Debt, Defaults and Crises: A Historical Perspective

Abstract

The financial crisis that has been wreaking havoc in markets across the world since August 2007 had its origins in an asset price bubble that interacted with new kinds of financial innovations that masked risk; with companies that failed to follow their own risk management procedures; and with regulators and supervisors that failed to restrain excessive risk taking.A bubble formed in the U.S. housing markets as home prices across the country increased each year from the mid 1990s to 2006, moving out of line with fundamentals like household income. Like traditional asset price bubbles, expectations of future price increases developed and were a significant factor in inflating house prices. As individuals witnessed rising prices in their neighborhood and across the country, they began to expect those prices to continue to rise, even in the late years of the bubble when it had nearly peaked.When the 2008 crisis hit, governments, corporations and individuals defaulted on interest payments. However, government debt defaults are a recurring feature of public finance. These defaults have typically involved low-income and emerging-market economies, although recent cases include advanced-economy sovereigns.Sovereign states have borrowed money for hundreds of years. Sovereign debt was one of the first financial assets ever traded, and continues to comprise a significant fraction of global financial assets. Unlike private debt, sovereign debt is especially difficult to enforce. For centuries, the legal doctrine of sovereign immunity limited suit against defaulting sovereigns, while few government assets are available for attachment in foreign jurisdictions.