30.07.2005
Lessons of the Spanish Empire
№3 2005 July/September
Vladimir Mau

Vladimir Mau is Rector of the Russian Presidential Academy of National Economy and Public Administration.



 

NATURAL
RESOURCES AND DEVELOPMENT

 

The role
that natural resources play in stable economic development has
recently attracted the attention of economists and politicians. An
overwhelming majority of countries with a high average per capita
gross domestic product (Western Europe, Japan) are not rich in
natural resources. Africa, which after World War II was
approximately at the same level of development as Southeast Asia,
is today a region of extreme poverty (many Southeast Asian
countries, by comparison, have slowly begun to catch up with the
developed world). Just half a century ago it seemed that the Black
Continent had very good prospects due to its natural wealth and
relative proximity to European markets.

 

The
abundance of natural resources, however, may serve as a negative
factor for social and economic development. How can this
be?

First, the
presence of significant natural resources prompts the political and
business elite to focus their efforts on controlling the natural
resource rent, instead of seeking to increase labor productivity.
When the elite is not interested in restructuring, modernizing and
diversifying the economy, it loses an opportunity for implementing
reforms.

 

Second,
the inflow of funds generated by the sale of natural resources
corrupts the ruling elite. On the one hand, the authorities are
tempted to take a populist line: they can afford to experiment with
economic policy and make rather extreme and irresponsible
decisions; if the new policies have negative consequences, they can
be relieved through large financial injections. On the other hand,
the risk is high that corruption will inevitably grow as the
authorities are engaged in the distribution of the natural resource
rent.

 

Third,
dependence on natural resources provokes the development of a
lop-sided, often single-product, economy and, especially,
single-product export. The so-called ‘Dutch disease’ impedes the
development of non-export (in this case non-raw material) sectors
of the economy: exports ensure the inflow of “cheap” foreign
currency into the country, thus leading to an overstatement of the
national currency’s exchange rate. This undermines the
competitiveness of domestic producers oriented to the home market.
The same process reduces investment activity, since the import of
goods proves to be more profitable than the production of these
same goods inside the country. Naturally, import substitution in
this situation becomes practically impossible, and the economy
becomes strongly dependent on fluctuations in export
prices.

 

Fourth,
the abundance of natural resources becomes a serious obstacle to
political democratization. As mentioned above, a high natural
resource rent impedes economic growth, that is, the achievement of
an economic development level necessary for the formation of stable
democratic institutions. This refers, above all, to countries where
the bulk of the national budget is formed by revenues from the
export of one kind of raw material (for example, oil). Control over
this resource brings in enough revenues to meet the authorities’
needs and to ensure social stability, and allows the government to
ignore other sources of income, thus leaving the national tax
system undeveloped. The lack of the authorities’ need for
significant tax revenues actually allows them to ignore the
political demands of society and creates conditions for a peculiar
“social contract:” “We do not levy taxes on you, and you do not
demand political rights.” This is essentially how things stand in
the absolute monarchies of the Persian Gulf.

 

Finally,
some scholars argue there is a negative interrelation between the
presence of natural resources and the authorities’ attention to the
development of education. Sectors of the economy that are based on
raw materials demand lower skills for the workforce. Thus, the
domination of these sectors reduces the demand for educational
services.

 

An
additional danger arises when a country is suddenly inundated with
natural resource revenues which are generated by a leap in their
price. In the light of abundant revenues, the state begins to
actively participate in various kinds of investment and social
programs and comes out with ambitious projects for a foreign policy
expansion. In a bid to make the best use of its opened
opportunities, the state actively borrows additional funds from
both inside the country and abroad. Consequently, despite an
abundant inflow of money, the financial situation in the country
greatly deteriorates.

 

Later, the
country will find itself involved in a series of complex and
ineffective economic and political projects, as its hopes for an
abundance of “cheap” money prevent it from developing a serious
cost-benefit analysis. Furthermore, overwhelmed by the tremendous
inflow of funds, the state also gets more and more involved in
reckless foreign-policy schemes.

 

On the
other hand, the state’s social and economic structure is adapted to
fit the new, favorable situation. The reliance on the abundance of
“cheap” money makes the government forget about the effectiveness
of other sectors – the deficiencies of domestic production, for
example, can always be compensated for with imports. Domestic
producers start degrading, which for some time does not worry the
authorities who are lulled by the raw material-based economic
growth.

 

But when
the source of revenues suddenly disappears (due, for example, to a
change in the market price of the natural resources), a full-scale
crisis will appear which may hit the entire system.

 

Such problems have arisen in various
countries over the last few decades. Many of these crises are
obvious when we analyze the economic and political processes caused
by fluctuations in oil prices following the 1973 oil crisis.
Mexico, the Soviet Union, and Iran in the times of the shah’s rule
provide the best examples.

 

At the turn of the 1970s, oil prices
reached U.S. $90 per barrel (in terms of the present exchange
rate), and it seemed that exporters had ensured an affluent future
for themselves. Soviet leaders pursued an active oil-for-food
policy, purchasing abroad consumer goods, foodstuffs, and equipment
for expanding oil and gas production, while Mexico’s president
José López Portillo declared proudly: “We must learn to
administer abundance.”

 

Portillo’s policy of “administering
abundance” provided for sharply increasing growth rates and
strengthening the country’s economic independence through the
development of the economy’s public sectors. The government
launched various investment programs; growth rates increased from
3-4 percent (1975-1977) to 8-9 percent (1978-1981); the average
annual increase in investment eventually reached 16 percent. At the
same time, the national budget accumulated high deficits since the
government pinned much hope on continued rates and therefore
greatly ignored this parameter.

 

Mexico’s situation began to deteriorate
with a decline in oil prices at the beginning of the 1980s: GDP
began to demonstrate negative growth rates; the peso was devaluated
by more than 40 percent; foreign debt increased from U.S. $40
billion in 1979 to $97 billion in 1985. Capital flight accelerated,
and the gold and hard-currency reserves decreased to U.S. $1.8
billion. By the end of Portillo’s six-year presidential term, he
was accused of wasting the oil revenues, concluding “extravagant”
foreign-loan deals and inflating budget expenses. After his
resignation, Portillo was forced to leave the country. When he died
in early 2004, he was not even provided a state funeral, which was
a departure from the usual practice.

 

The history of the Soviet Union in this
regard is already familiar to most people. After wavering attempts
to reform the economy in 1965-1972, the Soviet government
completely abandoned these initiatives; it chose to ensure steady
(albeit low) economic growth rates and social stability by stepping
up energy exports. In the second half of the 1980s, the decline in
oil prices and the growing budget deficit forced Mikhail Gorbachev
to launch the so-called acceleration reform. This provided for
resolute measures to reduce the country’s dependence on raw
materials. These efforts to boost economic growth rates, however,
threw the economic system off balance and triggered its
collapse.

 

As yet another example, Iran’s regime
initially gained from an oil price boom but then suffered a
complete fiasco. Iran’s economy, as distinct from other countries,
was hit by crisis during the most favorable situation on the world
oil market. The main factor behind the destabilization was an
accelerated modernization of the economy, which was conducted
largely by decree and did not have deep roots in any sphere of
economic and social life. As a result, Iran experienced a sharp
increase in social tensions which culminated in the outbreak of the
“Islamic revolution” in the late 1970s.

 

In all fairness, it must be admitted
that some countries that are rich in natural resources have reached
a very high level of economic development (for example, the United
States, Canada and Norway). The reason is that some specific
circumstances can neutralize the negative influence of the
abundance of natural resources.

 

These circumstances include, above all,
the nature of resources from the point of view of the possibility
of monopolizing control over them. An abundance of natural
resources that are “scattered” about a country and not available
for monopolization by the state does not create a serious obstacle
to economic development.

 

Norway provides a nice example. Its
wellbeing was primarily built on the abundance of its fish
resources, namely cod. Fishing, of course, is a far cry from
hydrocarbon extraction: cod fishing does not require much
investment, while the state can neither exercise rigid control over
access to cod catching, nor accumulate this resource in its hands.
Also, the location of cod is not always predictable. As a result,
practically any Norwegian could engage in the fishing business,
which laid the foundation for economic (and thus civil) freedom in
relations with the authorities. As Finnish economist Pekka Sutela
wrote, what is important is not whether or not a country is rich in
natural resources, but whether these resources serve as a natural
basis for the emergence of oligarchy and autocracy because of their
high concentration, or as a natural basis for building democracy
and equality as a result of their extensive occurrence.

One must add to this the extent of
natural resource diversification. Natural variety and the absence
of economic preferences for individual kinds of resources provide a
basis for competition, the diversification of the economy, and the
prevention of the formation of a single-product economy or
single-product export. It is important to diversify control over
resources, making it both state and non-state owned. Such tactics
are an essential factor of steady economic development and, later,
political democratization.

 

Second, a tremendous role is assigned to
the political situation at the moment when the abundance of natural
resources emerges. Occasionally the abundance of natural resources
emerges in a country that is already experiencing a very high level
of economic and political development. Under such conditions,
governmental decision-making procedures for using natural resources
are transparent. Furthermore, there exists a very low level of
corruption, together with a diversified economy. Such countries
include Britain and, especially, Norway, which unexpectedly came
into possession of a great amount of hydrocarbon resources
following the discovery of oil and gas fields in the North Sea.
Even in this case, however, governmental policies continue to run
the risk of sliding into populism. In the medium term – if we
follow the trend of Norway’s experience of the last 20 years – the
quality of economic policy will inevitably degrade under the
pressure of various kinds of lobby groups.

 

Third, under conditions of abundant
natural resources an economy can successfully develop in absolute
monarchies. This is true since the national budget of those
countries is actually identical to the budget of the ruling
dynasty. Furthermore, there is concern about the future generations
in monarchies because these are generally the rulers’ own heirs.
The authorities in those countries are more capable of making
long-term and effective decisions, including those intended to
raise society’s general wellbeing. However, this type of regime is
exceptionally rare in the contemporary world and their decisions
are not always effective in the long term, as indicated by the
record of the Gulf monarchies.

 

AMERICAN GOLD AND THE DOWNFALL OF THE
SPANISH SUPERPOWER

 

It seems to be a general rule that when
governments of different countries and different epochs encounter
similar problems, they initiate similar steps and commit similar
mistakes. This would apply to the situation when a particular
country suddenly strikes rich natural resources – especially when
this sudden gift is coupled with the country’s political
ambitions.

 

After the unification of the kingdoms of
Castile and Aragon in 1479, the possessions of the Spanish Crown
rapidly expanded. By the 16th century, Spain was one of the
strongest states in Europe and, therefore, in the entire world. By
the middle of the century, the Spanish emperor’s rule extended to a
large part of the Iberian Peninsula, the Netherlands, Sardinia,
Sicily and the whole of Italy south of Rome. From there it
traversed to the Central European dominions of the Habsburgs, and
also to the newly discovered lands in America.

 

The country had a strong army (including
Europe’s best infantry), navy, and extensive dynastic ties with the
major royal houses of the Old World. There emerged prerequisites
for the emergence of a new large empire, especially after King
Charles I of Spain was crowned emperor of the Holy Roman Empire
under the name of Charles V in 1519. The activities of Spanish
monarchs had a pronounced messianic nature: the suppression of
Islam and Protestantism, and the unification of the whole of
Catholic Europe.

 

Economic factors also seemed to be on
the side of the Spanish monarchy in its bid to become a real
superpower. At a time when economic prosperity was based
predominantly on agriculture, Spain held the leading positions in
horticulture and sheep breeding. This, in turn, laid the foundation
for the successful development of its textile industry. Add to this
the high level of agriculture and several industries in the Spanish
Netherlands, as well as the presence of mineral resources (iron,
copper, tin and silver) in Spanish-controlled areas of Central
Europe.

 

Yet the main source of the Spanish
empire’s power was based on precious metals discovered in America.
The new lands became the source of metal money – all the more
valuable since silver had risen in price in Europe shortly before,
causing a natural fall in the prices of other goods. By that time,
new technological methods were invented for extracting silver,
which considerably reduced the cost of its extraction in the New
World. The money came into the possession of the Crown (that is,
the national budget) and, to an even greater extent, into private
hands, which contributed to the country’s enrichment and increased
budget revenues (through taxes, revenues from coinage, and so on).
Gold from America was expected to pave the way for the realization
of Spain’s ambitious political goals. Quite possibly, the Spanish
monarch viewed the new source of countless riches as God’s blessing
for his Catholic mission.

The logic in the struggle for the title
of superpower inevitably aggravated the foreign-policy situation
and involved the Spanish Crown into a series of protracted wars.
Active military operations, which continued for almost 150 years,
required immense spending – the cost of war increased as the
knight’s cavalry began to be replaced with firearms.

 

With the circulation of coin, silver and
gold seemed to create the basis for the country’s reliable
financing. The inflow of precious metals meant a sharp increase in
the money supply, on the one hand, and the government’s budgetary
resources, on the other. The abundant monetary flow enabled Spanish
rulers to ignore the economic situation and therefore the need to
update their tax and budgetary policies.

 

The economic policy of the Spanish
government proved to be amazingly shortsighted (the same mistake
would be repeatedly made later by other resource-rich countries).
Spain did not have a long-term strategy to stimulate production,
and the isolated measures enacted by the government were largely
intended to ease social tensions and receive additional revenues.
Certain elements of the Spanish Crown’s economic policy (i.e.
attempts to regulate prices, the creation of monopolies on trade in
staple goods and their production, high and unfair taxes and the
retention of customs barriers inside the country) already looked
old-fashioned in the 16th century.

 

To combat grain price hikes, for
example, the government established price controls, which only
brought about grain shortage. To cope with this problem, the
government decided to stimulate grain import, which ruined domestic
grain production and turned the country into a grain importer for
centuries. The situation was much the same with its fabric
production.

 

The Spanish tax system (with one of the
highest tax rates in Europe) remained archaic. Although about 97
percent of all lands belonged to the aristocracy and the Church,
direct taxes were levied on peasants, artisans and merchants. Some
of the taxes were collected by the aristocracy, which then passed
the money on to the Crown. Therefore the tax base proved very
narrow, and the tax system ineffective in terms of budget revenues
and remained purely fiscal, thus suppressing, rather than
stimulating, economic development. There remained customs barriers
between different parts of the empire (and even inside the Iberian
Peninsula), which was motivated by fiscal considerations and the
authorities’ devotion to tradition. Different currencies circulated
in the country, making their conversion a painful process.

 

Thus, it turned out that the abundant
inflow of precious metals was creating serious
problems.

The first problem was that the need for
money grew faster than the amount of funds received by the Crown
from its overseas dominions. In spite of the abundance of monetary
resources, the country faced a steady budget deficit, which had
never happened before the accession of Charles I.

 

On the one hand, the vast silver and
gold reserves allowed the Crown to borrow money in any amount, as
it was confident of its ability to pay off any debts. On the other
hand, creditors easily lent money on the security of future
supplies of precious metals (and at usurious interest). Thus, Spain
suffered from something similar to “moral hazard” – a condition
described in contemporary literature – when an economic agent can
afford a lackadaisical attitude to decisions made.

 

In the first half of the 1570s, Spain’s
annual budget spending exceeded revenues by 50 percent, with huge
sums of money used to repay old debts. For example, in 1575 alone,
36 million ducats – an amount equivalent to the country’s revenues
over six years – were spent to pay off old debts. In 1577, the
Crown’s revenues stood at 13 million ducats, whereas in 1582, the
country’s accumulated debt amounted to 80 million ducats. Later,
the national debt continued to increase, reaching an unprecedented
sum of 180 million ducats by 1667.

 

The second problem was inflation. As it
turned out, Spain fell into a trap: the abundance of currency
metals provided the authorities with large monetary resources but,
at the same time, reduced the per-unit purchasing power of the
precious metals (see Fig. 1) which gave rise to inflation. This, in
turn, reduced the Crown’s revenues.

 

Figure 1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Since inflation was at that time a
little-known phenomenon in Western Europe, a large part of the
treasury’s revenues was established in absolute values. In the
second half of the 16th century, traditional budget revenues, fixed
in absolute sums (see Fig. 2), began to decrease. For some time,
the declining revenues were compensated for with American gold and
silver, although, as it turned out later, the amount was
insufficient for creating a steady financial basis for the
expansionist policy of the Spanish authorities. Already in the
second half of the 16th century, Spain’s budget, as a rule, ended
up with a deficit (see Fig. 3).

 

Figure 2

 

Figure 3

 

Furthermore, since Spain was the first
to be hit by the depreciation of a metal currency, the competitive
ability of Spanish producers naturally decreased: the value of
their goods in coinage was higher than the value of goods produced
by other countries. Something similar to “Dutch disease” resulted,
although its effect was not as significant as it would be within
the present conditions of the global economy.

 

The third problem was that the empire’s
economy and policy were adapted to meet the established situation
with its currency revenues, which made Spain extremely vulnerable
in two aspects. First, the Crown revealed its political and
commercial weakness with regard to creditors who, knowing that the
Crown could no longer survive without their loyalty, received an
instrument for blackmailing. Second, the Crown was exposed to
external shocks, that is, it became increasingly vulnerable to
market fluctuations.

 

Spain received foreign loans at high
interest rates from a financial cartel controlled by the Genoese,
as well as from German, Flemish and Spanish bankers. By way of
security, the Spanish Crown offered the creditors shares in silver
supplies and individual tax items, and the bankers were given the
right to serve the Crown’s financial transactions, including
monopolies on international money transfers and currency exchanges.
Considering that Spain’s lands were scattered throughout Europe,
this function played a significant role not only in the economic
sphere, but also in political and military respects. Since
different parts of the empire had different currencies in
circulation, the stability of money transfers was an imperative
factor for maintaining political stability. A still more important
factor was the implementation of financial transactions to pay war
expenses; any incorrect move by the debtor prompted creditors to
stop the transfer of money.

 

In the second half of the 1550s, the
supply of American precious metals to Spain decreased, thus
triggering the Crown’s first default in 1557, followed by another
in 1560. (Those developments were preceded by an unprecedented
political default: Charles V, apparently realizing that the
mounting problems had a systemic nature, abdicated the throne in
1556 after forty years in power.)

 

Interestingly, between 1556-1560 the
supply of precious metals to Spain decreased by more than half
compared with the previous five-year period, yet their amount was
proportionate with supplies from earlier periods (before the late
1540s). However, the preceding 15-20 years were marked by serious
monetary and structural changes. On the one hand, inflation reduced
the purchasing power of “American” money; on the other hand, the
Crown’s dependence on new financial infusions increased as Spain
was involved in more and more expansionist projects.

 

By the end of the 16th century, Spain
became completely dependent on the state of affairs in the American
mines. The country, which had formerly had a stable financial
system, began to repeatedly default on its foreign debts: after
1557 and 1560, defaults occurred in 1575, 1596, 1607, 1627, 1647,
1653 and 1680. For some time (under Philip II), Spain continued to
expand, and eventually conquered Portugal with its huge Eastern
colonies (1581). Later, however, followed a series of military
defeats (the crushing defeat of its Invincible Armada in 1588 came
as one of the heaviest blows). The financial crisis was followed by
a monetary one: not having enough budgetary resources, Philip III
and Philip IV began to “spoil” the currency by reducing the gold
and silver content of some coins. These measures, however, produced
only short-term effects for the national budget and could not
prevent a general degradation. The 17th century witnessed the
steady economic decline of Spain, and it eventually turned into a
second-rate country.

 

Despite mounting problems, the heirs of
Charles V continued to abide by his policy: they focused their
efforts on the achievement of imperial and messianic goals and
ignored the need for creating favorable conditions for economic
development. Spain lagged more and more behind other European
countries, which took the leading positions (the Netherlands,
England and France). Spain’s natural wealth (in this case
tantamount to “cheap” money) played a trick on the country: having
first created an illusion of political and economic
invulnerability, it caused the Crown to change its needs to meet
the new income level which led to a grave crisis. The crisis in
Spain continued for four centuries.

 

Thus, the collapse of the Spanish Empire
was a result of its over-inflated ambitions and ill-considered and
ineffective economic and budgetary policies. The inflated political
ambitions were partly provoked by the increasing inflow of “cheap”
money, which prompted the Crown to intensify its efforts to
consolidate and enlarge the empire.

 

World history knows many instances when
countries conducted bitter and protracted wars without bringing
things to financial or economic crises. These are, for example, the
Netherlands of the 16th-17th centuries or Britain of the 18th
century. Those countries did not have abundant natural wealth (thus
cheap financial resources) and were ruled by more reliable
governments which took into consideration the interests of
production and trade.