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- Financial Markets
The recent showdown between the parliament and the executive in the US began when a faction in the Republican Party tried to stop the implementation of the healthcare law of President Obama. They refused to raise the legislatively determined ceiling on the federal public debt – a ceiling that has to be raised with the growth of the economy.
The showdown had developed into a game of chicken that was played – by both sides – on the dire consequences of missing payments on US bonds (Drezner 2013). This time the Republicans have lost, but some of them promise to renew the fight in a few months, when the newly established ceiling will be reached.
Our recent research highlights a strikingly similar showdown that occurred in 1575 Castile, with catastrophic consequences (Álvarez-Nogal and Chamley 2013).Sovereign debt in 16th-century Spain
Under Philip II, when the Spanish empire was the dominant superpower, the domestic public debt reached a 'modern level' of about 60% of GDP for the first time in history. The main part of the debt was domestic and was in long-term bonds (mostly redeemable perpetuals) called 'juros', which paid a rate of around 7% (when inflation was about 1%). Given the small administrative capability of the central government – with very few tax collectors – and its uncertain commitment to service the debt, the juros were funded, as later in 18th-century England (Chamley 2012) – the service of the debt was financed by earmarked revenues (e.g. sales taxes, monopolies, customs farms). Recall the protests that prevented the Bush administration from including the Social Security tax (that finances retirement benefits in the US) into the general revenues.
Juros were prized for their stable income, and the juros of the highest grade were administered at the city level. The 18 main cities of the realm were committed to pay a fixed annual payment (encabezamiento) to the Crown. For each city, the service of the local juros – which were bonds of the Crown and tradable through the realm – had first claim on that annual payment. Such a setting contributed to an alignment between the tax enforcers and the bond holders in city governments, enhancing the security of the debt payments and therefore lowering the interest rate.
The amounts of the encabezamiento for each city were set, for a number of years, by simple majority in the Cortes, where each city had two delegates. These contributions were the dominant part of the ordinary revenues that could be used for the service of the juros. These ordinary revenues imposed a de facto ceiling on the service of the juros, which – given the stable interest rate – was tantamount to a ceiling on the domestic debt. When the king wanted to raise the encabezamiento or other taxes managed by the cities, he had to get the approval of the Cortes. The cities could not oppose indefinitely the tax increases, but they could moderate or delay them through protracted negotiations. Philip II was not an absolute monarch, and the decentralisation of the revenues through cities that enjoyed some independence lowered his borrowing costs.
The other part of the debt, which was smaller than the juros, was unfunded and had a different purpose and nature – it was in financial contracts called asientos, signed with Genoese bankers, that combined transfers abroad for the military ventures of the Crown (especially in Flanders) and loans of a maturity between one and three years or more at a rate of about 12%. A large fraction of the asientos was purely domestic however, with both disbursements and repayments in Castile. These loans could absorb transitory shocks, and when shocks turned out to be permanent, they were converted into the funded juros.
The system functioned smoothly as long as there were sufficient ordinary revenues to service the juros. Each of the three financial crises under Philip II occurred when ordinary revenues were about to fall short of servicing the juros (Álvarez-Nogal and Chamley 2013). The 1575 crisis is the clearest case.Budget wars in Castile, 1575
In the early 1570s, when military expenditures were rising, the service of the juros neared the level of the ordinary revenues. Philip II tried to more than double the contribution of the cities. After years of fruitless efforts and facing a stubborn resistance, in September 1575 he suspended payments on the asientos. Juros were untouched. The realm of Castile was cheered by what seemed like a tough action against foreign bankers, a situation that we can understand today.
The cheers turned gradually into bitter complaints. The Genoese bankers financed a large fraction of the asientos through financial intermediation with the Castilian commercial credit market. Deposits and letters of exchange between commercial fairs were channeled into asientos. The bi-annual fairs of Medina del Campo, in the centre of Castile, were focal points that provided market thickness, and many financial contracts were contingent on the holding of a particular fair.
Our current research indicates that after the payment stop, bankers could not repay their creditors, who in turn could not satisfy some of their own obligations. The pyramid of credit unraveled and the commercial credit market froze. For more than two years, the cities resisted in the Cortes. No commercial fair took place. The two main banks of Sevilla, which had been involved in the intermediation of asientos, failed. In addition to Castile, the impact was felt in the important financial markets of Europe. Numerous documents attest that Philip II protected the bankers against the claims of their Castilian creditors. Bankers agreed to the terms of the payments on the asientos in March 1577, but Philip II made explicit that the signing was contingent on the acceptance of higher taxes by the cities which kept up their delaying tactics in the Cortes.
Eventually, in November 1577, the cities – realising the growing damage to their own economy, and probably facing the discontent that some Republicans face today – agreed to a doubling of their tax contribution, and begged the Crown for a rapid settlement with the bankers. That settlement was signed two weeks later. But the cost to the economy and the 1575–1577 missing fairs of Medina del Campo could not be recovered. The fairs resumed their activity, but lost their main position to other places in Europe. Coincidently, the crisis marks the turning point from a booming to a stagnant economy in 16th-century Castile.
In 1575, Philip II most probably foresaw that the payment stop would have a strong impact on the commercial credit market, and he intentionally used that impact to extract a tax increase which was much larger than what was required for servicing the debt at the time.
Before becoming king, he had recommended against an interest rate ceiling on the letters of exchange in the commercial credit market that was supposed to lower the borrowing cost of the Crown, and he was aware of the intermediation process. The cities may not have had the same expectations. The clock of the credit market was regulated by the bi-annual commercial fairs instead of fibre optic cables. The links in the intermediation process became gradually more visible, like rocks appearing at low tide.Concluding remarks
In a standard game of chicken, one of the two parties bows out before the disaster which is not supposed to happen. Although Republicans just bowed out in the nick of time before a payment stop on some US debt – and there is some uncertainty on the impact that such a payment stop would have – some damage has already been incurred by the economy and by both players in the recent showdown.References
Álvarez-Nogal, C and C Chamley (2013), “Debt policy under constraints between Philip II, the Cortes and Genoese bankers”, Economic History Review, forthcoming.
Chamley, C (2011), “Interest Reductions in the Politico-Financial Nexus of 18th Century England”, Journal of Economic History 71: 555–589.
Drezner, D (2013), “The Dumbest Game of Chicken, Ever”, Foreign Policy, 7 October.