During the first decade, primary surpluses were about two-thirds of the level necessary for stability. Interest rates were relatively high, and revenue grew moderately. Debt levels were higher than could be sustained indefinitely. The second decade, from 1575 to 1584, showed a decline in interest rates and higher growth rate of revenue. Reduced military spending allowed primary surpluses to increase markedly. These surpluses were now higher than necessary to stabilize debt levels. Actual indebtedness was below the maximum sustainable level. In the final decade, military events caused expenditure to increase again. The primary surplus required for stability fell to 0.23, which is three percentage points (of revenue) higher than the actual number. For the period as a whole, sustainability was not compromised despite near-continuous warfare and major military efforts in the last two decades of the sixteenth century.
ROBUSTNESS
Our conclusion that Philip II’s finances were largely sustainable rests on newly collected data, a reworking of existing estimates, and the derivation of information from combining these different series. At each step, we made assumptions that may impact our assessment. We now examine how our conclusions are affected if we use alternative indicators or assumptions.
ALTERNATIVE REVENUE GROWTH RATES
The revenue growth rates we used so far were calculated as the compound growth rate between end points. Results are therefore sensitive to the choice of the first and last year of the period considered. An alternative is to regress the natural logarithm of revenue on a time trend. The coefficient on the time variable will then be a measure of the average annual growth rate taking into account intraperiod fluctuations. In table 7, we show the results for the period as a whole if we use the alternative measure of revenue increases. Overall growth is somewhat lower, increasing the gap between the actual and required primary surplus. The difference nonetheless remains relatively small. The gap between sustainable and actual debt levels also increases, but it remains less than the revenues of an average year.
ALTERNATIVE GDP SERIES
GDP is the standard scaling variable for fiscal variables. While we argue that revenue is a better yardstick in the case of an early modern economy, here we demonstrate that our main conclusion is robust to the use of GDP. The most recent GDP estimates for Castile, by Carlos Alvarez Nogal and Leandro Prados de la Escosura (2007), are presented as an upper and lower bound on GDP. The difference between the two can be large; they vary on average by a factor of 3. In table 7, we repeat our sustainability calculations using both the upper and lower bound as well as the midpoint. As a further check, we use a different set of GDP figures from Albert Carreras (2003).
Our conclusions are unaffected if we use GDP as a scaling variable, independent of the particular series employed. In each case, we find that the required and actual primary surpluses are nearly identical. With Carreras’s GDP estimates, which are relatively pessimistic, there is a 9 percent gap between actual and sustainable debt. In any of the variations of the Alvarez Nogal and Prados de la Escosura figures, we find full sustainability. We do not take a stand on whether 1.9 or 3.4 percent growth of output is the correct number for sixteenth-century Castile, but note that even with the most pessimistic figures, the gap d−d* is small.
Table 7. Robustness
Note: G is the growth rate of revenue, r is the interest rate, ps is the actual primary surplus relative to revenue, ps* is the surplus required for stabilizing the debt-to-revenue ratio, d is actual debt to revenue, and d* is the debt-to-revenue ratio that can be sustained given actual primary surpluses. Growth rates are calculated as annualized compounded rates of growth between benchmark dates. Hence, the overall rate is not equivalent to the weighted average of the growth rates in subperiods.
NO PRINCIPAL REDUCTIONS DURING DEFAULTS
It can be asserted that one particular aspect of our analysis stacks the odds in favor of finding sustainability. During the 1575 and 1596 defaults, lenders saw the present value of their principal reduced. The debt outstanding would have been higher without these adjustments. How much of the “health” of Philip II’s finances derived from the write-downs after the defaults?
We calculate a counterfactual debt series by adding debt service on the defaulted asientos plus principal to the debt stock. After applying this correction, the counterfactual debt in 1577, the year of the medio general, is 5.5 million ducats higher than the actual level. We then scale up debt service charges in line with the new debt stock in the preceding year. This reduces primary surpluses and increases the primary deficits. Likewise, in 1596, we add the write-down from the medio general to the debt stock outstanding, raising it by 1.4 million ducats. Even without the default of 1577, the new taxes would have been adequate to bring debt back under control in the 1580s. The debt to revenue would have remained around a factor of 6 until the 1590s, before rising to a factor of 8. After the Armada, debt would have increased much more rapidly without the 1575 default. The final debt stock could have been higher by the equivalent of two years’ revenue.
Arguably, even this extremely pessimistic scenario would still not imply a lack of sustainability; Britain’s debts in 1815, for example, stood at 185 percent of GDP (Barro 1987).10 Yet it is likely that the rapid rise in debt ratios after 1588 in our counterfactual could have raised questions about Castile’s ability to service debts in the long run, a sequence of primary surpluses in the 1590s notwithstanding. In other words, up to the Armada, Spanish government finances would have been sustainable even without the default of 1575 and haircut imposed on lenders. After 1588, in contrast, Philip’s actual fiscal position was more manageable partly because of the 1575 default.
ALTERNATIVE ASIENTO-SERVICING COST
For our baseline scenario, we calculated the cost of servicing asientos from the agreed-on cash flows in each year, based on the evidence in the complete set of contracts. While this allows for precise comparisons between individual loans, the overall cost estimate relies on our chosen measure of profitability: the modified internal rate of return (MIRR). One alternative is to use average financing costs and duration when converting asiento borrowing into debt-servicing costs. We assume that all (transfers, exchange, and financing) costs accrue in the first year of a loan’s life. Since the average asiento had a duration of eighteen months, this involves a certain amount of front loading, which increases the debt burden. To further stack the odds against our main conclusion—that the king’s debts were sustainable—we also use the gross value of the asiento (including transfers), not just the borrowing component. Finally, we use a high value for the interest rate: 16 percent.
This is our calculated median rate of return on asiento lending plus a premium of 2 percent. The new estimate for annual asiento-servicing costs is
where ds is the total value of asientos contracted. Under this assumption, the debt-to-revenue ratio would have increased to 6.4 instead of 5.9. The difference remains small, even if this approach clearly raises the debt burden. We can be fairly certain that this approach is too pessimistic. It implies a debt level of 73 million ducats by 1598, for instance, when the actual observed amount is 66 million. Our original methodology yields much more accurate results.
THE VALUE OF VICTORY IN THE LOW COUNTRIES
One important consideration in assessing sustainability is whether the downturns in Castile’s fiscal position reflected fiscally irresponsible policies or bad luck—unanticipated shocks. As we will see in the next few chapters, financial markets treat these two situations quite differently, reacting in a more lenient way to shocks that are perceived to be outside the sovereign’s control. On the other hand, if a country runs up large debts to engage in current consumption and has no sensible plan to raise future revenues, it is hard to contend that the fiscal situation is sustainable. We now examine the two major shocks to Philip II’s fiscal position: the loss of the Invincible Armada and protracted campaign in the Netherlands. Both of them had large potential upsides and hence should not be considered as examples of r
eckless fiscal policy.
With hindsight, we know that the Armada marked a turning point in Philip II’s fortunes. And yet we know that “under the sun … the race is not to the swift, nor the battle to the strong … but time and chance happeneth to them all” (Ecclesiastes 9.11, King James version). Ex ante, it was by no means clear that Spain—which had recently routed the Ottoman fleet in a major naval battle at Lepanto—would fail in its attempt to invade England. As we discussed in chapter 2, contemporaries took the Armada seriously. Sir Walter Raleigh, among other prominent figures, openly worried that England would have been left defenseless had the fleet managed a successful landing. As Parker (1979) observes, even if the Armada had only achieved its minimum goal of establishing a beachhead in Kent, Spain would have reaped large benefits. Success, while not guaranteed by any means, was far from unthinkable. By the same token, the scale of the disaster—one-third of the fleet and half the lives lost at sea, and no landing in England at all—must have been toward the most pessimistic end of the range of possible outcomes.
We argue that the large financial losses incurred by Castile as a result of the Armada were an unexpected shock. While defeat is always a possibility in war, complete military and financial disaster was probably more like the proverbial “black swan” events in financial markets—an unlikely and damaging negative outcome.
Attempting to subdue the Dutch rebellion was arguably different. The Armada was a single throw of dice; the Dutch War represented a continuous, expensive, and seemingly interminable commitment of fighting power and financial resources. While the Armada was inspired by the need to make progress in Flanders, protracted attempts to conquer Holland and Zeeland cannot be construed as an unexpected expenditure shock. The continued demands of this war placed enormous strain on Castile’s finances for the last three decades of Philip’s reign and were a key factor in the accumulation of debt. We will argue that the expected benefits from eventual victory and subsequent peace in the Netherlands were such that they justify Spain’s prolonged and expensive efforts, even in a narrow economic sense. Victory in any form, even at a late stage, would have rapidly improved Philip II’s finances.
Spain ultimately lost its bid for control of the Netherlands. If there was any chance of success at any point, then the fiscal outcome that we documented above constitutes a lower bound on the sustainability of Castilian finances—one that reflects what must have been the worst-case scenario in military terms based on the available information. Ex ante, Philip and his advisers had good reason to hope that they might succeed in suppressing the Dutch Revolt. Few large, populous areas had ever broken away from their rulers in Europe; Switzerland was the only notable exception. Philip’s empire was the superpower of the age. Many contemporaries were convinced that Philip II’s fearsome tercios, which had repeatedly vanquished their opponents, would eventually prevail. The Dutch rebels themselves were fully aware that the effort to discard their ruler and become independent was extraordinary. After the Spanish victory at the Battle of Mook in 1574, William of Orange declared that “we have done what no other nation has done before us, to wit that we have defended and maintained ourselves in such a small country against the great and horrible assaults of mighty enemies, without any help.” Indeed, leaders of the revolt like Orange were convinced that they would eventually lose without outside intervention (Swart 1978, 24). The bankers that bankrolled Spain’s military operations must have had similar thoughts.
We now gauge how much of a difference victory in Flanders would have made to Philip’s finances. A successful conclusion to Philip II’s campaign in the Low Countries would have reduced military expenditure. In addition, it may have yielded extra revenue through taxing the rebellious provinces. We hazard conservative guesses for both figures. These strongly suggest that even relatively small changes to actual expenditure and revenue would have had a considerable impact on the Crown’s overall fiscal position.
After the Sack of Antwerp in 1576, there was a lull in the fighting. This situation illustrates how quickly Castilian finances recovered once military spending fell. During the period 1566–96, Philip II spent 163 million ducats on nondebt expenditures, of which 144.3 were military expenses. Of these, fully 53 percent—77.3 million ducats—was spent on the Army of Flanders. During the Armada and its aftermath, from 1587 to 1596, expenditure in the Low Countries amounted to 40.6 million ducats. During the ten preceding years, when no major military operations took place, the total expenditure on the Army of Flanders was only 16.8 million ducats, amounting to 59 percent less.
In our counterfactual, we assume that a breakthrough in the Netherlands might have been achieved by the late 1580s, following the Duke of Parma’s big push into Dutch territory (an earlier victory—by the Duke of Alba, for example—would have yielded even more favorable outcomes). We use 1588, the year of the Armada, as a reference point. This choice is dictated by the availability of data—1588 is as late a date as we can choose and still have enough data afterward for a counterfactual to be meaningful. We assume that military expenditure following a Spanish victory would have been similar to the figures for 1577–86. Thus, some 17.6 million ducats could probably have been saved from 1589 on. Note that our calculations provide a lower bound on the reduction in expenses that would have followed this success, as our figures continue to count the full cost of rebuilding the decimated Armada. Excluding it could have saved another 5.56 million ducats after 1588 (Parker 1998).11
Additional tax revenues are a more speculative source of improvement in Philip II’s finances. Victory over the rebellious provinces would have allowed Philip to tax them.12 We take the estimates of tax revenue in Holland compiled by Wantjie Fritschy (2003). To err on the side of caution, we assume that Castile would not have been as efficient in taxing its reluctant subjects compared to how efficient they were themselves. We therefore reduced the tax estimates by 50 percent. Accordingly, most of the change in Philip’s fiscal position would have reflected lower expenditure (saving 2.5 million ducats in 1596) rather than higher revenue (adding 0.53 million).13
To examine the impact of lower expenditure and higher revenue, we recalculate overall expenditure, the fiscal balance, primary surpluses, and total debt for each year. As a result of victory in the Low Countries, Philip could have ended his reign with debts of 39 million ducats instead of 66 million. The debt-to-revenue ratio would have resumed the downward trend it was on before the plan for the Armada was hatched. Figure 9 shows the two counterfactuals. The first uses only lower military expenditure, while the second adds possible revenue from Holland. There is little difference between the two; the key reason why Philip’s finances would have looked healthy by the end of his reign would have been less war, not more taxes. Thus, the Armada and the renewed Dutch campaign could have made good sense in fiscal terms at the time the decisions were taken. This is not to say that fiscal considerations were paramount among Philip’s advisers. It simply implies that religious or strategic considerations need not be the only reasons why attacking England and the Netherlands seemed like promising projects at the time.
CONCLUSION
Could Philip II repay his debts? Our reconstructed fiscal accounts suggest that he could have done so. While liquidity was scarce during periods of intense warfare, years of relative peace brought large surpluses. A systematic analysis based on the IMF’s methodology to evaluate fiscal sustainability shows that Castile was able to service its debts in the long run. Because our data were constructed with a bias against finding sustainability, this result represents a lower bound for the actual health of Crown finances. Our conclusions are not affected by employing a variety of scaling variables, alternative growth rates for revenue, a more aggressive way of calculating debt service, or ignoring the debt reductions negotiated during the defaults. Bankers and investors were not lured into lending their money to an insolvent state; Castile was able to honor the king’s debts.
FIGURE 9. Victory in Flanders: Counterfactual debt-to-revenue paths
To perform our analysis, we reconstructed Castile’s annual fiscal accounts. This is a complex task for the early modern period; it requires high-frequency information on virtually all the financial activities of the state. Such information was not collected at the time. Our data collection effort produced new yearly series of revenue, military expenditure, short-term debt issues, and short-term debt service. Using conservative assumptions and the logic of the government’s budget constraint, we derived figures for long-term debt service, civil expenditures, and overall debt stocks. The resulting database spans a full thirty-one-year period—enough to employ modern quantitative techniques.
We also asked whether the events that led to major downturns in Castile’s financial fortunes could have been anticipated. Based on contemporary assessments, we conclude that the Armada had a reasonable chance of success. While defeat was a possibility, the actual scale of the disaster that unfolded must have seemed highly unlikely ex ante. The expenses associated with rebuilding the fleet were an unexpected shock. Furthermore, fighting the Dutch rebels was economically rational. Castile was heavily favored to win the war, and even limited success would have resulted in a large peace dividend.
Overall, our analysis provides strong evidence that Castile’s fiscal position in the second half of the sixteenth century was on a solid footing. The resources to service debt were available. Why, then, did bankruptcies continue to take place? Was Philip II an opportunistic borrower, defaulting on his commitments when he could have made good on them? Were there inherent failures in the sovereign debt market? Or were other mechanisms at work, with payment stops playing an integral role in a complex system of international finance? The next chapter addresses these questions.
Lending to the Borrower from Hell: Debt, Taxes, and Default in the Age of Philip II (The Princeton Economic History of the Western World) Page 17