The role of institutions to solve sovereing debt problems : the Spanish monarchy's credit (1516-1665)

The Spanish Monarchy borrowed foreign credit during more than 150 years despite repudiating its agreements from time to time.According to the extant literature on sovereign debt, lenders should not have lent any money to the Spanish Monarchy, especially because they were not organized as a cartel. Sovereign debt theory asserts that the principal constraint on sovereign behavior is the penalty that lenders or an external organization can impose on the borrower. When the sovereign decides whether to honor the loan agreement, his main consideration lies on the size of the penalty he will suffer in the event of a default. The inability to punish the sovereign does not lead to indiscriminate reneging, but to an absence of credit. Thus, the extant theory cannot explain the borrowing that took place in Castile during a large part of the Habsburg dynasty (1516-1665). This paper explains why, in the absence of penalties and having experiences of defaults, bankers kept lending. The mechanism that made this credit possible was based on expectations of the king's revenues in any given period. Bankers did not have to punish the sovereign because the king was trying to cooperate with many lenders to reduce uncertainty about future credit and to expand the amount of money available.