Media Briefings

Why Banks Keep Lending To Suspect Governments: Historical Lessons

  • Published Date: December 2011

Repeated lending to weak sovereign borrowers – such as sixteenth century Spain or modern-day Greece – can make perfect sense, according to a historical study by Professors Mauricio Drelichman and Hans-Joachim Voth, published in the December 2011 issue of the Economic Journal.

Their research examines why bankers continued to lend to King Philip II of Spain – the ‘borrower from hell’ – who still holds the record for the largest number of sovereign debt defaults in a single reign. Contrary to the conventional view that Philip’s access to credit was a result of banker stupidity, the new evidence reveals that bankers made good money on average despite the defaults. What’s more, lenders stuck together so that Philip was eventually obliged to repay 60-80% of the face value of his debt, which compares with a 50% ‘voluntary’ haircut for Greek debtors today.

What lessons are there for discussions of the current debt crisis? The researchers conclude:

‘First, don’t believe every story you read about banker stupidity; the profession has been dealing with sovereign defaults for 500 years, and has mostly done well despite them.

‘Second, there is nothing necessarily cataclysmic about debt holders not being made whole in every single crisis – if there is no chance of bailout in bad times, bankers know how to deal with the risk.’

The debt troubles of European countries are in the headlines every day: will Greece default, and might Italy, Spain and France follow? One of the underlying questions that deserves more attention is why international lenders continue to extend credit to countries with a lousy history of repayment. Greece has defaulted four times since independence fewer than 200 years ago; and prior to its last default in 2001, Argentina’s record was little better.

The history of sovereign debt suggests two diametrically opposed answers. First, lender stupidity: banks and bondholders offer funds because they just don’t realise how risky some loans are. They may be dimly aware of the fact that a country has a poor track record, but they are convinced that ‘this time is different’. This is essentially the story told by Carmen Reinhart and Kenneth Rogoff in their eponymous book.

According to this view, lenders are like lemmings: they all offer credit at the same time and withdraw at the same time. They learn little from the past, and endanger financial systems and entire economies recklessly.

The alternative story casts bankers not as fools, but as coldly calculating machines. They know what is going on – Greece isn’t a good risk, but lending makes sense even if there is trouble in the distant future. There is good money to be made now, and even if something goes wrong several years into the future, the average profits can still be quite good.

Distinguishing between these two tales is hard. Most people have a view either one way or the other, based on personal views of ‘fat cats’ or the efficiency of markets. In this study, Professors Drelichman and Voth examine why bankers continued to lend to Philip II, ruler of the Spanish Empire at the height of its power and influence.

They uncover compelling evidence that such repeated lending to weak borrowers can make perfect sense. Their study uses Spain’s history between 1550 and 1600 as a laboratory. On coming to the throne, the young Philip defaulted on his father’s bankers – and did so three more times until his death.

Many scholars have interpreted Philip’s continued access to credit as clear-cut evidence in favour of banker stupidity – the old view was that wave on wave of new bankers offered credit, only to be undone by another payment stop.

The new research, derived from more than half a decade of work in the archives of Spain, now shows this to be a myth – the same banking families lent to Philip II throughout his reign. Very few exited the business after each default: the exit frequency was about the same as in normal years.

Why did bankers continue to lend as before? Why was the bankers’ cartel stable over time? Drelichman and Voth point to two facts:

  • First, bankers made good money on average. A default every 12 years is not so bad if you can earn interest rates in the range of 15-20% in an average year.
  • Second, international bankers stuck together in years of crisis. Most of them hailed from Genoa, and – despite many attempts by Philip’s crafty diplomats – not one of them ever cut a side-deal with the sovereign in years of crisis. This resulted in decent settlements overall after the defaults: Philip II repaid 60-80% of face value (compared with a 50% ‘voluntary’ haircut for Greek debtors today and an 80% loss for Argentine lenders).


Notes for editors: ‘Lending to the Borrower from Hell: Debt and Default in the Age of Philip II’ by Mauricio Drelichman and Hans-Joachim Voth is published in the December 2011 issue of the Economic Journal.

Mauricio Drelichman is at the University of British Columbia. Hans-Joachim Voth is at the Universitat Pompeu Fabra in Barcelona.

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email:; or Hans-Joachim Voth via email: