More Credit, More Debt: Lessons from the Last Great Unraveling

“The lord giveth increase, but man devised credit.”  — Garet Garrett

Solving the Debt Problem with Credit

Something quite remarkable happened in the years following the war to end all wars.  European economies were ruined and European governments were buried in debt owed to the United States Treasury.  On top of that, Germany’s economy was being strangled by reparation payments to France as part of the Versailles peace treaty.

One option for Europe was to default and repudiate the debt.  While such an option would have been incredibly disruptive, it would have given Europe the opportunity to clear the financial baggage of the war, and slowly rebuild a sound economy.  Instead, Europe’s solution to its mammoth debt burden was to attack it with credit.

The United States’ government, which was owed a bundle, resisted financing European reconstruction.  However, private American creditors and speculators were eager to put their excess capital to work.  In fact, Wall Street was so enthusiastic to invest in Europe they too fell under the delusion that Europe’s debt problem could be solved with American credit.

In short order, credit flowed from America to Europe like flood water to the Mississippi Delta.  The general notion was that extending massive amounts of credit to Europe was needed for America to expand its foreign trade.  What was really happening was, like China extending credit to America to consume Chinese products in recent years, America was lending Europe money so they could use it to buy American goods.

Where is the State of Minas Geraes?

Wall Street made little care to where the credit was actually going.  Predictably, it was misallocated to unprofitable projects and enterprises.  Author Garet Garrett, in his 1932 work, A Bubble that Broke the World, captures the folly of it all…

“Obsessed with the thought of having a surplus of goods and a surplus of credit that we were obliged to lend, only to be rid of them, still there was no surplus in this country of good housing for people of low income in the cities.  There was and is enormous need for such housing.  The credit with which to meet it is difficult to command.  Yet American credit was loaned freely to other countries for that purpose, notably to Germany.

“Capital borrowed on public credit to replace slum dwellings with model tenements may not be very profitable.  It seldom is.  But if we use our own capital for that purpose, even though it be lost, still we have the model tenements.  If we build pyramids with our own credit at least we have the pyramids to enjoy; if we use our credit for works of private profit that turn out badly, the creditors who loaned the credit may send the sheriff to sell the property into new hands for what it will bring, and although we have wasted some credit, we have the externalized corporality of it entire.

“But if we lend our credit to foreign countries and they build pyramids with it, we have to spend money in foreign travel even to look at them; and if we lend our credit for skyscrapers and railroads and power plants to be built in foreign countries and these turn out badly we cannot send the sheriff to seize them.

“Where is the State of Minas Geraes?  You would not be expected to know.  We loaned sixteen millions [equivalent of $218 million today] of American credit to the State of Minas Geraes, and all we know about it is that the bonds of Minas Geraes are in default.  If Amarillo, Texas, had lost sixteen millions of American credit we should at least know where to go look for it.”

More Credit, More Debt: Lessons from the Last Great Unraveling

These days America is no longer the world creditor.  It, along with most western governments, is a debtor.  Over the years, America has attacked its debt problem with credit.  As a result, the gross federal debt’s grown about $7 trillion dollars since the 2008 financial crisis while the economy has slumped over like a rotten potato sack.

For the first time in 60 years, more credit does not equal more growth; it equals more debt with little or no growth.  Moreover, growing the economy has been near impossible when it is weighted down with so much debt.  What’s going on?

The U.S. economy, and most western economies, has reached total debt saturation.  That’s why piling on more debt through massive fiscal stimulus and monetary easing over the last four years has failed to produce a notable economic recovery.  Suspending the problem of too much debt by adding more credit has pushed the economy beyond its debt capacity…the addition of new debt now only weighs the economy down.

During the last great unraveling it took a great depression and a second world war to sort out the consequences of the first world war and the credit delusions of the 1920s.  As credit fails over the next decade, governments will eventually be forced to default and repudiate their debt.  Following the loss of credit living standards will fall from the acclimate levels that the credit made possible.  Entitlements will be reneged.  People will be outraged.

In the meantime, in the words of Garrett, the solution will be, “more credit, more debt.” But, alas, the solution is the problem.

Sincerely,

MN Gordon
for Economic Prism

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