The building industry and the financial sector expanded more than other segments of the economy. Many governments allowed their expenditure to rise in pace with higher tax revenues. Like the banks, many governments also moved some expenditure off the balance sheet, through public private partnership (PPP) agreements, for example. The bubble was allowed to expand. Households borrowed too much, house prices were too high, banks and the building industry were too big and government expenditure and debt grew too rapidly. The imbalances gradually surfaced. The problems arose initially in the US housing market and spread in earnest when money and capital markets abruptly dried up in September 2008. Once the crisis had become a reality, the authorities responded rapidly. To begin with, they provided support where the financial markets had failed, by providing guarantees, offering liquidity and funding and purchasing securities. Central bank key rates were aggressively cut. The crisis in the 1930s had shown that the cost of failing to implement such measures was very high. (See Chart: Sovereign debt to GDP in the G7.) The rescue packages moved private debt onto government and central bank balance sheets. In addition, tax revenues declined and social security expenditure increased. In the next phase, governments had to counteract falling corporate and household demand for goods and services by increasing public consumption and investment. Many countries entered the crisis with deficits and a relatively high level of debt.
When a loan matures, it may therefore be tempting for a government to renege on its promise to repay the  3  See Carl August Fleischer (2005): Folkerett (International law). 4  Eduardo Borensztein and Ugo Panizza (2009): “The Costs of Sovereign Default”, IMF Staff Papers, Vol. 56, No. 4. BIS Review 123/2010  3  debt. In economic policy this is known as a time-inconsistency problem. It can be profitable to make lofty promises, but turn your back on them once you have cashed in the benefits. Why do countries not renege on commitments in stable times? We observe that they do honour their commitments, but the economic literature does not provide us with a good explanation for why this is the case. Countries want to preserve a good reputation. Governments that default do so in adverse times, but only after sharp fiscal retrenchment to avoid that fate. 3. Countries default more frequently than we believe  It is no new phenomenon that some countries live beyond their means and fail to settle the bill. History shows that many countries have defaulted on sovereign debts. This has occurred during emerging phases. From 1500 to 1900, Spain defaulted on its sovereign debt 14 times. 5 France defaulted nine times in the same period, while the states that later became Germany defaulted six times. England also defaulted once, but as far back as in 1594. (See Chart: Sovereign debt default.)