Spain’s 1575 Default Still Leaves Scars

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. (more)