the thery of soveriegn debt and spain underphilip

8/12/2019 The Thery of Soveriegn Debt and Spain UnderPhilip

1/32

The Theory of Sovereign Debt and Spain under Philip IIAuthor(s): James ConklinSource: Journal of Political Economy, Vol. 106, No. 3 (June 1998), pp. 483-513Published by: The University of Chicago PressStable URL: http://www.jstor.org/stable/10.1086/250019.

Accessed: 27/03/2014 06:05

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at.

http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of

content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms

of scholarship. For more information about JSTOR, please contact [email protected].

.

The University of Chicago Pressis collaborating with JSTOR to digitize, preserve and extend access toJournal

of Political Economy.

http://www.jstor.org

This content downloaded from 103.24.98.179 on Thu, 27 Mar 2014 06:05:12 AMAll use subject to JSTOR Terms and Conditions
http://www.jstor.org/action/showPublisher?publisherCode=ucpresshttp://www.jstor.org/stable/10.1086/250019?origin=JSTOR-pdfhttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/stable/10.1086/250019?origin=JSTOR-pdfhttp://www.jstor.org/action/showPublisher?publisherCode=ucpress


2/32

The Theory of Sovereign Debt and Spainunder Philip II

James Conklin

University of Texas

This paper examines lending by a Genoese-led cartel to Philip IIof Spain (155698) from the perspective of theory on sovereigndebt. Models in this literature suggest that the Genoese linked spe-cie deliveries from Spain to the Low Countries to lending in orderto create a penalty to enforce their loans. The king tried to renege,the Genoese applied the penalty, and the king ultimately repaid.When the episode is used to examine theory, the Crowns observeddebt ceiling and estimates of its cost of enduring the penalty andits ability to repay are in line with predictions of Bulow and Rogoff.The nature of the penalty has the flavor of Cole and Kehoesmodel; its observation on the path of play is suggestive of Atke-sons model.

I. Introduction

The history of sovereign lending over the last 500 years is markedby numerous episodes of partial default or repudiation by medievalprinces, absolute monarchs, dictators, and democratic regimes alike.More recently, the rapid expansion of lending to less developed

This paper evolved from dissertation research and was completed while I was avisiting fellow at the Banco de Espana. The Ministry of Culture of Spain and theMellon Foundation through the Institute of Latin American Studies of the Universityof Texas contributed funding. The staff of the Archivo General de Simancas pro-vided valuable assistance. I thank Scott Freeman, Ed Green, Avner Greif, PrestonMcAfee, Felipe Ruiz Martn, Thomas Sargent, Francois Velde, Ethan Watters, BarryWeingast, and two anonymous referees for valuable comments and discussions. Spe-cial thanks to Javier Daz Gimenez and Robert E. Hall, my dissertation advisor. Thestandard disclaimer applies.

[Journal of Political Economy, 1998, vol. 106, no. 3]1998 by The University of Chicago. All rights reserved. 0022-3808/98/0603-0002$02.50

483

This content downloaded from 103.24.98.179 on Thu, 27 Mar 2014 06:05:12 AMAll use subject toJSTOR Terms and Conditions
http://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/page/info/about/policies/terms.jsp


3/32

484 journal of political economy

countries in the 1970s led to a series of reschedulings and partialdefaults in the 1980s. Another expansion of international capital

flows to a more select group of less developed countries in the late1980s and early 1990s has created concern that similar consequencesmay arise again. The sustainability of the debt of nations such asBelgium, Canada, Italy, or even the United States is not beyond ques-tion. Risk of sovereign default is an enduring phenomenon, it ap-pears likely to remain, and it poses a major obstacle to the movementof capital across national borders and to the conduct of fiscal policy.

The reign of Philip II of Spain (155698) provides an unusuallygood episode for extending our knowledge about sovereign lending.

Philip II fought wars throughout his reign and borrowed extensivelyto finance fluctuations in military expenditures. Philip IIs Genoeselenders repeatedly imposed a debt ceiling on the Crown. Once afterthe Crown had reached its debt ceiling the Genoese suspended lend-ing and executed a penaltyan embargo on specie deliveries toSpains Army of Flandersin order to enforce payment on theirloans. The military consequences of this penalty were severe, andeventually Philip II capitulated to the lenders. Finally, data are avail-able from the episode that allow us to estimate the Crowns ability

to repay its creditors and to estimate a lower bound for the costof the Genoese penalty to the Crown. The episode also has specialhistorical significance: Spain was the predominant military power ofthe age, and Philip II was arguably the last sovereign to crediblythreaten to dominate Europe until Napoleon.1 Evidently, limitationson the Crowns ability to commit to repaying debt played a signifi-cant role in checking Philip IIs military ambitions in Europe.

Recent literature on sovereign debt shapes my account ofPhilip IIs reign.2 This literature begins with the premise that the

sovereign is subject to no third-party enforcer and that lenders mustbe able to enforce their claims against it on their own. Sovereigndebt theories use reputation arising through repeated interaction togenerate equilibria in which lending agreements are self-enforcing.These theories make various predictions about the level of sustain-able debt. Bulow and Rogoff (1989b) show that no lending will occurif the only threat that lenders possess is to cut off future loans in-definitely. The reason is that the threat to withdraw credit is notsevere enough to prevent the sovereign from repudiating its debt.

Lenders anticipate this, and consequently they do not lend in the1 Kennedy (1987, p. 30) states that after Philip II, the landscape of dynastic-military

competition would be one of political plurality in Europe, containing five or sixstates, and various smaller ones for the next two centuries.

2 The seminal article on international sovereign lending is by Eaton and Gersovitz(1981).



4/32

theory of sovereign debt 485

first place. Two broad classes of models elaborate on Bulow and Ro-goffs result, and they provide environments in which reputation

does sustain positive debt. The first class of models, which includesGrossman and Van Huyck (1988) and Atkeson (1991), assumes thatsovereigns have no alternative means to save or to smooth expendi-tures in the face of fiscal shocks, and consequently they depend ontheir lenders to smooth expenditures. This class of models showsthat positive lending can be supported and that lending agreementsmay exhibit state contingency if fiscal shocks are mutually observ-able. The second class of models that support positive debt assumesthat sovereigns do have access to alternative vehicles for savings and

expenditure smoothing, but it assumes that lenders can impose addi-tional and costlier penalties than those narrowly pertaining to theloan contract itself. My argument draws on models by Bulow andRogoff (1989a) and Cole and Kehoe (1994) within this class.

An important issue addressed by both classes of debt models iswhether or not penalties are observed along the path of play. Un-der perfect information, penalty strategies are never realized alongthe path of play. Lenders can anticipate whether a sovereign willrepudiate and, consequently, do not lend in the first place. Sover-

eigns that have received loans anticipate the severity of the penaltythat results from repudiation, and consequently, they choose to re-pay. On the other hand, models of imperfect information, such asthose by Abreu, Pearce, and Stacchetti (1986, 1990) and Atkeson(1991), can generate equilibria in which penalties are observedalong the path of play.

In my argument the relationship between theory and history runsin two directions. The first vein of the argument takes as given theresults of the sovereign debt literature and uses them to interpret a

historical episode. The second vein of the argument considers howwell events in the episode correspond to the assumptions and predic-tions of theory. Specifically, the arguments first vein posits that theGenoese linked international specie deliveries to lending in orderto create an additional penalty that would enable them to enforcerepayment. The Genoese imposed a debt ceiling on the Crown. Theking tried to renege and the Genoese applied the penalty. The Gen-oese penalty ultimately forced the king to repay. The debt ceilingimposed by the Genoese accounts for why the Crown swapped long-

term domestic debt for short-term international debt at the conclu-sion of its periodic bankruptcies. The arguments second vein positsthat various features of the episodespecifically the Crowns ob-served debt ceiling, estimates of the cost to the king of the Genoesepenalty, estimates of the kings ability to repay, the linking of otherfinancial services to lending in order to create a penalty, and the



5/32


observation of the Genoese penalty along the path of playare inline with the assumptions and predictions of the sovereign debt liter-

ature.In what follows, Section II gives a brief historical background andSection III reviews selected models of sovereign debt. Section IV de-scribes the circumstances that gave the Genoese a near-monopolyon providing the Crown international transfers of payment and de-scribes how they linked these services to lending agreements as anenforcement mechanism. Section V analyzes the Crowns debt ceil-ing and its relationship to estimates of the loss the Crown placed onthe Genoese penalty and estimates of the Crowns ability to repay

in light of the model of Bulow and Rogoff (1989a). Section VI con-siders two hypotheses that may account for the observed impositionof the Genoese penalty on the path of play. Section VII argues thatthe debt ceiling imposed by the Genoese accounts for why the Crownswapped long-term domestic debt for short-term international debtat the conclusion of its periodic bankruptcies. Section VII also de-scribes the credibility mechanism that backed the Crowns long-termdomestic debt. Section VIII concludes the paper.

II. Military Finance during the Reign of Philip II

Revenues and Expenditures

The revenues the Crown depended on to meet volatile and increas-ing military expenditures were also volatile and increasing. This cre-ated two financial necessities: to anticipate increasing revenues inthe future and to cover the difference between fluctuating revenuesand expenditures. In addition, the Crown needed to transfer specie

from Castile to its troops fighting outside of Spain. The Crownsrevenues belonged to four general categories: (1) ordinary rents,which included excise taxes, customs duties, revenues from royalmonopolies, pasturage fees, and the like; (2) extraordinary rents,which included monies whose renewal required a vote or permissionby some other body, such as the Church or the Cortes de Castilla,the representative assembly of the third estate; (3) revenues fromthe American colonies; and (4) extraordinary expedients, whichwere revenues derived from measures such as the seizure of mer-

chants silver, the sale of offices, and the sale or resale of lands onwhich the Crown may have had a claim. The first two revenuesources came largely from within Castile and were stable and increas-ing throughout the reign. Income from the Indies and extraordinaryexpedients were volatile and also grew during the period. ThoughPhilip IIs other European subjects in Italy, Portugal, and the Low



6/32


Fig. 1.Revenues and expenditures

Countries paid taxes, only Castile and the colonies in the Indies gen-erated enough surplus to provide revenues for war. Revenues pro-vided by Flanders, for example, were far less than expenditure onwar and administration in that kingdom.

Data on revenues and expenditure are presented in figures 1, 2,and 3. These and the other data that follow have been collectedfrom sources that vary from original archival documents to informedguesses by experts such as Modesto Ulloa.3 Many observations ap-pear in more than one archival source but are not consistent. When

it was not clear whether one source was more accurate than the oth-ers, I chose the intermediate figure. There are many missing observa-tions. For annual income and expenditure items with little volatility,I interpolated. Therefore, the data are not exact and should be inter-preted with caution. They do accurately capture major movementsand present a clear overall picture. Real quantities are shown in 1575ducats. Hamiltons (1934) price indices were used to deflate thedata. Though the sixteenth-century Spanish economy was famous

3 The sources are Archivo General de Simancas (CJH 36466, 5014), Hauser(1930), Hamilton (1934), Haring (1947), Carande (1949, 1990), Ruiz Martn (1965,1968, 1974, 1990), Braudel (1972), Lovett (1972, 1980, 1982), Parker (1972, 1985),Ulloa (1975, 1986), Thompson (1976, 1992, 1994a,1994b), Dominguez-Ortiz (1981,1983), Lynch (1981), Artola (1982), Flynn (1982), Barrett (1990), Homer and Sylla(1991), and Motomura (1994). A more extensive description of how the data wereconstructed can be found in Conklin and Daz Gimenez (1997).



7/32

Fig. 2.Breakdown of expenditures

Fig. 3.Breakdown of crown revenues



8/32


for its price revolution, the average annual inflation rate of justover 1 percent seems mild by todays standards.

Expenditure data appear in figure 1. They are net of interest pay-ments on foreign debt, but they include debt service on juros, thename given at that time to long-term domestic debt. Therefore, thelarge deficits before 1575 and 1596 are not later covered by surplusesbecause they were capitalized by juros that appear in the accountsas debt service. Figure 2 gives a breakdown of Crown expenditures.Nonmilitary expenses are fairly constant and trend upward onlyslightly faster than inflation. Nominal debt service on juros trendsupward rapidly over the reign; deflated debt service, shown in the

graph, has a mild upward trend. Military expenditures show thegreatest volatility and increase during the reign. The three spikesin the series on nonmilitary expenditures are figures reported byThompson (1976) and were apparently transitory.

Figure 3 shows the breakdown of sources of Crown revenues. Ordi-nary rents are smooth and grow steadily over the reign. The largemajority of these revenues were earmarked to fund juros. Revenuesfrom the colonies in the Indies were highly variable and increasedthroughout the reign. Extraordinary revenues include extraordi-

nary rents (monies voted by the Cortes de Castilla, the representativebody of the royal municipalities) and extraordinary expedients (arbi-trios,or arbitrary revenues from land sales, office sales, or the sei-zure of silver of private parties). Extraordinary revenues increasesharply in 1591 because of the tax of the millones,voted by the Cortesto offset the fiscal impact of the loss of the Armada (the tax soonbecame permanent).

Debt

The Crown contracted international credit through the asiento, ahigh-interest, short-term debt instrument lent by a Genoese-led car-tel. Asientos were actually lent by a number of lenders, among themSpanish men of commerce, Flemish financiers, Florentine mer-chants, and wealthy investors in Germany. However, because theGenoese were so prominent in the cartel, I refer to the entire lend-ing coalition as simply the Genoese. In sixteenth-century usage,asientowas a general term that described a variety of contracts, and

the Crown and its financiers would throw anything and everythingthey were contracting over into the same agreement: specie trans-fers, foreign exchange transactions, military procurement agree-ments, and loans could appear in the same legal document. Asientosbore little resemblance to any single modern financial instrument.The Crown typically owed creditors 34 million ducats in asientos



9/32


Fig. 4.Asientos and juros

or roughly one-half of a typical years total revenues. The figure roseon various occasions above one years revenues, once to more thantwo years revenues.

The asiento contracts the Crown struck with the Genoese gener-ally covered one or some combination of three specific transactions:an unsecured short-term loan, a transfer of payment, and a currencyexchange agreement. For example, the Crown might contract in Ma-drid for a certain number of gold florins to be delivered in Bruges,

and the Crown would pay the banker in Madrid. When the Crownpaid, it paid in silver reales, not the coin that had been deliveredabroad. Finally, the Crown would not have to deliver the agreedquantity of silver for a number of months or even more than a year.Agreements specifying payment on the arrival of the Indies fleetwere also common. Many asientos were contracted for the purposeof rolling over earlier asientos that had matured and that theCrown could not fully retire. Interest rates on asientos ranged from8 to 22 percent, with 12 percent being typical. Fees for exchange and

transfer ranged from 6 to 12 percent of principal. Data on principaloutstanding on asientos appear in figure 4.4

4 For more background on asientos, see Carande (1949, 1990), Ruiz Martn (1965,1990), Braudel (1972), Lovett (1972, 1980, 1982), and Ulloa (1986). Note that dataon principal outstanding are not available for the years between 1578 and 1596.



10/32


The Crowns long-term debts, or juros, were essentially annuities,though they came in a variety of types. Some were perpetual (juros

perpetuos), others perpetual though redeemable by the Crown at anyfuture date (juros al quitar), and still others were life annuities, expir-ing on the death of the holder (juros de por vida). Two classes ofjuros,juros de caucionand juros de resguardo,were created specificallyfor the purpose of providing collateral to Crown creditors. All typesof juros were funded by specific, regional tax sources, and their bear-ers had to collect the annual coupon of the bond at regional taxcollection stations. Juros were bearer certificates and were traded inan active secondary market. Almost all long-term holders of juros

were resident in Spain, though foreigners often found themselvesholding juros when the Crown could not pay its debts to them incurrency. This practice on the part of the Crown would have beenmore prejudicial to foreign financiers and merchants were it not forthe liquid secondary market in juros (Castillo-Pintado 1963).

The Bankruptcies

The four royal bankruptcies of 1557, 1560, 1575, and 1596 were

similar in most of their attributes.

5

When the bankruptcies weresettled quickly, as in 1560 and 1596, the Crown emerged with itsfinances and military prospects improved. When they were settledslowly and acrimoniously, as happened in the long negotiations of157578, the kings armies floundered for lack of funds (Lynch1981; Braudel 1984, p. 168; Parker 1985). Contrary to common per-ception, the Spanish Crowns bankruptcies were not wholesale repu-diations of obligations to creditors or signs of Crown insolvency.Rather, they were events in which different creditors reelaborated

and swapped claims on the Crown, apparently with the aim of solidi-fying their claims collectability in the future.6

In the typical bankruptcy, the Genoese would initiate the bank-ruptcy by cutting the Crown off from new asientos and refusing toroll over expiring asientos (Castillo-Pintado 1973; Lovett 1980). The

5 For the bankruptcies of 1557 and 1560, see Ruiz Martn (1965) and Ulloa (1986).For the bankruptcy of 1575, see Parker (1978), Lovett (1980, 1982), Braudel (1984),Ulloa (1986), and Ruiz Martn (1990); for the bankruptcy of 1596, see Castillo-Pintado (1973) and Ulloa (1986). The bankruptcies provide important evidence

on Crown-Genoese lending; however, this paper does not purport to offer a full ex-planation of them.

6 Thompson (1994b, p. 160) states that Conventionally, the series of Crownbankruptcies . . . have been taken as an indicator of . . . fiscal crisis. However [their]periodicity suggests that, rather than manifestations of crisis, these were an integralpart of the financial system of the Monarchy. These events . . . were a reschedulingof debts, but they did not mean the Crown was without resources.



11/32


Crown would then announce a suspension of payment on asientosand other accounts payable in arrears. This was known as thedecreto.

Payments on juros were not suspended.

7

The Crown and its creditorswould then negotiate to resolve the suspension. Creditors wouldslow or halt new lending and international transfers of payment untilterms were settled. During the shorter negotiations of 1560 and1596, it is not clear whether a freeze was imposed or whether in theconfusion of negotiations the expedition of asientos was slowed. Itis abundantly clear, however, that freezes on lending and on trans-fers were forcefully imposed from 1575 to 1578. The two freezes wereseparate measures: the freeze on transfers could have been eased

even as new loans were denied, since the king could have simplypaid silver up front for new transfers. However, both measures wereimposed, with the consequence that the Crowns capacity to makewar beyond its borders was seriously impaired until it reached anagreement with its lenders.

The agreements that concluded the negotiations, calledmedios ge-nerales,made the following stipulations: (1) Lenders of asientos mustbe repaid mainly with juros and the rest in specie. (2) Lenders mustaccept a write-down on principal. The write-down might be implicit,

in that the juros the lenders accepted paid low interest and tradedbelow face value in secondary markets. The write-down also mightbe negotiated explicitly. (3) The lenders must end the freeze onfinancial services; in particular, they must resume transfers of pay-ments to the kings troops abroad. Simultaneously the king wouldnegotiate an increase in taxes to fund the new juros with the Cortes,the representative body of the towns and villages under royal juris-diction (Actas de las Cortes de Castilla, vols. 3741). Despite the fre-quency, and on the one occasion the acrimony, of the Crowns bank-

ruptcies, the Crown repaid its asiento creditors to the extent thateach bankruptcy was settled to the satisfaction of the Genoese: theyresumed financial services immediately afterward and made high expost positive returns on lending to the Crown relative to their otheropportunities.8

The bankruptcy of September 1, 1575, was different from the oth-ers of Philip IIs reign and illuminates much about the incentivemechanisms the Genoese exploited to enforce their contracts withthe Crown. In contrast to other bankruptcies, in 1575 when the Gen-

7 The fact that payments on juros were not suspended suggests that juros andasientos were backed by different commitment mechanisms. This thesis is pursuedin Conklin (1996) and is summarized below.

8 Braudel (1984, p. 167) shows deposit rates in Genoa in the 1.54 percent range.Conklin (1994, pp. 2124) estimates ex post real rates of returns of Genoese lendingto the Crown of Spain to be 814 percent. See also Homer and Sylla (1991).



12/32


oese cut off new lending, the Crown resisted their demands andbroke off negotiations. The Genoese imposed an embargo on all

currency transfers and letters of exchange between the Crown andits agents and troops in the Low Countries. At this moment theCrown was engaged in a major campaign against Dutch rebels. Thestandoff had lasted over a year when in November 1576 the troopsof the kings own Army of Flanders mutinied and sacked Antwerpbecause they had not been paid. This was a grave military setbackfor Philip. Shortly afterward the king resumed negotiations with theGenoese. An agreement-in-principle was reached in 1577, and in1578 the Crown paid off its arrears in asientos with a combination

of specie and newly issued juros. The Genoese ended their embargoon transfers of payment to the Crowns troops and agents abroad.A more extensive discussion of the bankruptcy of 1575 appears inthe Appendix.

III. Theory on Sovereign Debt

Bulow and Rogoff (1989b)

Bulow and Rogoff (1989b) demonstrate a no-lending result. Theyassume perfect information, they assume that the sovereign is sub-ject to exogenous fiscal shocks, and they assume that the only threatlenders possess is to cut off future lending. The critical feature oftheir model is that the sovereign can smooth fiscal shocks withoutthe help of lenders through contingent savings deposits. Depositsoffer an expected return equal to the international interest rate, r,and do not give negative payouts under any realization of uncer-tainty. Under these assumptions the sovereign will inevitably chooseto repudiate debt in the future: once it has borrowed, it can either

repay or use any portion of funds it is scheduled to repay to buya contingent savings deposit. Because savings are just as good forsmoothing fiscal shocks as loans, the sovereign will inevitably finditself in a situation in which it is best to divert funds to build upsavings instead of to pay down past loans. Lenders impose a debtceiling of zero to avoid this and, hence, do not lend.

Bulow and Rogoff (1989a)

In a second model, Bulow and Rogoff (1989a) assume perfect infor-mation, they assume that sovereigns can smooth against shocks, andthey assume that lenders can impose additional and costlier penal-ties beyond cutting the sovereign off from credit in the future. Fromthese assumptions they show that (1) positive debt is sustainable,



13/32


(2) lenders will impose a (positive) debt ceiling on the sovereign,(3) this ceiling may be well below the present value of debt service

payments the sovereign can feasibly make, and (4) the debt ceilingincreases with the severity of the punishment lenders can imposeand decreases with the real interest rate lenders can get from lend-ing to somebody else. The model incorporates the fact that the credi-bility problem in sovereign lending is two-sided: just as the sovereigncannot commit to repaying ex ante, lenders cannot commit to walk-ing away from the table and implement an inefficient sanction ifby renegotiating they can salvage more value from the contract. Thatis, ex post, lenders may be tempted into not carrying out sanctions

in return for compensation greater than they would receive imple-menting the punishment, but less than the full value of paymentsinitially contracted. Consequently, lenders do not lend so much asto put themselves in such a situation.

Cole and Kehoe (1994)

Cole and Kehoe (1994), like Bulow and Rogoff (1989a), explore anadditional penalty model under perfect information. In their model

the sovereign and the lender both receive benefits by cooperatingin a strategic, nonlending relationship, such as the exploitation ofa common, nonexcludable resource. If the lender links cooperationin the nonlending relationship to the repayment of loans, it effec-tively creates a penalty to sustain positive lending. Were the sover-eign borrower not to repay in good faith, the lender would cease toplay the cooperative strategy in the nonlending relationship. Theloss associated with the linked-strategy penalty is the present valueof cooperation versus defection in the nonlending relationship. On

positive-debt equilibrium paths, debt does not rise above the presentvalue of cooperation, the sovereign repays, and both players cooper-ate in the nonlending relationship.

Grossman and Van Huyck (1988)

Grossman and Van Huyck (1988) assume perfect information, andthey assume that the sovereign cannot smooth fiscal shocks withoutthe help of lenders. They derive positive lending equilibria in which

repayments are state-contingent. In the state-contingent equilibria,lending serves to insure the sovereign against adverse shocks inthe sense that access to lending allows it to smooth expenditures. Forexample, if the sovereign experiences a bad shock, its equilibriumrepayment is smaller in that period. If it receives a favorable shock,its repayment is higher in that period. The authors interpret many



14/32


observed partial defaults or debt reschedulings as manifestations ofsuch equilibria being played.9 So while reduced payments (in prac-

tice observed as partial defaults) occur on the equilibrium path, theyare not violations of the true, or implicit, agreement between sov-ereigns and lenders and do not elicit the implementation of a pen-alty by lenders.

Atkeson (1991)

Atkeson (1991) considers an environment similar to that of Gross-man and Van Huyck; however, he assumes asymmetric information

between the sovereign and the lenders: the latter are not able tomonitor whether the government consumes or invests the proceedsof a loan. Moral hazard prevents lenders from offering full insurancebecause it would diminish the sovereigns incentive to invest the pro-ceeds of the loan. Atkesons model shows that under the optimallending contract, in the worst possible state of nature (e.g., lowestrealizations of output), a capital flow from the borrowing country tothe lenders occurs. The reverse capital flow equilibrium in Atkesonsmodel is like equilibria in Abreu et al. (1986, 1990). They show that

in cartels, in the presence of moral hazard, punishment phasesoccur on the equilibrium path. For example, a bad outcome (lowprice) can occur either because of a low realization of a randomprocess or because some player cheated. In the random process,even if no one ever cheats, bad outcomes can still occur. A bad out-come always invokes a punishment phase: players cannot observewhether anyone has cheated. Consequently, all players participatein meting out the collective punishment in order to preserve incen-tives not to cheat in the future. The reverse capital flows of Atkesons

model have this character: low output could be due to the sover-eigns consumption of loans intended for investment or to a badshock. Because of asymmetric information the lender cannot deter-mine the cause of low output. Consequently, the optimal contractspecifies a punishment phase whenever low output occurs.

IV. The Genoese Penalty

Evidently, by their actions during the bankruptcy of 1575, the Geno-

ese possessed the ability to halt transfers of payment used to pay andprovision the kings army in Flanders. The halted transfers of 1575

9 (1) Defaults are associated with identifiably bad states of the world. (2) Defaultsare usually partial rather than complete. (3) Sovereign states often are able to bor-row again soon after default (Grossman and Van Huyck 1988, p. 1088).



15/32


78, however, do not necessarily constitute incontrovertible evidencethat the Genoese played an equilibrium resembling that of lend-

ers in the class of debt models that assume lenders have additionalpenalties. In light of the large sums owed to them by a Crown sus-pending payment, the Genoese may have been simply unable toclear letters of exchange on European bourses. However, this wasnot the case. The Genoese remained active during the bankruptcyand cleared letters of exchange on behalf of other clients (Ehren-berg 1928, p. 120; Ruiz Martn 1990, p. 28). Moreover, throughoutPhilips reign, the Indies fleet arrived every year with silver worthroughly one-quarter of annual expenditures. The fleet arrived dur-

ing bankruptcy negotiations as well, enabling the Crown to pay upfront for letters of exchange. Still, the Genoese did not executetransfers. Their boycott on transfers inflicted appreciable losses onthe Crown. One measure of this magnitude is the Crowns annualexpenditure in Flanders, estimated at 2 million ducats a year(Thompson 1976, p. 268). At roughly one-fourth of the annual royalbudget, this figure reveals that the Crown had a strong desire to fightthere. If the Crown received some consumer surplus in its militaryexpenditures, its utility loss due to not being able to fight in Flanders

would be even higher. A second measure of the Crowns loss fromthe Genoese embargo is the actual outcome in military terms. Thesacking of Antwerp in November 1576 by Philips own troops was amilitary disaster. Though it was not uncommon for sovereigns of theperiod to owe their soldiers arrears of as much as two or even threeyears (the kings Dutch opponents also owed arrears to troops), itwas critical to make regular and periodic partial payments so thattroops could eat (McNeill 1982).10 The mutiny spurred the kingsDutch opponents to a more aggressive offense and interrupted com-

merce and tax revenues in the heart of the Spanish Netherlands.Shortly after the king ascertained the extent of the deteriorationof his military position, he moderated his demands and reinitiatednegotiations with his creditors.

Circumventing the Penalty

A possible reaction by the Crown to the Genoese embargo wouldhave been to circumvent it by exchanging and transporting specie

itself. A number of factors made this option impractical, however.Hostilities with France ruled out the most direct overland route to

10Just as lenders rendered their agreements with sovereigns self-enforcing, so didthe mercenary troops. If a sovereign reneged on its obligations beyond a certain,tolerated degree, troops mutinied.



16/32


Flanders. Poor relations with England meant that Spain risked losingany specie it tried to ship through the English Channel.11 Finally,

the costs and risks of shipping silver specie along the Spanish Road,an overland route from northern Italy to the Low Countries runningthrough nonhostile principalities, were deemed to be too great aswell.12 The Crown could simply not deliver the necessary amountsof silver specie to Flanders on its own behalf. International financierswere able to make the transfer because they could exploit net flowsof international payments to clear letters of exchange between theLow Countries, Spain, and Italy, for the most part avoiding physicaltransport of specie altogether. In those cases in which the interna-

tional balance of payments required financiers to transport gold be-tween bourses (at a large profit, generally), it was standard practiceto reinsure the specie shipped.13 The Crown apparently did not seekto reinsure large-quantity shipments of specie through the channelin 1575. While I have found no direct evidence, the Genoese mayhave been able to extend their boycott on the Crown to reinsurance.

Maintaining the Cartel

The Crowns other potential option to get around the embargo wasto entice other financiers or even renegade members of the Genoesecartel to conduct transfers on its behalf. The Genoese, in response,had to provide their coalition members with incentives strongenough to prevent them from going over to the side of the Crown.The problem of preventing coalition defections is well known ingame theory. In order for a coalition to credibly impose a penalty,no member may gain more by defecting than by participating inimposing the penalty. This would imply that the Genoese had to

have intracoalition promises and penalties.

14

The obvious measurefor the Genoese was to kick a defector out of the lending cartel in

11 During the bankruptcy of 1575, the Crown sent 800,000 ducats of bullion toLaredo, a port on Spains northern coast, to be shipped to Flanders through theEnglish Channel. Crown officials responsible for the transfer ultimately shipped lessthan half of it, determining that the risks of weather and seizure by the English weretoo great (Lovett 1982, p. 4).

12 In the late sixteenth and early seventeenth centuries the Spanish Road was ofenormous strategic importance to Spain, since it was the principal and often theonly route by which Spain could move Spanish and Italian troops and Albanian

mercenaries to Flanders. See Parker (1972) for a history.13 Lovett (1982, p. 15) recounts an incident in which Elizabeth of England seized

a number of pay ships in 1569. The ships were contracted through the Genoese, whoreceived 120,000 ducats in compensation for the loss thanks to their reinsurance.

14 See Greif (1989, 1993, 1994), Greif, Milgrom, and Weingast (1994), and Wein-gast (1995) for strategic analyses of these issues in the context of Europe in theMiddle Ages.



17/32


the future. A banned lender would lose access to information andcoordinated efforts that made the operations of the Genoese so

profitable in the first place (Ruiz Martn 1990, pp. 41, 1023). Lossof citizenship and other rights within Genoa might have been a pos-sible threat as well. During the bankruptcy of 1575, the Fuggers15

came to the Crown with an offer to exchange and ship currency toFlanders in return for being exempted from the bankruptcy decree,an offer the Crown was quite willing to accept (Lovett 1982, p. 4; RuizMartn 1990, pp. 1819). Nevertheless, the Fuggers were unable todeliver the quantities of specie that the Crown needed: during theearly 1570s, payments from Castile to Flanders averaged over 2 mil-

lion ducats a year; transfers by the Fuggers amounted to just 1 mil-lion ducats over the entire three years of the bankruptcy (Ulloa 1986,p. 795).16 In no small part, this failure was due to countermeasuresand harassment by the Genoese and their agents. The Genoese pre-vailed by 1578, and in the end, the Fuggers were not exempted fromthe suspension decree. Just as with the Fuggers, any single defectorfrom the cartel would not be able to deliver on the scale of the coali-tion as a whole and would not be successful in striking and executingcontracts with the king.

In summary, during the bankruptcies of 1557, 1560, and 1596, theCrown accepted the need to negotiate with the Genoese in goodfaith and settled its arrears quickly. In 1575, it attempted to repudi-ate its debt and in the course of this action tried, in two ways, tocircumvent the Genoese penalty, first by shipping specie itself andsecond by attempting to lure defectors from the Genoese-led coali-tion to make transfers on its behalf. Neither measure succeeded, andthe Crown repaid its lenders.

The Monopoly on Specie Transfer

The Genoese-led cartels dominance in the clearing of bills of ex-change and large-scale specie transfer was a critical element in thesuccess of the embargo. The advantages of the Genoese in this busi-ness included an extensive network of depositors throughout Eu-rope; the capacity to integrate lending, specie exchange, trade, and

15 The Fuggers were an important family of bankers that lived in southern Ger-many. They were the principal lenders to Philips father, Charles V.

16 Ehrenberg (1928) also reports on these efforts by the Fuggers: Direct bill trans-actions between Spain and Antwerp were now [by the late sixteenth century] abso-lute; but the Fugger were very nervous about using the new markets, especially theGenoese bill fairs, but also Lisbon, Lyons and Florence. This nervousness arosefrom the hostility of the Genoese toward competitors breaking the boycott. More-over, their action roused the other creditors against the Fugger, so that they triedto do them at Court all the harm they could (pp. 12526).



18/32


insurance services; and a strong presence in the great fairs and ex-changes throughout the Mediterranean and Western Europe (Ruiz

Martn 1990, pp. 82105). Through these resources, the Genoesewere able to capture increasing returns to scale in internationalfinancial services. More decisive, however, was Genoas geographicproximity to Venice, which allowed its financiers to clear a three-way market in spices and luxury goods, silver, and gold. Specifi-cally, spices and luxury goods originated in the Far East and werepaid for in silver by northern Italian merchants. The luxury goodstraded to northern Europe were ultimately paid for in gold coin,leaving traders and, by extension, their agents in the Low Countries

long in gold and short in silver. The Spanish Crown had a longposition in silver (received from its American colonies) and a shortposition in gold (needed to pay troops in Flanders). The Genoesecleared the traders long position in gold for the Crowns short posi-tion in gold via letters of exchange: traders would receive deliveryof silver in Seville, Medina del Campo, or Madrid. On the other sideof the transaction, the Crown received gold in the Low Countriesand delivered silver to Seville, Madrid, or Medina del Campo(Braudel 1984; Ruiz Martn 1990).

The Portuguese would seem natural competitors to the Genoesein clearing international balances of payments because they hadcheaper transportation to the Far East than the Venetians. However,precisely during this time period (15501625) the Portuguese lostmilitary and political control over the hinterlands of their Persianand Indian factories (fortified trading posts). The Venetians, thoughthey had higher transportation costs with their overland routes, didmore business than the Portuguese because they had better relationswith local political powers (Boyajian 1983, introduction; Braudel

1984, p. 170). The situation favoring Venice reversed to favor thePortuguese by the 1620s. Not surprisingly, the Genoese suffered un-usually large write-downs in the bankruptcy of 1627 and afterwardwere replaced by New Christian financiers of Lisbon as the principallenders to Philip IV. By 1627, the Genoese threat to prevent the kingfrom transferring funds to provision troops was no longer sustain-able.

A Broader Consideration of the Genoese Penalty

It is not obvious why, given the near-monopoly position in interna-tional transfers of payments the Genoese enjoyed, they would wantto lend to the Crown of Spain. If they could extract the Crownsconsumer surplus from warring in the Netherlands by providingtransfers of payment, it would not be in their interest to lend and



19/32


bear the risk lending entailed. The position of the Genoese is similarto that of modern-day banks that lend to less developed countries

and link the repayment of long-term loans to the provision of short-term trade credits. In both cases, lenders anticipate that by lendingto the sovereign they will earn greater profits than by just providingthe linked transaction service. In the case of the Genoese and theCrown, this can be seen in the volatility in both military expendituresand Crown revenues. The surplus to be won from the Crown forfinancing the short-term gap between military expenditures and rev-enues was appreciable. The Genoese would not have been able tosoak all the surplus out of the Crown through transactions services

only. The question, of course, is whether the Genoese could lendto the Crown and make the Crown repay; there is little surplus tobe won from a Crown that repudiates.

The model of Cole and Kehoe (1994) addresses this issue. Boththe Crown and the Genoese benefited from international transfersof payment, the Genoese benefiting from their profits and theCrown benefiting from the transfers to its foreign armies. As in equi-libria arising in Cole and Kehoes model, the Genoese linked trans-actions servicesinternational transfers of paymentwith lending

to create a penalty.Philip IIs father, Charles V, used the Fuggers of southern Ger-many as his principal bankers. Their sway and political importancein that region were important to Charles because he was Holy Ro-man Emperor.17 Philip II, who did not inherit his fathers Austrianpossessions or the Holy Roman imperial title, quickly came to em-ploy the Genoese as his principal financiers. The Low Countrieswere of far greater importance during his reign, and the Genoesehad a heavy commercial and financial presence in that region.

Within a year of Philips accession, the Fuggers found that the Geno-ese claims on the Crown received a much higher priority than theirown. In 1563 the Fuggers were still trying to collect claims from be-fore the bankruptcy of 1557. Philip II did not receive surplus fromthe other services the Fuggers could provide to the same degree hisfather did, and the loss of cooperation of the Fuggers in the HolyRoman Empire no longer concerned him as much.18

17 Charles borrowed from the Fuggers 530,000 of the 850,000 florins he used tobribe the Electors for the title of emperor. Such was the simplicity of politics in that

time that the bribe won Charles unanimous election in 1519.18 The strategic usefulness of the Fuggers is a complex issue that goes deeper than

the fact that Philip II was not Holy Roman Emperor but his father was. The Fuggerswere no longer the dominant banking group that they had been in the first half ofthe century. Much of the wealth that the Fuggers invested in royal loans came fromsilver mines. These mines became decidedly less profitable with the rapid increasein Indies silver production in the 1550s (see Ehrenberg 1928).



20/32


V. The Debt Ceiling

The model of Bulow and Rogoff (1989a) predicts that lenders will

impose a debt ceiling on the sovereign, that the sovereigns debtceiling will be below the present value of debt service payments itcan feasibly make, and that the debt ceiling will be below, possiblysignificantly below, the present value of the loss of enduring thelenders penalty. To determine whether a debt ceiling due to acredibility constraint was binding as predicted by Bulow and Ro-goffs model, I document the actual level of the debt ceiling theGenoese imposed on the Crown. I estimate lower bounds on theCrowns ability to repay and its loss due to the Genoese penalty. I

compare these estimates to the Crowns actual debt ceiling.

The Crowns Actual Debt Ceiling

Determining a sovereigns actual debt ceiling has two complexities.First, from theory, a debt ceiling may change over time accordingto fluctuations in the real interest rate available to lenders on otherinvestments and variations in the factors governing the severity ofthe lenders penalty. Second, theory does not identify how to distin-

guish whether a maximum level of indebtedness represents a sover-eigns hitting its ceiling or simply a coincidental peak unrelated tothe ceiling. Fortunately, circumstances in the Spanish episode allowus to identify the Crowns actual debt ceiling. The Genoese initiatedeach bankruptcy by withholding further lending to the king: Lovett(1982, p. 1) states that the bankruptcy of 1575 took place becausethe bankers refused to advance any more money, and the king re-sumed for his own use the revenues assigned to pay royal debts.The same was the case in 1596 (Castillo-Pintado 1973). Lovett also

documents that Philip IIs own advisors were confounded by the abil-ity of the Genoese to anticipate decrees of suspension of paymentbetter than they themselves, an easy forecast for the Genoese tomake given that they initiated the decree by refusing to lend more(Lovett 1980, p. 909). Therefore, I identify the Crowns debt ceilingby the quantity of arrears in asientos not backed by collateral on theeve of each bankruptcy. Figure 4 shows the total principal owed onasientos in 155577 by a dotted line. The circle point in 1575 rep-resents the total principal of asientos less the value of the juros de

resguardo given as collateral by the Crown.19 The circle points in

19Juros de resguardowere granted to the Genoese as backing for asientos in theyears between 1562 and 1575. The Genoese were allowed to sell this juro (and hencerecover their capital) on the condition that once the Crown repaid the asiento, thebanker had to produce and return a juro of equal value. See the Appendix.



21/32


TABLE 1

Present Value of Indies Revenues up to1660 (in Millions of Ducats)

Discount Rate 1550 1575 1600

2% 54.3 67.2 40.55% 20.8 37.2 22.810% 8.5 20.1 11.4

1560, 1575, and 1596 show the value of the principal outstandingin asientos on the eve of these respective bankruptcies. The graph

shows that uncollateralized arrears on asientos fell in the range of79 million ducats on the eves of the bankruptcies. I interpret thisrange to indicate the Crowns effective debt ceiling.

The Present Value of Revenues Availablefor Servicing Asientos

The Crowns total fiscal liabilities included many obligations besidesasientos; therefore, the present value of all revenues would yield an

upper bound on a ceiling for all liabilities, not asientos alone. Nearlyall of the Crowns Indies income was paid over to the Genoese-ledcartel to service the asientos (Ulloa 1986, pp. 77487). Moreover,many debts in asientos were paid back not through Indies silver, butby juros backed by taxes within Castile. Therefore, the net presentvalue of Indies revenues constitutes a conservative lower bound fora debt ceiling based on revenues available to service asientos. TheCrowns share of Indies silver appears in figure 3. Table 1 shows thenet present value of these revenues up to 1660 at various discount

rates. I choose 1660 as the terminal date for the present values be-cause after the Treaty of the Pyrenees in 1659 Spain was no longera military power of significance in Europe and ceased contractingasientos in large amounts. While a Genoese banker or Spanish sover-eign would not have known when the endgame was, this exerciseapproximates the expected present value of revenues available topay asientos using the ex post realization as the expected value ofthe terminal period of play. In 1575, at a 5 percent discount rate,the present value of Indies revenues for the next 85 years was over

37 million ducats.

The Present Value of Enduring the Genoese Penalty

I construct an estimate of the present value of the Genoese penaltyby assuming that the Crown valued waging war, or wars expected



22/32


TABLE 2

Military Expenditures in Flanders,Various Years

Expenditure(in Millions Deflated

Year of Ducats) Expenditure

1566 .48 .481577 .9 .861588 2.73 2.441594 4.1 3.241598 3.45 2.361608 2 1.351621 3.1 2.17

TABLE 3

Debt Ceiling Compared to Different Present Values(in Millions of Ducats)

Present ValueObserved of Indies

Debt Discount Revenues Present ValueYear Ceiling Rate in 1575 of the Penalty*

1560 9.2 2% 67.2 81.081575 8.5 5% 37.2 41.151596 7.9 10% 20.1 21.98

* Estimated as military expenditures of 2 millions of ducats a year.

outcome, at least as much as the resources it spent on war. Underthis assumption the present value of military expenditures in theLow Countries yields a conservative estimate of the loss of not being

able to wage war in Flanders. Though exact data do not exist for allyears, Thompson (1976) provides accurate figures for selected years,shown in table 2. Over the seven years in this sample, the Crownsreal military expenditure in Flanders averaged just over 2 millionducats a year. Exceptionally low expenditure levels occurred in 1566,in 1577 during the Genoese embargo, and in 1608, on the eve ofthe 12-year truce. This makes the estimate conservative. Table 3 pre-sents the present value of expenditure streams of 2 million ducatsat various interest rates at an 80-year horizon. At a discount rate of

5 percent, the present value of the Genoese penalty would be justover 40 million ducats.Reviewing table 3, the Crowns observed debt ceiling (79 million

ducats), the estimated present value of revenues available to repayasientos (2067 million ducats), and the present value of enduringthe Genoese penalty (2281 million ducats), one sees that the ob-



23/32


served debt ceiling lies well below these other estimated limits. Thesefigures are in line with the predictions of Bulow and Rogoff (1989a).

VI. Why We Observe the Penalty

The models of Cole and Kehoe (1994) and Bulow and Rogoff(1989a) account for many features of the Genoese penalty and theassociated debt ceiling that backed asientos. Because they assumeperfect information, however, these models do not account for theobservation of the penalty along the path of play. Two factors mayaccount for the penaltys observed implementation. The first is infor-

mation: in models of imperfect information such as Atkeson (1991),penalties take place along the path of play. In late sixteenth-centuryEurope, imperfect information is a plausible assumption: communi-cation and transportation conditions were slow, unreliable, and sen-sitive to geography, changes in the weather, and political circum-stances. Because of these factors, the Crown could not verify theimplementability of the Genoese penalty or its own ability to circum-vent their embargo. The Crowns attempt at repudiation was a wagerthat the penalty would not hold up or, more formally, a wager on

the action space of the game (incomplete information).The second factor accounting for the penaltys observed imple-mentation was that its effectiveness hinged critically on the fact thatthe Crown was fighting an ongoing war in Flanders: were the kingto have won in Flanders, the Genoese penalty would suddenly havebecome less harmful. The Genoese needed to lend in a fashion suchthat the moment victory came, the kings debts to them would benegligible. On the eve of the 1575 bankruptcy, Philips military gov-ernor, the Duke of Alva, had achieved a string of military successes

and appeared to be on the verge of victory. This posed a problemfor the Genoese, since their claims against the king not covered bycollateral were in the neighborhood of 7 million ducats, about oneyears revenues for the Crown. While there is no direct evidence,the logic of sovereign debt theory suggests that the Genoese hadample motive to undo Philip in Flanders for fear he might not repaythem once he had won.20 Stated more formally, the severity of thepunishment by the Genoese was endogenous to the state of comple-tion of the project the Crown was borrowing to finance. Simulta-

neously, the state of completion of the Crowns project dependedon whether the Genoese exercised their penalty. As the Crownneared peace (through either defeat or victory), the Genoese pen-

20 Ruiz Martn (1990, p. 12) hints that the Genoese may have had a hand in incitingthe troops to mutiny in Antwerp.



24/32


alty became threatened. As it so happened, Alvas run of victoriesin the early 1570s brought the Crown close to peace at a moment

when its debt to the Genoese was high. By implementing their pen-alty, the Genoese set the kings project back from completion andpreserved the penalty mechanism backing the asientos.

VII. Other Features of the Episode Accountedfor by the Debt Ceiling

The debt ceiling predicted by theory accounts for the juro-for-asiento swaps the Crown and the Genoese conducted at the conclu-

sion of each bankruptcy.

21

Because the Crown was at its debt ceiling,the Genoese could not roll over more asientos without underminingthe mechanism that backed their claims. Nevertheless, to continuelending to the Crown, the Genoese needed to find a way to allow itto defer payment. Accepting newly issued juros as payment forasientos in arrears, the Genoese would then sell the newly issuedjuros to Castilians and liquidate their position. Consequently, theGenoese enabled the Crown to float more debt yet no longer benear its asiento ceiling. To secure funding for the newly issued juros,

the Crown would convene the Cortes de Castilla to raise new taxes.While the Genoese accepted juros because they could unload themright away, this begs the question of credibility once more: a Castil-ian subject would not accept a juro from a king just emerging frombankruptcy unless he had some leverage over the Crown.22

The historical record reveals that the Crown did honor its debtsin juros and that annual debt service on juros grew for decades afterthe conclusion of Philip IIs reign. I conclude from this that somecredibility mechanism backed juros and that during Philip IIs reign

the Crown was below the ceiling on juros. Beyond empirical evi-dence, recent theory on sustainable domestic debt and features ofCastilian fiscal institutions reveal the mechanics of the enforcementmechanism backing juros.23

21 Providing a general rationale for the Spanish system of finance and its periodicbankruptcies lies beyond the scope of my analysis. Such an exercise would have toconsider the political economy of taxes voted to service juros, the periodic timingof bankruptcies, and many other issues. Here I explain only the asiento-for-juro swapfeature of the bankruptcies and summarize the analysis of Conklin (1996) on the

enforcement mechanism backing juros.22 The fact that asientos and juros were backed by different commitment mecha-

nisms does not clarify why the Crown waited until it was at its debt limit with theGenoese to conduct a simultaneous new issue of juros along with a conversion ofasientos into juros. It would seem a more effective method of war finance to antici-pate the debt ceiling and do the conversion in advance.

23 The following passage is a summary of the analysis of Conklin (1996).



25/32


The commitment problem of domestic debt is similar to that ofinternational debt: the sovereign is tempted to repudiate debt owed

to domestic residents, whether to divert interest and principal repay-ments to other expenditures or to reduce the future tax burden.The most apparent explanation for why governments repay domes-tic debt is reputation: if the government defaults, it will never beable to borrow domestically again. However, much as Bulow andRogoff (1989b) show for international lending, Chari and Kehoe(1993) demonstrate that a standard reputation equilibrium does notsupport domestic lending in a general equilibrium economy. Addi-tional constraints or incentives, beyond the narrow threat of losing

future access to borrowing, are required to make the sovereign repaydomestic lenders.In the case of the Spanish Crown under Philip II, three institu-

tional circumstances bound the Crown to repay domestic holders ofjuros: (1) Elites such as nobles, the high clergy, city oligarchs, androyal bureaucrats held a large proportion of the juros the Crownissued. The Crown, in turn, depended on these same elite subjectsto administer taxes, fill key offices in the royal bureaucracy and judi-ciary, and run the military. (2) Juros were funded by specific regional

taxes and paid investors their annual coupon at the royal treasuryoffice nearest the earmarked tax. City oligarchs, who determinedand administered the collection of a majority of the revenues fund-ing local juros, were also some of the largest investors in these instru-ments. That is, municipal elites in charge of administering nearbyroyal taxes held title to the juros these same taxes funded. (3) Juroswere traded in a secondary market. This prevented the Crown fromselectively defaulting since it was impossible to know which juroswere held by less influential subjects. Even a default first, ask ques-

tions later policy, whereby the Crown reimbursed the powerfulafter the fact but not the humble, would not have worked either.Such a policy simply would have enabled the influential to make asizable profit buying repudiated juros at a discount from humblesubjects and selling them to the Crown at a preferential reimburse-ment rate.24 Hence, the high political standing of many juro holders,the royal institutions that made these subjects indispensable to the

24 Such an arbitrage has been observed more than once historically. For example,

just after the War of the American Revolution, U.S. citizens feared that the newgovernment would not honor their debt. The Dutch, on whom the new Americangovernment depended for trade and international support in the face of Britishresistance, bought a large part of this debt at a far smaller premium than that withwhich it traded in the United States. Apparently, the Dutch did not fear that thegovernment of the United States would renege on them. Historyor the first secre-tary of the Treasury, Alexander Hamiltonproved the Dutch to be correct.



26/32


king, and the infeasibility of selective default were the basic elementsof the mechanism that backed juros.

VIII. Conclusion

In this paper I examine asiento debt contracts between Philip II ofSpain and his Genoese lenders. Using literature on sovereign debtto interpret historical events, we see that the king tried to renegeon his debt and the Genoese applied an additional penalty to en-force their claims. The penalty ultimately forced the king to repay.The debt ceiling imposed by the Genoese accounts for why the

Crown swapped long-term domestic debt for short-term interna-tional debt at the conclusion of its periodic bankruptcies. Using thefacts of the episode to better understand the assumptions and pre-dictions of theories, I find that the kings observed debt ceiling, theestimates of the cost to the king of the Genoese penalty, and esti-mates of the kings ability to repay are in line with the predictions ofBulow and Rogoff (1989a). The Genoese linking of other financialservices to lending in order to create a penalty has the flavor of equi-libria that arise in Cole and Kehoe (1994). Finally, models of imper-

fect information, such as Abreu et al. (1986, 1990) or Atkeson(1991), may account for why we observe the Genoese penalty alongthe path of play. The endogeneity of the severity of the penalty to thestate of completion of the project the Crown was financingthe waragainst Dutch rebelsis also a candidate hypothesis for accountingfor the penaltys observed imposition.

Viewed in the broader context of early modern Europe, my analy-sis shows how the institutional mechanics of fiscal commitmentmechanisms can influence war. As in Spain, all European sovereigns

faced the fiscal commitment dilemma: the need to protect citizensand enforce contracts compels the sovereign to finance a military.Yet the sovereign is tempted to violate the very rights and contractsit is charged with enforcing to raise revenues to meet the demandsof military competition. The resolution of this dilemma is embodiedin the commitment mechanisms that restrict the states fiscal behav-ior.25 In Philip IIs case, the institutional mechanics of the mecha-nism backing asientos had significant consequences: Alvas offensivewas stopped short in 1575 and the Crown lost its best chance to sup-

25 How the state resolves the fiscal commitment dilemma is a key determinant ofthe relationship between military power and economic growth. See North andThomas (1973), North (1981), Tracy (1985), Rosenberg and Birdzell (1986), Ken-nedy (1987), Brewer (1988), North and Weingast (1989), White (1989), Bordo andWhite (1991), Fox (1991), Sargent and Velde (1995), and Schultz and Weingast(1995).



27/32


press the Dutch rebels because of the Genoese debt ceiling. If theCrownor the Genoesehad had a superior mechanism to back

asientos, one that allowed the Crown a debt ceiling of perhaps 16million ducats rather than 8 million (the present value of Indiesrevenues alone was 2065 million ducats), the Duke of Alvas Dutchcampaign of the 1570s might have turned out differently. Whencompared with the much higher debt ceilings allowed by Englishand Dutch fiscal institutions, Spains commitment constraint ap-pears to have been binding and perhaps decisive in the outcome ofthe 80-year war against Holland.

Appendix

The Bankruptcy of 1575

Before the Bankruptcy

In the 15 years before the bankruptcy of 1575, the Crown fought on twomilitary fronts simultaneously: the rebellion in the Low Countries and thewar against the Turks in the eastern Mediterranean in alliance with theHoly League. The de facto strategy was to try to maintain a tactical balanceby which the Crowns forces would be engaged with only one foe at a time.

From 1559 to 1566, Philip offered concessions to the Dutch to avoid anoutright military action for which the Crown did not have resources. Thesuccessful suppression of the first revolt of the Netherlands was under-taken in 156768 because the Turkish fleet could not sail, freeing veteranSpanish troops in northern Italy from their regular garrison. By 157071,hostilities in Flanders ebbed. This gave Philip a critical reprieve, since arevolt of Moorish subjects in Granada in 156971 and a new offensiveagainst the Turks demanded resources urgently. The Spanish Crown con-tributed 1.14 million ducats to the Mediterranean fleet of the Holy Leaguein 1571 out of a royal budget of roughly 6 million ducats. Expenditure was

rewarded with overwhelming victory at Lepanto that same year; however,the Turkish threat did not diminish. Philip supported the Holy Leaguescontinued offensive, providing 1.95 million ducats in 1572, 1.78 million in1573, and 2.16 million in 1574 (Parker 1972).

In 1572, however, the Crowns luck in alternating resources between At-lantic and Mediterranean fronts ran out. Louis of Nassau and Coligny,leader of the French Huguenots, planned a joint invasion of the Nether-lands. Emboldened by the promise of aid from French Protestants, Williamof Orange intensified his military efforts against Spain. Though the promiseof French support did not immediately materialize, the Crown was forced

to reengage its Dutch foes, despite being fully committed in the Mediterra-nean. The king sent 1.84, 1.89, and 3.97 million ducats to Flanders in 1572,1573, and 1574. This extraordinary increase in military expenditures wasfinanced by the delay of payments to royal provisioners, the delay of com-pensation to noble officers who could be counted on to finance their owncompanies and galleys, and, most important, by Genoese credit. By the eve



28/32


of the suspension of payments of September 1, 1575, arrears in asientoshad risen to almost three years of royal revenue.

The Genoese anticipated that affairs with the Spanish Crown might cometo this. In the early 1570s, as obligations in asientos rose, the Genoese bank-ers demanded that the Crown grant them some form of security. Presum-ably, the alternative for the king was getting cut off from lending earlierthan in 1575. The king offered security in the form of high-yielding juros.There were two classes of such juros, the juro de resguardoand the juro decaucion. A key condition in the transactions of both instruments was thatif the Crown failed to pay back the principal on a given asiento, the bankergot to keep the juro. Also, the Crown had to continue to pay the differencebetween the original interest rate on the asiento and the interest rate onthe juro, typically 25 percent, until the asiento was repaid. The juro deresguardocould be resold by the Genoese on the condition that when theCrown came to redeem the collateral security (i.e., repay the principal onthe associated asiento and recover the juro), the banker had to produce ajuro of equal face value, though not necessarily the original instrument.

In the early 1570s the Crown issued large quantities ofjuros de resguardoto the Genoese, in parallel with the new issue of asientos.26 With the issueofjuros de resguardo,the Crowns legalistic fiction concerning the face valueof juros came back to haunt it: the Genoese sold high-interest (10 percent)

juros de resguardoat what may well have commanded a premium over their

face value, knowing that when the Crown came around to redeem the secu-rity they could produce a low-interest (3.5 percent) or unreliable juro, ofequal legal value. The latter security could be easily purchased at a discountfrom a client in the Genoese network of Castilian depositors. The juro decaucioncould not be resold to a client and never became a form of guaran-tee or security that the Genoese would accept. Moreover, the Genoese tookthe proceeds from the sale of the juros de resguardoand reinvested them inasientos, demanding higher interest rates and more juros de resguardo forsecurity. It was estimated by one royal official that debt service on juros deresguardoissued within the five years preceding the bankruptcy amounted

to 480,000 ducats a year.

The Bankruptcy Decree

By 1575, revenues suitable for the funding of new juros de resguardowereexhausted and the coalition of bankers ceased to provide new lending.Philip II took an antagonistic posture toward the lenders for abandoninghim in his hour of need. Whether because of the severity of the Crownsstance or the sheer magnitude of the assets involved, the royal decree ofsuspension of payments caused panic in financial centers in Spain, in Ant-

werp, and in Genoa as well (Ulloa 1986, p. 790). In the decreto the king26 It was long-standing practice by the Crown to issue juros with greatly varying

interest rates and reliability, yet treat all the instruments as having the same legalvalue at par. This practice enabled the Crown to differentially default on differentsubjects on those occasions in which it repaid obligations in juros instead of cur-rency.



29/32


ordered an investigation into every asiento struck since 1560 to look intothe possibility of illegal profits and usurious practices by the Genoese. TheGenoese objected on the grounds that the Crowns own ministers origi-nated every single asiento and that the ministers themselves, largely juristsand theologians, were experts on usury.27 The bankers refused to capitulateto a renunciation of a large portion of the principal owed, which was esti-mated at over 18 million ducats (this figure does not deduct the value ofthe juros de resguardoceded to the Genoese as security on asientos, whichwas about 8 million ducats).

This standoff lasted well into 1576, during which time the Genoese im-posed an embargo on specie transfer on Philip. The Crown was unable toget appreciable funds to its troops in Flanders, with the result that in No-vember 1576 troops mutinied over arrears and sacked Antwerp, a strategicentrepot in Spanish possession. Just as difficult for the Crown, new siegesin the 1575, 1576, and 1577 campaigning seasons (May through October)were ruled out. The Duke of Alva, who in 1574 seemed on the verge offinal victory, suffered grave reverses to William (the Silent) of Orange by1578.

The Bankruptcys Resolution, orMedio General

The bankruptcy was resolved when the king moderated his demands inearly 1577, a few months after the sack of Antwerp. Philip conceded that

the total debt owed was 15,184,464 ducats, minus debts contracted in Ant-werp and Bruges. The Crown conceded title on thejuros de resguardoalto-gether, with a negotiated value of 8,132,983 ducats. If annual payment onthese juros was 480,000 ducats, this capitalized value would have been com-puted at a discount rate of 6 percent, not the 10 percent that some of thejuros paid. On the net of 7 million ducats still owed, the bankers accepteda write-down of 2,245,673 ducats on the premise of illegal profits. Of theremaining 4.8 million ducats, two-thirds were converted into juros payinga coupon of 3.5 percent, and one-third were repaid in specie. The agree-ment also stipulated that the bankers be allowed to repay Castilian deposi-

tors in 3.5 percent juros at par rather than in specie (this device was referredto as de la misma moneda). The final term of the agreement was for theGenoese coalition to provide 5 million ducats in new asientos over thecourse of the following six years. The Genoese were not obligated to fulfillsubsequent deliveries if the king fell into arrears on earlier ones. It is appar-ent from Ulloas account that the king was more concerned with lifting theembargo on specie delivery than securing more credit. Thus, in the end,the bankruptcy was concluded in a fashion similar to those of 1560 and1596.

27

Twenty years later, during the negotiations following the decreto of 1596, theGenoese brought along a team of theologians to debate such matters if they cameup. In fact, some of the kings counselors did object to the proposed medio generalas being too generous to the lenders. However, the expert theological witnesses ofthe Genoese dispatched the reservations, and the negotiations continued placidlyand without delay (Ulloa 1986, p. 821).



30/32


31/32


Empire, 15201640. Manuscript. Austin: Univ. Texas, Dept. Econ.,1997.

Dominguez-Ortiz, Antonio. Un presupuesto de la real hacienda de Castilla

para el ano 1611. Hacienda Publica Espanola69 (1981): 17583.. Poltica y hacienda de Felipe IV. 2d ed. Madrid: Ediciones Pegaso, 1983.Eaton, Jonathon, and Gersovitz, Mark. Debt with Potential Repudiation:

Theoretical and Empirical Analysis. Rev. Econ. Studies48 (April 1981):289309.

Ehrenberg, Richard.Capital and Finance in the Age of the Renaissance: A Studyof the Fuggers and Their Connections.New York: Harcourt, Brace, 1928.

Fox, Edward Whiting. The Emergence of the Modern European World: From theSeventeenth to the Twentieth Century. New York: Blackwell, 1991.

Flynn, Dennis O. Fiscal Crisis and the Decline of Spain (Castile).J. Econ.Hist.42 (March 1982): 13947.

Greif, Avner. Reputation and Coalitions in Medieval Trade: Evidence onthe Maghribi Traders. J. Econ. Hist. 49 (December 1989): 85782.

. Contract Enforceability and Economic Institutions in Early Trade:The Maghribi Traders Coalition. A.E.R. 83 (June 1993): 52548.

. Cultural Beliefs and the Organization of Society: A Historical andTheoretical Reflection on Collectivist and Individualist Societies. J.P.E.102 (October 1994): 91250.

Greif, Avner; Milgrom, Paul; and Weingast, Barry R. Coordination, Com-mitment, and Enforcement: The Case of the Merchant Guild. J.P.E.102(August 1994): 74576.

Grossman, Herschel I., and Van Huyck, John B. Sovereign Debt as a Con-tingent Claim: Excusable Default, Repudiation, and Reputation.A.E.R.78 (December 1988): 108897.

Hamilton, Earl J.American Treasure and the Price Revolution in Spain, 15011650.Cambridge, Mass.: Harvard Univ. Press, 1934.

Haring, Clarence H. The Spanish Empire in America. New York: Harcourt,Brace, 1947.

Hauser, Henri. The European Financial Crisis of 1559.J. Econ. and Bus.Hist.2 (February 1930): 24155.

Homer, Sidney, and Sylla, Richard. A History of Interest Rates. 3d ed. NewBrunswick, N.J.: Rutgers Univ. Press, 1991.

Kennedy, Paul M.The Rise and Fall of the Great Powers: Economic Change andMilitary Conflict from 1500 to 2000. New York: Random House, 1987.Lovett, A. W. Juan de Ovando and the Council of Finance (15731575).

Historical J.15 (March 1972): 121.. The Castilian Bankruptcy of 1575. Historical J. 23 (December

1980): 899911.. The General Settlement of 1577: An Aspect of Spanish Finance

in the Early Modern Period. Historical J.25 (March 1982): 122.Lynch, John.Spain under the Habsburgs.2 vols. 2d ed. London: Oxford Univ.

Press, 1981.McNeill, William H.The Pursuit of Power: Technology, Armed Force, and Society

since AD 1000. Chicago: Univ. Chicago Press, 1982.Motomura, Akira. The Best and Worst of Currencies: Seigniorage and Cur-rency Policy in Spain, 15971650. J. Econ. Hist.54 (March 1994): 10427.

North, Douglass C.Structure and Change in Economic History. New York: Nor-ton, 1981.

http://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/page/info/abou

the thery of soveriegn debt and spain underphilip

Documents