Why do lenders repeatedly loan money to sovereign borrowers who promptly go bankrupt? When can this type of lending work? The answers may lie with a 16th-century Spanish monarch, says UBC’s Mauricio Drelichman
As the United States and many European nations struggle with mountains of debt, Mauricio Drelichman of UBC’s Vancouver School of Economics believes there are lessons to be learned from the debts and defaults of Philip II of Spain. Ruling over one of the largest and most powerful empires in history, King Philip defaulted four times yet never lost access to capital markets and could borrow again within a year or two of each default.
In the new book, Lending to the Borrower from Hell, Drelichman and co-author Hans-Joachim Voth provide powerful evidence that in the right situations, lenders not only survive despite defaults–they thrive. Drelichman and Voth also demonstrate that debt markets cope well, despite massive fluctuations in expenditure and revenue, when lending functions like insurance.
Why did bankers lend time and again to a king with a history of repeated default?
Because they made money in the long run – the losses sustained when the king did not pay were smaller than the profits generated during those times the king did pay. While this answer may seem to flirt with the obvious, that is not what most people think. For a country, defaulting on its debt is not necessarily an unmitigated catastrophe. During the Euro crisis of 2011-13, investors and governments repeatedly warned that a Greek default would be a global financial catastrophe of unimaginable consequences. The lesson is that, when lending to a risky country, investors price in the possibility of a bankruptcy. When it actually happens, lenders that have planned for it have ways of mitigating the consequences.
What insights can we gain on modern lending practices by looking at historical cases such as King Philip II?
Modern sovereign debt scholarship holds that it is not feasible to write contingent sovereign debt contracts as they would be difficult to enforce; countries could “fudge” the numbers to make a fiscal situation appear worse than it actually is, and thus justify defaulting. The experience of Argentina, which in the last ten years has consistently published figures that clearly underreport inflation for political reasons, is an example of this.
This is unfortunate because contingent sovereign debt contracts could greatly ease the financial strain that governments experience during recessions, and mitigate the austerity and unemployment consequences. What we show in the book is that Philip II and his bankers had effectively solved the problem by 1550. If a handful of clever bankers managed to write contracts that effectively spread fiscal risks while keeping a sovereign accountable in the age of galleons and messengers on horseback, surely the age of jet travel and the internet can come up with a solution as well.
What surprised you most from this research?
The depth and complexity of 16th-century contracts was most surprising. We found contracts that allowed for an unprecedented degree of insurance and risk sharing between borrowers and lenders – to a degree rarely seen even today. Some of the clauses in these contracts allowed for the automatic rescheduling of payments, and even for “contingent-convertible” bonds – a relatively recent innovation. Yet we find them fully developed and extensively used in sixteenth–century Spain.
If King Philip II read your book, what do you think he’d say about it?
Probably “What else is new?” Historians spend a lot of time painstakingly reconstructing what must have been obvious to decision-makers at the time. I certainly hope he wouldn’t tell me I got it all wrong!
Mauricio Drelichman is an associate professor in the Vancouver School of Economics and a fellow in the Institutions, Organizations, and Growth program of the Canadian Institute for Advanced Research. For more information on Lending to the Borrower from Hell, visit here.