|Forecasting America's Destiny ... and the World's|
|HOME WEB LOG COUNTRY WIKI COMMENT FORUM DOWNLOADS ABOUT|
Read the following text:
This is a delusion about credit. And whereas from the nature of credit it is to be expected that a certain line will divide the view between creditor and debtor, the irrational fact in this case is that for more than ten years debtors and creditors together have pursued the same deceptions. In many ways, as will appear, the folly of the lender has exceeded the extravagance of the borrower."
The above sounds very familiar. It's similar to things that I and many other people have written about the debauched use of credit today.
But this wasn't written today. It appeared in a 1932 book that a web site reader recently alerted me to.
The book is A Bubble that Broke the World, by Garet Garrett. A pointer to the PDF file for the entire book can be found on this web page on mises.org. It was based on a series of articles by the author appearing in the Saturday Evening Post during 1931.
I strongly urge everyone to read the entire book. Much of what the book describes informs us about what's happening for the next 2-3 years, especially in our relationship with China. In this article, I explore the similarities between then and now, and make some predictions about the next couple of years.
From the point of view of Generational Dynamics this kind of material is extremely valuable, because it gives you a window into the attitudes and behaviors AT THE TIME that great events are taking place. It's true that some of the opinions and facts claimed in Garrett's book turned out later to be wrong or discredited, but that's not the point. The point is that this book tells us what people were thinking at a crucial time, just following the crash of 1929. Books written in later decades may be more factually accurate, but the attitudes of people are filtered by later political and generational changes.
What's remarkable about this book is how closely it mimics many of the discussions that are going on today. The paragraphs quoted above say that the 1920s stock market bubble "mass delusion" -- in fact, a "delusion affecting the entire world" -- something that I've said many times is going on today.
Garrett also says that that lenders and borrowers are practicing the same deceptions, and that "the folly of the lender has exceeded the extravagance of the borrower."
In 2005, almost no one would have said that this is true in modern times. But today, in 2007, this is generally accepted to be true. Almost everyone now agrees that mortgage lenders and mortgage borrowers used similar deceptions with each other, and that, in many cases, "the folly of the lender has exceeded the extravagance of the borrower," especially in the area of subprime mortgages.
Garrett says: "The general shape of this universal delusion may be indicated by three of its familiar features."
He lists three familiar features of the universal delusion, given below.
As you read this text, make sure that you understand that some things are REVERSED from where they were in the 1920s: At that time, the U.S. was a CREDITOR nation, lending money to many countries in Europe, especially Germany.
Today, the U.S. is a DEBTOR nation, and China is the CREDITOR nation, lending huge amounts of money to the U.S.
So, as you read the text below, and compare it to today's situation, remember that what was true of the U.S. in the 1920s is true of China today, and what was true of Europe, especially Germany, in the 1920s, is true of America today.
Here are the three familiar features of the universal delusion. The comments in [brackets] are mine:
Debt in the present order of magnitude began with the World War [World War I, 1914-18]. Without credit, the war could not have continued above four months; with benefit of credit it went more than four years. Victory followed the credit. The price was appalling debt. In Europe the war debt was both internal and external. The American war debt was internal only. This was the one country that borrowed nothing; not only did it borrow nothing, but parallel to its own war exertions it loaned to its European associates more than ten billions of dollars. This the European governments owed to the United States Treasury, besides what they owed to one another and to their own people. Europe's attack upon her debt, both internal and external, was a resort to credit. She called upon this country for immense sums of private credit—sums which before the war had been unimaginable—saying that unless American credit provided her with the ways and means to begin moving her burden of debt she would be unable to move it at all.
Result: The burden of Europe's private debt to this country now is greater than the burden of her war debt; and the war debt, with arrears of interest, is greater than it was the day the peace was signed. And it is not Europe alone. Debt was the economic terror of the world when the war ended. How to pay it was the colossal problem. Yet you will find hardly a nation, hardly any subdivision of a nation, state, city, town or region that has not multiplied its debt since the war. The aggregate of this increase is prodigious, and a very high proportion of it represents recourse to credit to avoid payment of debt.
[[There has been no recent World War that has caused America's enormous debt to China today. However, as the last paragraph shows, it wasn't the war that caused the huge debt, but the profligate use of credit in the 1920s. Garrett expands on this concept in the following paragraphs. It's this profligate use of credit that was the CAUSE of the huge debt in the 1920s, and is the CAUSE of the huge debt today.]]
[[In the 1920s, it was believed that everyone could be part of the American dream by investing in the stock market. Even a poor person could enter the stock market by investing on margin. In the 2000s, the argument made for widespread use of subprime mortgages was that people who ordinarily couldn't afford a home could now own one.]]
Result: Probably one half of all government, national and civic, in the area of western civilization is either bankrupt or in acute distress from having over-borrowed according to this doctrine. It has ruined the credit of countries that had no war debts to begin with, countries that were enormously enriched by the war trade, and countries that were created new out of the war. Now as credit fails and the standards of living tend to fall from the planes on which credit for a while sustained them, there is political dismay. You will hear that government itself is in jeopardy. How shall government avert social chaos, how shall it survive, without benefit of credit? How shall people live as they have learned to live, and as they are entitled to live, without benefit of credit? Shall they be told to go back? They will not go back. They will rise first. Thus rhetoric, indicating the emotional position. It does not say that what people are threatening to rise against is the payment of debt for credit devoured. When they have been living on credit beyond their means the debt overtakes them. If they tax themselves to pay it, that means going back a little. If they repudiate their debt, that is the end of their credit. In this dilemma the ideal solution, so recommended even to the creditor, is more credit, more debt.
[[This was written in 1931, two years after the crash. This paragraph gives us a picture of where the U.S. and the world are headed -- social chaos.
Garrett didn't know that another world war was coming, but we'll discuss below how this situation gave rise to Naziism in Europe and Japanese imperalism in Asia.
Today, as I've said many times, my expectation is that the coming worldwide financial crisis will destabilize many countries, most notably China, which is already approaching civil war.]]
This inverted way of thinking was fundamental. It rationalized the delusion as a whole. Its most astonishing imaginary success was in the field of international finance, where it became unorthodox to doubt that by use of credit in progressive magnitudes to inflate international trade the problem of international debt was solved. All debtor nations were going to meet their foreign obligations from a favorable balance of trade.
[[This hardly needs any comment. The worldwide credit bubble today has been implemented by "financial engineering" techniques by international financial firms. They've created a huge mass of CDOs and other credit derivatives with a notional value of $750 trillion, when the total annual value of all goods and services (GDP) of the entire world is only $45 trillion.]]
A nation's favorable balance in foreign trade is from selling more than it buys. Was it possible for nations to sell to one another more than they bought from one another, so that every one should have a favorable trade balance? Certainly. But how? By selling on credit. By lending one another the credit to buy one another's goods. All nations would not be able to lend equally, of course.
Each should lend according to its means. In that case this country would be the principal lender. And it was.
[[In the 1920s, the U.S. lent huge amounts to other nations, so that those nations could purchase American goods. Today, China is lending the U.S. huge amounts, so that the U.S. can purchase Chinese goods.]]
As American credit was loaned to European nations in amounts rising to more than a billion a year, in the general name of expanding our foreign trade, the question was sometimes asked: "Where is the profit in trade for the sake of which you must lend your customers the money to buy your goods ?"
[[A billion a year? That's nothing today, where China has loaned America hundreds of billions of dollars, by purchasing long-term Treasury bonds.]]
The answer was: "But unless we lend them the money to buy our goods they cannot buy them at all. Then what should we do with our surplus?" ...
[[This is EXACTLY what we're hearing today. Americans arrogantly claim that the Chinese MUST continue lending us money, because otherwise the Chinese economy will crash.
As for China, the Chinese Prime Minister has warned that China is becoming unstable, and also as "unsteady, unbalanced, uncoordinated and unsustainable," mainly because the country is so dependent on exports. The implication is that China MUST continue its high level of exports -- which means, of course, that Chinese must continue giving us credit. The only concern that the Chinese express is over the compulsive xenophobia in Congress.]]
By this argument for endless world prosperity as a product of unlimited credit bestowed upon foreign trade, we loaned billions of American credit to our debtors, to our competitors, to our customers, with some beginning toward the backward people; we loaned credit to competitors who loaned it to their customers; we loaned credit to Germany who loaned credit to Russia for the purpose of enabling Russia to buy German things, including German chemicals. For several years there was ecstasy in the foreign trade. All the statistical curves representing world prosperity rose like serpents rampant.
Result: Much more debt. A world-wide collapse of foreign trade, by far the worst since the beginning of the modern epoch. Utter prostration of the statistical serpents. Credit representing many hundreds of millions of labor days locked up in idle industrial equipment both here and in Europe. It is idle because people cannot afford to buy its product at prices which will enable industry to pay interest on its debt. One country might forget its debt, set its equipment free, and flood the markets of the world with cheap goods, and by this offense kill off a lot of competition. But of course this thought occurs to all of them, and so all, with one impulse, raise very high tariff barriers against one another's goods, to keep them out. These tariff barriers may be regarded as instinctive reactions. They do probably portend a reorganization of foreign trade wherein the exchange of competitive goods will tend to fall as the exchange of goods unlike and noncompetitive tends to rise. Yet you will be almost persuaded that tariff barriers as such were the ruin of foreign trade, not credit inflation, not the absurdity of attempting by credit to create a total of international exports greater than the sum of international imports, so that every country should have a favorable balance out of which to pay its debts, but only this stupid way of people all wanting to sell without buying.
[[Once again, we get a glimpse of our own future. In 1930 and 1931, in reaction to the stock market crash, one country after another, including the U.S., implemented harsh tariffs, supposedly to "preserve jobs." Today we're already moving in the same direction, with the Congress's compulsive xenophobia in Congress.]]
Writing in 1931-32, Garrett described the major features of the "Universal Delusion" that led to the stock market crash and subsequent financial crisis that was enveloping the world at that time.
We've already seen that this kind of universal delusion has already occurred in the last two years over the real estate bubble, and that these features are present in the world economy as a whole, especially thanks to the debauched use of credit derivatives.
The phrase "global savings glut" was made famous by Ben Bernanke, when he used it in a speech in March, 2005. When speaking about America's astronomical and exponential growing debt to other countries in March, 2005, Bernanke blamed America's debt on "global savings glut" in other countries. Since then, Bernanke has replaced Alan Greenspan as Fed chairman.
Something similar happened in the 1920s, only this time it was an "American savings glut." Here's how Garrett describes it, quoting international financier Dwight W. Morrow:
The contemplation of the extent and variety of America's investments in foreign bonds gives rise to three questions: Who buys these bonds? Why do they buy them? What do they get when they have bought them?"
From statistical evidence Morrow concluded that more than four buyers in every five were small investors and bought them in amounts from $100 up to $5,000.
We can only imagine what's been happening in China. Hundreds of millions of Chinese people have been saving money for years, just as Americans used to save money in the 1920s. These Chinese people have been investing their savings in businesses or the stock market or perhaps, in some cases, directly in US bonds. One way or another, the savings hundreds of millions of Chinese people has been lent to Americans, who have used the money to purchase Chinese manufactured goods.
The lynchpin of today's worldwide bubble is the financial services industry. Financial engineers in these firms have been brilliant in creating new kinds of securities, such as $750 trillion in credit derivatives. These securities could then be sold to investors, and financial engineers take fat commissions on the sales.
Do you think that this is new? No, it happened in the 1920s as well. Garrett explains how all those 127 different kinds of bonds from countries big and small around the world came to be sold to Americans.
According to Garrett, it starts with the banker: "There is first the bank that discovers and originates the bond issue. Let the borrower be a foreign government. The bank undertakes to buy from the foreign government so many bonds of a certain character...."
Then the banks in this business form a group of banks which Garrett refers to as a "jobbing group." Today we'd call it a hedge fund or an investment house. The bonds may go through another intermediary or two, but eventually they're sold to individual investors.
At each intermediate step, there is a significant commission paid to the intermediary in the form of a price increase. According to Garrett, "There are variations of the price steps, and, if the bond issue is small and juicy, the jobbers may go direct to the retail trade or the wholesalers themselves may perform the jobbing function, so that there may be only three steps instead of four; but with such slight modifications, the method as described is standard."
All of the above was discovered after the 1929 crash by the Senate Committee on Finance. They were trying to figure out what had gone wrong:
All of that the committee could understand. Given the point of view of the international banker, that he is like a grocer, and then the uncontrollable demand on the part of the American public for his merchandise, it could understand why representatives of Wall Street banking houses went frantically to and fro in the world, pressing American credit upon foreign governments, foreign cities, foreign corporations, soliciting them to issue bonds to satisfy that American appetite; why at one time twenty- nine such representatives were all soliciting a small Latin- American country to make a bond issue in Wall Street; even why American bankers paid large commissions, vulgarly mentioned as bribes, to influential private persons in foreign countries who could lead them to a new bond issue.
It received with pleasure an acknowledgment of practical error from the head of a private banking house who said: "Yes, but it is also true that those things existed not only in Latin America, but the world over, relating to governments, municipalities and industrial concerns. In other words, the accumulation of capital in America was seeking an outlet. The bankers were the instruments of the outlet. They were the purveyors of capital. The bankers competed to a degree that in retrospect was wholly wrong. I am not speaking morally."
In other words, it wasn't the just the borrowers with debauched use of credit; it was also the lenders.
At this point we're going to repeat a paragraph that appeared at the beginning of this posting:
You can see how counter-intuitive this is. If I'm going to lend money to you, I should normally be more cautious than you, because I want to be sure that I'll get my money back, perhaps with interest.
But if I'm a salesman for a financial services firm, then I have no need to exercise caution, because it's the firm's money, not my money. I have nothing to lose, and I have a fat commission to gain.
There are two things that are remarkable about this situation.
The first is that what was happening the 1920s is exactly what's happening today. People who think that everything that's happening is all new, because of the internet or whatever, are completely wrong.
The second thing that's remarkable is that none of this happened in between then and now. Think about the conversations that you had with your parents and grandparents, people who actually lived through the Great Depression, and you know how cautious they were about debt and credit.
All of the "financial engineering" that occurred in the 1920s had completely disappeared in the 1950s and 1960s. In the 1970s it started appearing again, and today it's rampant.
That's the Generational Dynamics cycle: A new financial crisis occurs at the time that the survivors of the previous financial crisis all disappear (retire or die), all at once.
Garrett's book has a lengthy discussion of how deflation occurs.
This discussion, which I won't excerpt here, makes many of the same points that are in my essay, "Understanding deflation: Why there's less money in the world today than a month ago."
I strongly urge reading Garrett's book for those who wish to better understand inflation and deflation.
On May 11, 1931, the Credit-Anstalt bank of Austria failed. This triggered mass panic and bank failures throughout Central Europe, and generated a worldwide banking crisis. On July 13, the German Danatbank failed. Foreign investors in Germany quickly withdrew their capital from Germany, heightening the crisis, leading to the complete collapse of the German economy. By the end of the year, there were over 6 million unemployed, and the resulting social tension gave rise to Communism and Naziism.
Almost none of the facts in the above paragraph appears in Garrett's book. Garrett was writing contemporaneously with these events, and he didn't see the "big picture" that we see today.
There's no sense in the book that a major Great Depression had begun; in fact, as far as I can tell, the word "Depression" didn't get used much by anyone until the 1932 Presidential campaign, where it became a political phrase. The real economic impact of the crash had not yet been felt.
There's no mention of Naziism in his book. Socialism is mentioned as the form of government favored in Britain by the Labor party. Communism is discussed as a major threat. Japan was invading Manchuria around that time, and war between Japan and China was beginning, but Garrett doesn't mention it. President Herbert Hoover is mentioned frequently, but of course future President Franklin Roosevelt is never mentioned.
What we DO see in Garrett's book is a window into the attitudes and behaviors of people in 1931, one to two years after the 1929 crash. In particular, we see America's attitudes towards Germany in a way that isn't possible in books written later, after Hitler came to power. That's an example of why contemporaneous books are so valuable from the point of view of Generational Dynamics.
What we also see in Garrett's book is a look into our own future. We can look at the relationship between America and Germany in 1931, and understand from that what our relationship with China might be in 2009.
After Germany capitulated in the World War (World War I), The Treaty of Versailles imposed reparations on Germany.
We're going to quote extensively from Garrett's descriptions of the contemptuous attitudes that Europeans had towards America, because that will tell us how Americans will develop an increasingly contemptuous attitude toward the Chinese in the months to come.
It's well known today that Germany inflated its currency in the early 1920s in order to be able to pay reparations in cheaper marks. Here's how Garrett describes what happened, writing in 1931:
Then the French conceived the grim idea of collecting reparations by force. That was when they went into the Ruhr and seized the very heart of Germany's industrial machine. All they proved was that you cannot collect reparations from an unwilling people by force. The Germans would not work their machine to produce tribute for the French. There were strikes and riots and, worse still, threat of wrecking the machine itself or jamming it by sabotage. Imagine it, when the slip of a monkey wrench in the hands of a sullen German workman might cost the French a million francs of tribute. That was the French problem in the Ruhr, where they had the industrial heart of Germany in their hands. Suppose they had said: "Very well, we shall take the machine into our own hands and run it." But that would mean bringing workers and technicians from their own country. There would be no profit in that. Besides, if they did it, they would have a starving, idle German population on their hands. The Ruhr party cost the French more than they got out of it. No reparations that way.
At this impasse the nations of Europe joined to call on the United States, saying: "We are emotionally and politically mad. We have only sanity enough left among us to know that we are. Simply, we cannot think economically. You over there have the vision of distance. Think of a way in which we may go on here in Europe. For unless you can we shall go to pieces. Bring us a plan." We did. We sent American experts to straighten them out; we gave them the Dawes Plan. Germany accepted it, crossed her heart for a policy of fulfillment, and borrowed $200,000,000 gold to get started with.
Since the Dawes Plan took effect-—since 1924, that is to say—Germany's net payments on account of reparations, according to her own figures, have amounted to $2,350,000,000.
In the same time, still according to her own statistics, she has borrowed from other countries the incredible sum of $3,750,000,000.
This is to say, that since 1924 she has borrowed $1,400,000,000 more than she has paid out on account of reparations.
Roughly, two thirds of this borrowed money came from the United States. The next largest part of it came from Great Britain. The rest of it from France, Holland, Switzerland, and other lending countries. More than three quarters of the total came from her former enemies.
Simply to say that Germany borrowed with one hand and paid reparations with the other, or that out of every dollar she borrowed she paid sixty-three cents in reparations and kept thirty-seven, does not tell the whole story. The money had a circular movement. It went one way into Germany, stopped there for ninety days, six months, a year or more, to work, and then went out another way, like water turning a mill wheel. It is important to remember this, for it explains many otherwise incomprehensible effects. The money did not just go in and out again; it was detained and put to work. That is what people who talk economics mean when they say that with borrowed money Germany built up her internal economy in order to be able to pay reparations and then paid them out of the increase of her wealth. She did build up her internal economy amazingly. She knew how to bend that stream of money on the wheel. And that is how it happens that she is to-day the second most powerful industrial nation in the world. The United States is first in the world. Germany is first in Europe."
Thus, according to Garrett, the whole regime of German reparations was part of the "universal delusion."
Yes, the Germans had paid $2.3 billion in reparations but, at the same time, they had borrowed $3.7 billion, mostly from America.
Meanwhile, our Allies had borrowed money from us to fight the World War, and were obligated to repay those war debts to America. In order to pay those war debts, the Allies depended on receiving the war reparations from Germany:
So, in the 1920s and early 1930s, it was American money taking a grand circular trip, to Germany, to the Allies, and then back to America, "the worse for wear."
Garrett indicates with the phrase "debtor mentality" that this situation caused a great deal of European resentment and hatred directed at America. He says that "we are now hated [for the war debts] in Europe and [they] no doubt will turn out to be worth very little." In addition, he refers to "that European feeling against America as the Shylock nation."
What did America gain for all the American credit?
Germany tells her people that if they did not have to pay reparations—called tribute—to the once allied nations, German wages would go up, German taxes would come down, German poverty would vanish, the German sun would rise."
During the 1920s, the international credit bubble grew, just as it's been growing today since the late 1990s. After the 1929 crash, the bubble started unraveling, and deflation set in. During all this period, it was the "Shylock nation" America that was preventing a larger international financial crisis by providing loans of billions of dollars.
In 1931 (following the May 11 failure of Austria's Credit-Anstalt, as we've described), it was no longer possible for American money to prevent further collapse. (Or, to put it another way, the credit bubble was many, many times larger than available American money. This is true on a worldwide basis today.)
Garrett, writing in 1931, did not see this "big picture." What he saw was American money being wasted by sending it to Europe where it did no good whatsoever.
Garrett felt particularly insulted by the arrogant German attitude that America and the Allies had no CHOICE but to continue to bail Germany out.
On June 20, 1931, President Herbert Hoover proposed to relieve the world banking crisis by means of a debt payment moratorium of one year on all intergovernmental debt -- that is, all reparations paid by Germany to the Allies, and all war debt payments by the Allies to America. It was thought that this would stem the banking crisis (just as it's thought that a Fed interest rate cut can always stem a worldwide banking crisis today).
Garrett provided a picture of the contemptuous view that Europeans held toward Americans:
Even so there were difficulties, because it would still cost Europe herself something to save Germany. The situation was that France, Great Britain, Belgium and others had been collecting as reparations from Germany a little more than $400,000,000 a year and paying the United States on account of their war debts to the American Treasury a little less than $250,000,000 a year. Thus a general international war debt holiday to save Germany would cost them the difference, or about $150,000,000. Great Britain had been collecting from her war debtors only $50,000,000 more than she had been paying to the United States on account of her own American war debt; and she was willing. But France had been collecting from Germany $100,000,000 more than she had been paying to the United States Treasury on account of her war debt, and she was unwilling. After long and painful negotiations it was agreed, for the sake of the debt holiday plan and to save Germany, that France should receive special treatment. An irreducible portion of her reparations money would be paid by Germany to the International Bank at Basle and then reloaned by France to Germany under a new arrangement. Everybody else took Germany's word for it.
Thus the plan took effect. It cost us $250,000,000. Well, a little more. While Germany's European creditors were debating the plan and higgling over what it was going to cost them, the Federal Reserve Bank in New York made a direct loan to the German Reichsbank to keep it open. Say, then, it had cost us altogether $300,000,000. Was it not cheap?
We really thought we had done a grand thing; we read every morning in the newspapers that it was a grand thing. The diplomats and chancelleries of Europe were saying so, on typewritten slips, or in interviews, and the American correspondents were quoting them to us by cable. But the typewritten words of diplomats and chancelleries are purposefully suave. What people were really thinking and saying, even the diplomats, was very different. They were saying, among other things: "This is the beginning of the end of our hateful war debts to the U(ncle) S(hylock) Treasury."
Conservative British newspapers did play up to the official Downing Street tune, the more willingly because it happened to be the British season for hating France; all the popular papers were sarcastic.
French opinion was caustic. These Americans, always saying they wouldn't and didn't, now again blundering their hands into the affairs of Europe, not understanding them at all. Interfering without knowing what it was they interfered with. Using their power of credit to dictate terms between France and Germany. Why shouldn't they lend their credit as credit merely, in a financial way, and otherwise mind their own business ? Besides, they were in bad manners, as usual, to propose that France should forego German reparations for a year without having first consulted France about it."
In fact, French political opposition torpedoed the plan. That's worth thinking about as we consider French attitudes towards the U.S. in recent years.
The Germans were even more contemptuous:
However, we still thought very well of it ourselves. And in any case, looking at it unromantically, the solvency of Europe was a bargain at $300,000,000, if really we had saved it. But in a little while it appeared very clearly that we hadn't. Within two weeks the whole of that $300,000,000 credit had been swallowed up and Europe was saying to us:
"Now see what has happened! The Hoover plan was all right; the intention was good. Only it was inadequate in the first place, and then, unfortunately, the dilatory and public discussion of it by the nations concerned has advertised Germany's condition to the whole world. Now all of Germany's private creditors are in a panic. American banks are calling their deposits out of German banks. The Germans themselves are in flight from the mark. What are you going to do about it? If after this you let Germany go down, it had been better to have done nothing at all. And if you let Germany go down, all of Europe may crash."
So, there was another American loan. That failed as well, and there was yet another American loan, this time to Britain:
Which was to say, the Americans had no right to name the terms on which they would lend their money to save the Bank of England or to save the credit of the British Treasury. They ought to lend their money and mind their own business.
How do people arrive at this ground of unreason—the English people, who before us were the world's principal creditors with a creditor mentality?
It is not simply that political passions have distorted the facts. That is true. But the facts belong to finance and finance is lost in its own world. It knows neither the way to go on nor how to go back. Having raised international debt to a new order of magnitude, now it faces international insolvency of the same grand order, and it is appalled. It cannot manage the facts. The only solution it can think of is more European debt, more American credit. By itself it cannot create any more debt. If the resources of private credit are not quite exhausted, the credulity of the creditor is about to be. But there may be still some resource left in the public credit of Europe. Finance at this point adopts the mentality of the crowd in the street. Let government do it. Let all the European governments increase their debts who can, to save themselves and one another. This is literal."
As the crisis worsened, the Shylock nation was blamed more and more, especially as debt owed to private American institutions began to exceed the amounts owed to the US government in war debt repayments:
This is the sequel international finance does not foresee. When it comes suddenly to the end of its own resources, as it did in 1931, it must call on governments to interfere; after that all talk of keeping finance free of politics is sheer nonsense.
The real crisis in Germany last summer came after all nations had been relieved of war debts for one year, under the first Hoover plan. It was concerning the solvency of Germany in respect of her debt to private creditors that a seven-power conference of prime ministers was held in London in July. There the United States was represented by the American Secretary of State and the American Secretary of the Treasury, and there came forth the second Hoover plan, to save Germany from having to default on her debt, not to other governments, but to private creditors. The situation had got beyond the control of international finance; therefore, governments were obliged to interfere."
The last paragraph moves us to the next great event: an international conference to be held in London on July 31. Americans and Europeans were going to figure out how to rescue Germany from its crisis.
Garrett quotes several selections from then-current German sayings:
German guilt was a lie.
The Treaty of Versailles is the great crime of modern history.
Reparations are tribute.
In 1917 America joined the Allies against Germany because then her money was on that side.
Among nations, the debtor is dear to the creditor.
The Hoover debt holiday plan in 1931 was to protect two billions of American money in Germany, for now America is bound by what Germany owes her to be Germany's political friend."
According to Garrett, the Germans were so resentful that they were unwilling to discuss any compromises whatsoever:
The above reveals an important comparison to today's credit crunch: Using short-term borrowing to pay long-term debts. This works as long as the short-term borrowing can continue to be "rolled over" at low rates. Once short-term credit becomes less available, a credit crisis begins.
This is exactly what's happening today, as I described in "IMF questions the globe's continuing financial stability." This is another similarity between then and now.
Germany began to become openly threatening toward America and the Allies, saying that if they refused to save Germany, then Germany would go bankrupt and even worse, will turn Communist:
At this point of the German discourse international finance began to shudder. For six years it had been pouring money into the German treasury, into German industry, into German banks, saying all the time: "If the world expects Germany to pay reparations it must lend her enormous sums of capital to build up her internal economy." Now Germany saying to her creditors: "If you expect to be paid you must lend us the money to pay you with. To save your investments you must save Germany first."
And what is it Germany must be saved from? First and always from reparations.
But the Germans were not through. They went on to say that unless international finance came to Germany's rescue with an enormous new loan it might expect, first, a total eclipse of German solvency toward the outside world. After that, what? After that, communism—a red Germany, for what that would mean to the peace and comfort of her neighbors. And suppose this did not happen. Suppose for her own sake she could avoid going red in a political sense. Nevertheless, if now it becomes necessary for Germany to save herself with no more benefit of credit, she will be obliged to go red in an economic sense. She knows how to save herself. She has only to forget her creditors, forget the rules of capital, forget the arrangements by means of which international finance has been trying to support a high capital structure, and simply flood the markets of the world with unlimited quantities of cheap German goods.
So that was what the conference of prime ministers had to face in London."
The Germans became increasingly unyielding and threatening:
Regard it. In weight and size and shape it is the most august meeting of high statesmen since war time. Imagine the opening, the formal gestures, a speech by the British premier saying now every one must forget his own and think only of the whole, of what will be best to do for the good of the world, since only by unselfish international collaboration can they hope to solve the problem before them.
Suppose Germany shall speak next. Has she any plan of her own to propose?
No. Germany is helpless. She has no plan. She submits the facts and leaves the solution to her creditors. All she can think of is that an international loan of half a billion dollars will keep her afloat.
For how long?
That she cannot say. For a while at least. It would mean a breathing space. What has Germany to offer for such a loan? Nothing. Germany is helpless. She has nothing left to offer.
But what security?
None, except her promise to pay.
But her promises to pay already exceed her power of performance. Is not that the very problem? That, of course, is the problem. The Germans admit it simply.
Will Germany be willing to secure such a loan by a lien on her customs receipts, as the French have suggested?
Because the German people will not submit to that humiliation. They will destroy any government that dares to propose it.
Will Germany make any political concessions to appease the French, such as to stop building battleships and to disband the troublesome Steel Helmets?
Again, because the German people will not suffer that humiliation. They would sooner go red.
But perhaps Germany will agree to stop working for a revision of the treaties? Perhaps she will agree, when this crisis is over, to return to the Young Plan and observe it faithfully, instead of trying meantime to get it revised ?
Certainly not. Germany would tactfully remind her very distinguished collaborators that what they are dealing with is a financial crisis. It is a mistake, not to say a breach of concord, to load it with political difficulties.
Very well. But with nothing to yield, nothing to give, nothing to offer that has not already been twice exhausted, on what ground does Germany expect her creditors to lend her another half billion of dollars?
The answer is ready. Germany would think her creditors could see the importance of doing it on the ground of their own interest. Suppose they refuse. Suppose they let Germany go. In the first place, the financial consequences will be uncontrollable. They cannot be confined to Germany alone. Germany might have to sink, but her creditors would sink with her, and the effect might well be a world-wide financial crash. Secondly, that would be the end of responsible government in Germany. Suppose then nationalism were to rise in its extreme form, or else communism. In any case Germany would be obliged to save herself, even though to do so it were necessary to repudiate not only her debts but all other forms of economic restraint, cut wages, cut prices, and overwhelm the markets of the world with German goods.
Helpless Germany! Able to challenge her creditors. Able to threaten the political structure of Europe. Able to threaten the economic structure of the world. How had she arrived at this oblique eminence? By intending her mind to it? By taking advantage of the stupidity of the world? By drift of forces that happened to be working for her? And was threaten the right word? No member of the London conference, gazing at the Germans, could answer even the last of these questions."
The conference ended in a political victory for Germany, in Garrett's view. Further reparations and debt repayments were canceled.
Furthermore, it turns out that Germany wasn't poor after all:
This was Germany's version of what today we call the "carry trade." German and other investors had put money into German banks because they were paying high interest rates, compared to other countries. Once the bank crisis occurred, German's pulled their money out of German banks and deposited them in other banks.
In today's carry trade, investors borrow money from Japan, where interest rates are still near-zero, and invest it in other countries, including the US, where interest rates are much higher. However, as the Fed lowers interest rates, and as the value of the dollar falls on international markets, this kind of carry trade becomes much less attractive.
So an analogue to Germany's 1931 bank crisis today would take the form of investors' taking money from American banks and depositing it in other banks, including banks in Japan, China, and possibly Europe.
The 1931 bank crisis resulted in many changes throughout Europe, including Germany. One major result was an instantaneous change among ordinary Germans from "spenders" to "savers," once the reparations were canceled:
At the time that Garrett wrote, he had no way of knowing what was coming. As economic conditions worsened in Germany, the Nazis began to gain in power throughout 1932. By January 30, 1933, Adolf Hitler was Chancellor of Germany. When a fire destroyed the Reichstag (parliament) building on February 27, Hitler was able to assume near-dictatorial powers by blaming the fire on Communists and Jews.
As we've described many times on this web site, there have been a series of major international crises, centered in Europe and later in America, roughly 70-90 years apart. Since the 1600s there have been only five major international financial crises: the 1637 Tulipomania bubble, the South Sea bubble of the 1710s-20s, the bankruptcy of the French monarchy in the 1789, the Panic of 1857, and the 1929 Wall Street crash.
What do all of these have in common?
One thing they all have in common is an asset bubble, whether it's tulips, railway shares or stock shares. These assets grow in price many times over the values of the underlying goods that they represent.
Another thing that they have in common is the debauched, abusive use of credit. Here is where the generational cycle comes in. The financial crisis teaches everyone that credit and debt must be used only very cautiously. When the generational of survivors of the credit crisis disappears, the generations that come after have no fear, and use increasingly abusive credit practices, until a new crisis occurs.
The key to the debauched use of credit and debt is to separate the creditor from the debtor. If someone lends his own money to someone he knows, there's more than a financial relationship. The creditor, concerned for the fate of his money, will practice whatever "due diligence" is available to him, whether it's inviting the debtor to an occasional lunch or performing regular credit checks.
But when the debtor and creditor have no relationship with one another, then credit abuse naturally increases.
That's certainly what's happened recently with the subprime mortgage credit crisis. Ordinary homeowners are debtors. In the 1950s, 1960s and 1970s, the creditor would be the local hometown bank, and the local banker could at least drive by the property every now and then to see if everything's OK.
But today, the mortgage loans have been packaged together and then sliced and diced into securities based on credit derivatives, so that there's no comprehensible relationship between debtor and creditor.
This is called the "securitization of credit," and it's another thing that all these international financial crises have in common.
Here's an anecdote that Garrett quotes from international financier Dwight W. Morrow:
The last paragraph was meant to be ironic, and anyone reading it should have a good laugh. In our time, investment bankers have been recommending many investments that they know little about. Why? To get a fat commission.
We mentioned earlier that 127 different kinds of bonds from countries big and small around the world came to be sold to Americans in the 1920s, and that these bonds were solicited by investment bankers. Like the Japanese bond described in the above anecdote, there's no way to know how the borrowed money will be spent, and how it could be repaid. Furthermore, the bonds themselves could be repackaged and "sliced and diced" into whatever form of security that the bankers or other middlement wanted. The individual investor in one of these securities would have no idea what he was investing in.
If we now look at the five previous international financial crises, we'll see that they all have securitization of credit in common:
Today, with $750 trillion in CDOs and other credit derivatives sitting in the portfolios of investors, mutual funds, investment trusts, hedge funds, savings banks, pension funds, college endowments, money market funds, insurance companies, and so forth, around the world, we can see how the world is in a huge credit bubble.
But that's not all. That's just the securitization of PRIVATE credit. Let's not forget PUBLIC credit, as represented by foreign ownership of Amercan Treasury securities. Here's the list of foreign countries that have US Treasury securities holdings, as of July, 2007 (in billions of dollars):
Japan 610.9 Canada 26.7 China, Mainland 407.8 France 21.2 United Kingdom 2/ 210.1 Thailand 19.7 Oil Exporters 3/ 123.8 Netherlands 18.9 Brazil 104.7 Russia 17.1 Luxembourg 64.2 Sweden 16.0 Hong Kong 58.9 Poland 13.7 Taiwan 57.5 Italy 13.4 Korea 50.7 India 12.9 Germany 44.2 Ireland 11.9 Mexico 37.6 Belgium 11.5 Singapore 33.3 Malaysia 11.4 Switzerland 31.1 Israel 11.3 Carib Bnkng Ctrs 4/ 29.4 All Other 94.1 Turkey 26.9
That adds to a grand total of $2.2 trillion.
Well, at least that's less than the GDP of the United States ($14 trillion).
Garrett's book points out that in 1931 there were dozens of countries that owed money to us.
Well, things are different this time. This time, we owe money to dozens of countries.
|Conflict risk level for next 6-12 months as of: 9-Feb-2006|
|W. Europe||1||Arab Israeli||3|
From the point of view of Generational Dynamics, we're headed for a "Clash of Civilizations" world war, as regular readers of this web site know. Over the years I've developed the above graphic to illuminate the six most dangerous regions of the world, along with two other international issues, under the expectation that a regional war or crisis in any one of these areas will spiral into a world war.
The scenario by which a worldwide financial crisis will "spiral into a world war" cannot be predicted, except by means of general statements about destabilizing China or large poor populations in other countries.
However, by examining the scenario described in Garrett's book, we can identify some elements that will occur in today's scenario. Thus, Garrett's book becomes a kind of "back to the future" roadmap.
I've always been assuming that once a crash occurred, here or in China or in Europe, then it would quickly spread around the world, and would destabilize some populations into war within a few months.
But that isn't what happened in 1929. America's stock market bubble started deflating, but the bubble kept growing in Germany, until the failure of the Austrian Credit-Anstalt on May 11, 1931. That's what triggered the massive bank runs and financial collapse in Europe, and that was 1½ years later.
Furthermore, America did not immediately abandon Germany when the central European bank panic started. Instead, President Hoover vigorously promoted a bail-out of Germany, first calling for a moratorium on war reparation payments, and then forgiving some German debts. It was France who was most recalcitrant about the bail-out, although nothing could have been done anyway, since the bubble was larger than all the money in the world.
Using the experiences described by Garrett in 1931, we can SPECULATE about some of the things that may be coming within the next couple of years:
Of course, there's no guarantee that what happened in 1931, after the 1929 crash, is going to happen again, or is going to happen again in the same way. However, it's worth starting by noticing that many of those things have ALREADY happened -- the existence of an uncontrolled creditor / debtor nation relationship, the securitization of credit through CDOs and other credit derivatives, and the huge asset bubbles around the world. These are the things that ALWAYS recur, from the point of view of Generational Dynamics.
The main thing that's the same today is the mass delusion that the world is suffering from today. The craziness that's going on today can be seen in every newspaper, every forecast by a financial analyst, and every speech by a politician.
Friedrich Nietzsche (1844-1900), the German philosopher, lived through massive genocide in the Franco-Prussian war and the Paris Commune (civil war), and saw the same craziness; that's presumably what he meant when he said, "Insanity in individuals is something rare - but in groups, parties, nations and epochs, it is the rule."
I strongly urge everyone interested in what's happening today to read Garrett's book for himself. You'll gain insights that will help you with everything from investing to politics to living today.