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Risk sharing with the monarch: contingent debt and excusable defaults in the age of Philip II, 1556–1598

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Abstract

Contingent sovereign debt can create important welfare gains. Nonetheless, there is almost no issuance today. Using hand-collected archival data, we examine the first known case of large-scale use of state-contingent sovereign debt in history. Philip II of Spain entered into hundreds of contracts whose value and due date depended on verifiable, exogenous events such as the arrival of silver fleets. We show that this allowed for effective risk sharing between the king and his bankers. The existence of state-contingent debt also sheds light on the nature of defaults—they were simply contingencies over which Crown and bankers had not contracted previously.

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Notes

  1. Eaton and Fernandez (1995), Rose (2005).

  2. Some scholars have argued that all sovereign debt is de facto contingent (Grossman and Van Huyck 1988).

  3. Greece avoided an outright default through a “voluntary” restructuring.

  4. Silver revenues were highly volatile; we describe them below.

  5. Elsewhere, we have shown that Philip II’s famous defaults do not reflect insolvency, but were caused by liquidity crises (Drelichman and Voth 2010).

  6. We also contribute to the literature on the hedging of macro-risks by new financial instruments (Shiller 1993).

  7. Strictly speaking, both the reputation and the sanctions view imply that defaults should not be observed in equilibrium. This implication can be avoided in models with imperfect information (Atkeson 1991), or when markets are incomplete (Kovrijnykh and Szentes 2007; Arellano 2008; Yue 2010).

  8. Cox (2011) argues that, in the absence of third-party commitment, it was not possible to separate insurance from debt contracts. The introduction of ministerial responsibility after the Glorious Revolution would have broken this link in England.

  9. The standard source on Charles V’s loans is Carande (2011).

  10. The account book of Ambrogio Di Negro, a Genoese merchant in the 1560 s, shows investments in six different types of juros as part of his overall portfolio (Archivio Doria, Fondo Doria, 143). The letters of another merchant, Giorgio Doria, contain specific instructions to his agent in Spain on how to collect the yearly payments of his juros (Archivio Doria, Fondo Doria, 490).

  11. For a history of juros, see Toboso Sánchez (1987).

  12. At first, lending was collateralized with revenues of the Casa de la Contratación, which oversaw the assessment and taxation of silver. While the management of the Casa was dismal, and the bonds it issued quickly lost up to 50 % of their value, collateralization continued with other juros. An excellent treatment of the system set up by the Genoese with respect to the Casa de la Contratación can be found in Ruiz Martín (1965).

  13. Selective defaults were technically possible. However, two reasons made them unlikely. First, the king would have no moral justification for defaulting; unlike in the case of asientos, investor payments for juros were made upfront, and the contractual conditions were unilaterally set by the Crown. Also, a selective default would have likely scared off other investors, and driven up the low interest rates that made juros a powerful financing tool in the first place. In this sense, the incentives that supported collateralization of one type of debt instrument with another are similar to those in Broner, Martín and Ventura (2010).

  14. Alvarez Nogal and Chamley (2012) argue that, because juros were callable and prevailing interest rates were falling, the defaults and the subsequent settlements can be interpreted as voluntary debt conversions. The results would have been the same if the king had called in all debt, and issued new, lower yielding juros in exchange. Our view is the opposite – the payment stops were abrupt, and the restructurings involved substantial haircuts. The haircut rate varied depending on the structure of each contract. Uncollateralized asiento holders, for example, received about 50 % of their original value in the settlement, while the juro rate reduction was much less. These facts are hard to reconcile with a ‘voluntary’ conversion.

  15. The fact that the bankruptcies were resolved with generous settlements is compatible with interpretations emphasizing the importance of signalling a borrower’s type (Cole, Dow, and English 1995). We discuss the details of the settlement in depth in the appendix to Drelichman and Voth (2010). The negotiations during the suspension of payments and the mechanism used by the Genoese to enforce the lending moratorium are described in Drelichman and Voth (2011a).

  16. Data for total outstanding debt is from Drelichman and Voth (2010).

  17. The legal limit against usury had stood at 10 % since 1534, when Charles V issued a law to such effect. Philip II confirmed it in 1567. See Nueva Recopilación, Libro Quinto, Título XVIII, Ley ix.

  18. Among them were the granting of licenses to export bullion in excess of the amounts required by the contract, life pensions bestowed on the bankers or their relatives, and the conversion of low-yield juros into high-yield ones at no cost.

  19. One important reason for choosing the MIRR over the standard internal rate of return (IRR) is that the latter is unsuitable for cash flows that swing from positive to negative multiple times, a very common scenario in our data. In Drelichman and Voth (2011b), we explore in detail the benefits of our rate of return measure and our parameter choices. We also perform extensive sensitivity analysis. Our choice of 7.14 % for the reinvestment rate is chosen after the median juro rate—juros were readily available, and hence obtaining a 7.14 % return was easily achievable. The 5 % finance rate was chosen after the rate Genoese bankers paid on their deposits.

  20. This is mostly due to material damage to the documents. In a few cases, the clauses were too vague to allow an accurate estimation of cash flows and rates of return.

  21. This asiento also shows how loans were combined with transfers. The bankers first disburse 38,000 ducats; the king next repays principal and interest on 95,000 ducats; and only afterward do the bankers disburse the final 57,000 ducats in Flanders. The latter disbursement is therefore a transfer rather than a loan, since the bankers had already received the money from the king.

  22. The deeper reason for collateralizing with juros is that fiscal centralization in Castile was limited – the king could sometimes not pay the bankers directly, but the City of Seville, say, would still pay holders of juros. Thus, the fragmentation of fiscal authority facilitated the continuation of lending.

  23. A tax levied on Church revenue, one of the so-called Three Graces, introduced in 1567.

  24. This example also shows the importance of weak tax collecting powers in determining lending arrangements, with the king effectively outsourcing the right to access taxes already collected.

  25. Archivo General de Simancas (AGS), Contadurias Generales, Legajo 90.

  26. By comparison, the median return of loans that do not have contingent clauses is 19 percent.

  27. The increase is a mere 0.4 %; the difference in cost compared to the baseline is not statistically significant.

  28. The king could, however, manipulate the order in which lenders were paid. Contracts were therefore quite specific in establishing the collection priority of individual lenders with respect to specific tax revenues.

  29. Juro interest was paid twice yearly. If the banker received juros in October, he would be allowed to collect the entire December interest payment, rather than the portion corresponding to the three months he had held the bond. This increases the profitability of the contract relative to a cash payout in December.

  30. The exception was the 1576–1580 period, when most lending came from the 1577 settlement.

  31. In Drelichman and Voth (2010) we also show that the king’s fiscal position was sustainable in the long run.

  32. Shocks arising from military defeat are an obvious case in point—it would be hard for the Crown to contract on the possibility of the Armada sinking, say.

  33. In Drelichman and Voth (2011b), we surmise that defaults were excusable; here, we argue the case based on a close reading of loan conditions and fiscal conditions.

  34. If there had been changes in actual loan conditions, these could also be rationalized by Bayesian updating (about, say, the strength of the Spanish navy). In this sense, demonstrating that rates did not change is requires the ‘strong’ version of our hypothesis to hold.

  35. All figures are from Drelichman and Voth (2010).

  36. See Morineau (1985).

  37. In Alfaro and Kanczuk (2005), rising interest rates after a default act as a punishment for borrowers that violated the original loan contract in a context of contingent lending.

  38. We obtain a value of 0.68 (p value 0.49).

  39. A t test has a value of 0.48 (p value 0.63).

  40. Data from Drelichman and Voth (2010).

  41. It should be noted that neither the debt stock nor the revenue ratio was readily available statistics. Oft he two, estimating the fiscal balance is substantially more difficult. This is true today, as it must have been for contemporaries (Drelichman and Voth 2010).

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Acknowledgments

We are grateful to Fernando Broner, Sebastian Edwards, Xavier Gabaix, Ed Leamer, Tim Leunig, Kris Mitchener, Richard Portes, Moritz Schularick, Richard Sylla, Jaume Ventura, Paul Wachtel, Mark Wright and seminar participants at the Harvard PIEP Workshop, CIFAR, Caltech, Colorado, Carlos III, ESSEC/THEMA, NYU-Stern, LSE, ESSIM, UCLA-Anderson, Vanderbilt, and Copenhagen Business School. Drelichman acknowledges financial support from SSHRCC, CIFAR, and the UBC Hampton Fund. Voth thanks the Spanish Education Ministry for a research grant. All errors are ours.

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Authors and Affiliations

  1. Vancouver School of Economics, The University of British Columbia, 997-1873 East Mall, Vancouver, V6T 1Z1, BC, Canada

    Mauricio Drelichman

  2. The Canadian Institute for Advanced Research, 180 Dundas St. West, Suite 1400, Toronto, M5G 1Z8, ON, Canada

    Mauricio Drelichman

  3. University of Zurich, Zurich, Switzerland

    Hans-Joachim Voth

  4. UBS Center for Economics in Society, Zurich, Switzerland

    Hans-Joachim Voth

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  1. Mauricio Drelichman
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Correspondence to Mauricio Drelichman.

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Drelichman, M., Voth, HJ. Risk sharing with the monarch: contingent debt and excusable defaults in the age of Philip II, 1556–1598. Cliometrica 9, 49–75 (2015). https://doi.org/10.1007/s11698-014-0108-8

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