Default More Than 400 Years Ago Leaves Scars: Christophe Chamley
The House Republicans, many of them opposed to raising the federal government’s borrowing ceiling, might take a lesson from the first sovereign debt crisis: Spain’s default in 1575. What events more than 400 years ago suggest is that it’s easy to ignite a dangerous chain reaction in financial and credit markets and inflict lasting damage on the economy.
Republicans today are playing the part of the cities of Castile, whose delegates to the Cortes (the Spanish parliament) opposed raising taxes to service King Philip II’s long-term bonds.
Spain, at the time, was the world’s sole superpower. Contemporaries described it as an empire “over which the sun never sets.” Yet the king needed the cities’ consent to borrow at a reasonable rate. And he needed it for a reason: The cities collected the taxes.
Each of the 18 main cities of Castile levied a special tax earmarked for long-term debt service. The level of this tax was set every six years through negotiation with the king. Tax collections were used first to pay off local long-term bondholders, with the rest sent to the central government. The local long-term bondholders were, in large part, the elderly living in the area. So local taxpayers realized that if they didn’t pay, their parents would be hurt. Thus, this precursor to Social Security had an effective enforcement mechanism -- the ire of the elders.
Confluence of Interests
But the king could only exploit this confluence of interests so far. The Cortes set the earmarked tax rate by majority rule, and that limited the king’s issuance of what were, in effect, his AAA securities. The king also issued other bonds secured by other, non-earmarked revenue. These securities were of a lower grade and sold at lower price.
Thanks to Philip’s expensive military adventures in the Netherlands and the Mediterranean, Spain’s debt had reached half of gross domestic product by 1573. At that point, the cities balked at paying higher taxes. For the next two years, they refused to budge in their confrontation with the king.
Finally, in September 1575, Philip took a circuitous route to outmaneuver the Cortes. He suspended payments not on the long-term debt, but on the short-term debt, which was owed primarily to Genoese bankers. The people cheered. Resentment against bankers ran as high then as now -- perhaps higher, because the bankers were foreigners. The upshot, however, was default and a full-blown credit crisis.
Why did the Cortes and the king play this game?
Stop the Spending
The cities wanted to stop Philip’s spending. They knew that bonds not explicitly backed by dedicated taxes would be very tough to sell, that a default would make it even harder for Philip to borrow without their help, and that his lack of direct taxing authority would force his hand in a standoff. But after the payments stopped on the short-term debt, things careened in an unexpected direction, much as they did after Lehman Brothers Holdings Inc. failed in September 2008. Many bankers who had lent to the king were, themselves, leveraged. The payment halt froze the funds deposited by local merchants to the bankers.
At that time of costly communications, periodic commercial fairs were essential events for the economic activity throughout Europe. Credit was rolled over from fair to fair by bankers, and lending agreements were renegotiated. With the Spanish commercial credit market frozen, the fairs couldn’t be held. Indeed, the main fair that was held twice a year at Medina del Campo was canceled. In short, the default caused a banking collapse, which led to a severe recession.
Caving on Taxes
After two years, in November 1577, the cities caved, agreeing to a very large tax increase. The king resumed debt payments to the bankers. As the king explained in the settlement agreement, called Medio General, the bankers were joined in their demands “by the petition of the delegates of the cities with particular urgency about the same business.” In other words, the cities were begging the king to restore the business of trade. The fairs at Medina del Campo resumed late in the next year, but they had lost their preeminence forever.
What’s the message for the House Republicans today? First, don’t overestimate your power. Second, history stays with us. Spain’s default is 424 years old, but its story is still being told and may, to this day, be affecting that nation’s perceived creditworthiness and cost of capital.
(Christophe Chamley is professor of economics at Boston University. The opinions expressed are his own.)
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