the king moderated his demands and reinitiated negotiations with his creditors.
Evading the Penalty
A possible reaction for the Crown to the Genoese Embargo would have been to circumvent it by exchanging and transporting specie itself. A number of reasons made this impractical. Hostilities in France ruled out the most direct overland route. Bad relations with England meant that shipping specie over the English Channel would mean risking losses. The Genoese were able to do this without actually moving the physical currency great distances. Instead, they cleared letters of exchange in many regions.
Maintaining the Cartel
The Crown’s other option was to entice other financiers or even renegade members of the Genoese cartel to conduct transfers. In response, the Genoese provided had to provide their members strong enough incentives that they would not break the cartel. The most obvious penalty for breaching the cartel agreement was to be kicked out of the lending cartel. A banned lender would then lose access to information and the coordinated efforts that made the cartel so profitable in the first place. In the end, neither of the possible alternatives worked and the Crown repaid its lenders.
In this paper I examine the asiento debt contract between Philip II and the Genoese lenders. We see that the king tried to renege on his debt, and the Genoese imposed penalties to enforce their claims. The penalty imposed by the Genoese ultimately forced the king to repay. Using the information provided, I find the king’s observation of the debt ceiling and the estimated cost to the king of the Genoese penalty in line with that of Bulow and Rogoff (1989a). In a broader context, you can also see how the mechanics of fiscal commitments can influence war. There is the dilemma of the need to protect citizens and enforce contracts which compels the sovereign to finance the military. Yet the sovereign is tempted to violate the contract to raise revenues to meet the demands of military competition.
Atkeson, Andrew. “International Lending with Moral Hazard and Risk of Repudiation.” July 1991:1069-89
Bulow, Jeremy and Rogoff, Kenneth. “A Constant Recontracting Model of Sovereign Debt.” Journal of Political Economy 97 (February 1989): 155-78. (a)
Bulow, Jeremy and Rogoff, Kenneth. “Sovereign Debt: Is to Forgive or Forget.” American Economic Review 79 (March 1989): 43-50. (b)
Conklin, James. “Theory of Sovereign Debt and Spain under Philip II.” Journal of Political Economy, vol.106, 483-512.
Flynn, Dennis. “Fiscal Crisis and the Decline of Spain” Journal of Economic History, Vol 42, 1982, 139-147.
Hamilton, Earl. “Spanish Banking Schemes before 1700.” The Journal of Political Economy, Volume 57, April 1949, 134-156.
Kennedy, Paul. The Rise and Fall of the Great Powers: Economic Change and Military Conflict from 1500 to 2000. New York: Random House 1987
Parker, Geoffrey. The Army of Flanders and the Spanish Road, 1567-1659:The Logistics of Spanish Victory and Defeat in the Low Countries’ Wars. Cambridge: Cambridge Univ. Press, 1972.