The rich mines of modern-day Mexico and Peru provided Spain and its Crown with a steady stream of silver between the mid-sixteenth and late seventeenth centuries, thrusting them to a position of hegemony in Europe and beyond. By the beginning of the seventeenth century, however, Spain entered a period of economic, political, and military decline, lagging behind the rest of Western Europe until well into the twentieth century, and never recovering the position of dominance it once had. The central contention of this dissertation is that the windfall acquisition of precious metals had a strong and persistent negative impact on the economic and institutional development of Spain. Two separate mechanisms, both anchored in the common root of exaggerated expectations about the magnitude and value of the silver remittances, worked towards such an outcome. The first channel was purely economic in nature: the perceived increase in permanent wealth set off a phenomenon known as the Dutch Disease, whereby resources were allocated away from traded sectors and into nontraded ones in a suboptimal manner, the competitiveness of domestic industries fell, and welfare was permanently reduced. The resource windfall, however, also had deep political economy implications. Relying on the hard currency base provided by the silver flows, the Crown was able to command unprecedented amounts of credit, which it used to finance its many ill-fated military campaigns; with costs soaring and revenue falling consistently short of expectations, the monarchy resorted to selling privileges, triggering a large increase in rent-seeking behavior. By the end of the seventeenth century Spain had lost most of its empire; it would still need over 200 years to rid itself of the perverse institutional legacy of American silver.

Standard Dutch Disease models revolve around static frameworks that, while exhibiting a shift in the composition of production from traded to nontraded industries in the presence of a resource boom, fail to explain the origin of long-term welfare losses that many resource-rich countries seem to experience.¹

In chapter 2 of the dissertation I build a dynamic general equilibrium model based on the work of Sergio Rebelo and Carols Végh to make up for this shortfall.² Such a framework preserves all the features of previous Dutch Disease models, but can generate welfare losses if agents fail to anticipate correctly the magnitude of the windfall. In the Spanish case, there is plentiful anecdotal evidence that both the Crown and private agents expected silver flows to be much higher than they actually were; these expectations might well have generated excessive consumption and insufficient savings in the short run. Once the true value of the resources was revealed, the Crown was repeatedly forced to declare bankruptcy, and individual income decreased markedly.

The model's main prediction, paralleling standard Dutch Disease results, is a discrete increase in the price of nontraded goods relative to that of traded goods (which is used as the numeraire) whenever the agents include a positive shock to permanent income in their expectations. Conversely, an expected reduction in permanent income would result in a discrete fall in the price of nontraded goods. Although national income data for the early modern period remain a chimera, prices for a wide range of goods and geographical regions are available in the works of Earl J. Hamilton.³

The price history literature, however, has not produced a suitable set of weights to convert those prices into the indexes of traded and nontraded goods needed to test the predictions of the model. I therefore constructed two such sets of weights, the first in the literature to be entirely derived from primary sources. My weights reflect data collected from 14 different institutions, representing purchases for over 250 different goods. The baskets used in the actual calculations were compiled from the records of the household of Queen Joanna in 1546⁴ and from the Hospital de las Cinco Llagas in Seville in 1587, because they had no gaps and contained the most representative bundles; results from the remaining sources were used to test the consistency of the baskets and to fill in gaps.⁵

The institutions whose records have survived to the present, namely hospitals, monasteries, and royal households, hardly resemble the Spanish representative consumer of the time. Royal households represent the extreme upper tail of the income distribution, whereas hospitals and monasteries exhibit consumption patterns that reflect their specific institutional goals. Hospitals are of particular interest; because they devoted most of their expenses to social assistance functions (such as feeding the poor), they provide a glimpse into the consumption of the lower classes, for which otherwise no records exist.

Armed with newly constructed price indices for traded and nontraded goods, I set out to identify whether their relative movements indicate the presence of Dutch Disease around the time of the silver discoveries. I use a Markov-switching regression model, which endogenously identifies the timing of the breaks and estimates their magnitude. For all three Spanish regions where price data are sufficiently complete, the model clearly identifies an increase in the price of nontraded goods at dates ranging between 1545 and 1550, precisely when the silver mines of Potosí entered full production. In all three regions, the model also identifies a discrete fall in the price of nontraded goods between 1575 and 1577, coinciding with the first Crown default on domestically held debt. Interpreted in context of the theoretical framework, a decline in the relative price of nontraded goods indicates a negative shock to permanent wealth; agents might well have interpreted the Crown's reneging as a signal that any future silver flows would have been used for servicing existing debt rather than for financing new consumption, as they effectively were.

The increase in the relative price of nontraded goods in the 1540s is estimated at between 5 percent and 15 percent, whereas its fall in 1575–1577 lies between 15 percent and 25 percent. A rough calibration of the model based on these values and parameters extracted from the data and the literature suggests that at the beginning of the silver boom agents expected its present value to be in the order of 50 percent to 100 percent of a year's GDP. The Crown and private Spaniards certainly spent much more than that in multiple military campaigns and luxury imports; in the face of adverse military events and declining silver returns, they were forced to decrease their permanent consumption by a substantial amount. It is worth noting that all my conclusions are obtained in the context of a simple, frictionless neoclassical model. Including considerations such as learning, rent seeking, and the allocation of human capital would predict even larger downturns, thus strengthening my results.⁶

Chapters 3 and 4 examine the decline of Spain in the light of rent-seeking theory. There is ample evidence that rent-seeking institutions such as venality, land entails, and ecclesiastical privileges gained a firm foothold in Spanish society starting in the second half of the sixteenth century, precisely when the silver windfall entered its culminating phase. Rent seeking did not occur directly over the ownership or distribution of the natural resources, however; although the bullion flows were substantial, they probably could not have been sustained for long without clear property rights defined over them. Rather, the Crown was able to leverage its share of the precious metals as collateral to engage in an unprecedented debt expansion, which it used to finance its multiple wars throughout Europe. As the silver stream fell short of the amount necessary to honor debt payments and sustain extremely expensive military campaigns, the Crown, rather than reduce some of its main expenditures, raised taxes while peddling all kinds of privileges and tax exemptions. The desperate effort to close the budget constraint from the revenue side encouraged a flight of skilled human capital to rent-seeking activities, as entrepreneurs abandoned productive trades to acquire nobility titles and the tax exemptions that came with them. The Catholic Church also received long-ranging privileges in exchange for a hand in raising revenue for the Crown, as did various guilds and trading organizations.

Rent seeking creates large welfare losses by diverting resources from productive uses into redistributive efforts, and discouraging additional wealth creation in the process. Its most damaging consequences, however, arise from situations where rent-seeking equilibria become traps from which economies are unable to escape without exogenous intervention. The model in chapter 4 uses a game-theoretical framework to show how a fiscal expansion combined with the possibility of buying tax exemptions from the government can drive an economy to such an equilibrium. Once the economy falls into a state where rent seeking dominates over entrepreneurship, it is no longer possible to reverse course using the policy tools available to the government. The global stability of the rent-seeking equilibrium can help explain why Spain continued to languish long after its wars of conquest and its mountains of riches had quietly become romantic stories of a golden past.

Economic and social decline are complex phenomena; although modern economic theory has concentrated its focus on economic growth, we still know very little about processes of decline. This work does not attempt to capture all the factors at play in Spain's fall from grace in the sixteenth and seventeenth centuries; it rather seeks to draw attention to one overwhelming force which set Spain apart from her neighbors, giving her access to vast economic resources. In the wake of the silver discoveries, kings, merchants, and ordinary people alike faced new choices and possibilities. The economic and institutional environments shaped and constrained those choices, leading Spain down a path of backwardness while some of her neighbors, unable to count on vast natural resources, slowly but steadily developed their industries and institutions, making their way towards modern economic growth. Blinded by silver dreams, Spain missed on the ways of technical progress and sound institutions; it would take two centuries for her to finally awake, and much longer to make up the lost ground.