Summary-A Bubble that Broke the World by, Garet Garrett (get the book here

Credit can be like a drug. If you have too much, it can become addictive, create dependency, and waste resources. In 1932, no one seemed to know this better than Garet Garrett. In this timeless work, Garrett explains the economic and political errors behind the international post-war credit bubble which led to world-wide depression.

As Garrett explains, the bubble was brought on by three different ideas which shaped American economic and political policies: 1) the belief that credit is a cure-all for debt, 2) the idea that people are entitled to certain betterments of life, and 3) the theory that prosperity is a product of credit.

Experts at the time saw credit as beneficial. Without it, Europeans weren’t able to buy American exports. It also funded the production of goods to compete with American goods. Without some industry the debtors couldn’t pay American creditors back (no one seemed to pay attention to the fact that tariffs defeated this purpose). For all economic problems, the answer de jour was more credit.

Credit is, by nature, the product of the accumulation of wealth beyond what one chooses to consume. Garrett defines it as the command of labor and materials. The goal in the use of credit, then, should be to produce more wealth, so the available stock of credit can continue to grow. Somehow, “experts” forgot this simple idea. The adopted policy in the 1930s was to create credit to create more wealth.

This led to a reckless extension of over $15 Billion of American credit, both public and private, to foreign countries from 1917-1932. America brought the bubble upon itself.

In 1917, Europe was in the midst of war and the Allies needed supplies. To do this, they needed access to American credit. After the U.S. declared war, Congress and the Treasury responded by selling Liberty Bonds to the American public and loaning the proceeds. Throughout the course of the war, the U.S. loaned over $7 Billion to the Allies, but the U.S. government’s lending didn’t stop there.

After the armistice, the U.S. was lending to both Germany as well as the Allies. Germany’s economy was wrecked, but they had to pay out reparations to the Allied nations. America supplied Germany credit so their post-war obligations to the Allied nations could be met. The same money was then used by the Allies to pay America back for their war debts. The U.S. government was, essentially, paying itself through its credit to Germany.

After giving out $10 Billion, the U.S. government credit gravy train came to a halt in 1920. At this point, the European nations turned to the American private sector for funding. The new Federal Reserve, unsurprisingly, played a pivotal role in allowing the issuance of credit to these desperate European nations.

Wall Street started to add to the credit debacle by brokering sales of foreign government bonds to the American public. European private debt to America began to outweigh their debts to the government. Americans were looking for ways to invest their money, and foreign government bonds had high interest rates and were “guaranteed.” Private individuals flocked to these bonds because there was the added benefit of knowing that the money was going to help the Old World “get back on its feet.”

Garrett makes the point that this notion of “surplus credit” Americans believed they had and needed to loan out was simply a failure of our productive imagination. To the unimaginative, it seemed as if all the present needs of the economy were being met. Yet, this did not mean there weren’t other domestic investments, like low income housing in cities, which individuals could have funded instead. The cultural pressure to “think internationally,” as Garrett puts it, influenced the private investments to instead go abroad. Americans made Europe’s recovery their personal emotional concern.

The decision to invest in a project generally depends on what the investment is going to create. With local investments, the projects are easy to see – restaurants, industrial plants, railroads – and the profitability can be easily judged. Foreign government bonds, on the other hand, offer no explanation as to what is being funded. All an investor receives is a promise to pay, not an explanation about what the debtor will create to pay back the debt.

The only responsible use of credit is to create something of lasting economic value. If nothing of economic value is created, then the debt cannot be paid back, and the labor and materials are lost forever. These wasteful projects provide temporary employment and stimulus of consumption, but produce nothing of economic value. Garrett calls these frivolous pursuits pyramids. There is nothing of economic value you can do with a pyramid.

This is what the credit given to Europe was used for. They borrowed to fund public works, to postpone balancing their budgets, avoid increasing taxation, and to artificially prop up their inflated currencies. None of these uses produced wealth; they propped up an overextended system.

By 1926, the Fed had loaned the largest sum during peace time up until this point and the U.S. had cancelled much of the foreign war debts. But the Europeans claimed the discounts weren’t enough (even though no country owed the U.S. more than 1.5% its national income per year). Many called for a complete forbearance on the debt (they couldn’t outright repudiate the debt for fear of it happening to them with their own debtors). In reality, no country had been actually burdened by the debt payments. For every payment they made, they borrowed an equal, if not greater, share from the American private sector.

All economic statistics showed that the economies of the world were growing by 1929. But, as the world soon found out, credit’s other, ugly face is debt. It seemed too good to be true, and as usual, it was.

In 1931, America loaned over $1.25 Billion spaced over a 3 month time span. The bubble had burst. It had all started with the Hoover Plan.

The plan placed a moratorium on war debt payments to the American government for a year, so Germany could suspend their reparation payments. America floated loan payments totaling $300 Million for that year. A few weeks later, America extended the moratorium to private debt payments as well (freezing over $4 Billion in private funds in Germany alone), which ended up costing another $600 Million.

The Bank of England suddenly suffered a run on its gold and America loaned another $350 Million to them. England turned around and demanded the dollars in gold. When the Americans finally stopped loaning, Britain went off the gold standard. American holdings of pounds were almost instantly devalued by 25%. The English, however, could still cash in gold for the dollars we loaned them. All the debtor nations could—and they all did.

Foreign governments began to sell their short-term American holdings (their stocks and bonds) and demand payment in gold. To deal with this demand, American banks had to do the same with their securities. Since their assets in Europe were frozen or grossly devalued, all they had left to remain solvent were their domestic investments. This contributed to the internal investment liquidation panic that was already crippling the nation.

In the end, everyone wanted something more. The English wanted to ease the burden of all international indebtedness through forbearance. France threatened to cash in over $600 Million of their assets for gold (causing American bankruptcy) if America didn’t reduce their war debt interest rate. Germany continued to ask for more credit. By 1932, Germany wasn’t saved, which meant Europe wasn’t saved. America walked straight into a trap it had set for itself.

The health of an economy comes from what individuals produce. When you produce nothing but pyramids, you’re doomed to leave multitudes of other satisfactions left unfulfilled. Labor becomes wasted, lost forever.

10 Takeaways

1) Credit is the command of labor and materials.
2) The other face of credit is always debt.
3) The main function of gold within a money economy is to limit the amount of credit that can willingly be made.
4) When labor is used, it is gone forever. The product of the labor is what endures. If it produces a pyramid, something of no discernable economic value, then it has been prevented from being used to produce something that is of value and that satisfies future wants.
5) Economic bubbles are caused by the irresponsible use of labor and materials in ways that turn out to be unproductive. Expansion of credit is the easiest road towards this end result.
6) The basis of credit is production and sacrifice. That is to say, credit is a product of producing a good or service of value, receiving monetary payment for the good or service, and choosing to not spend all of the money on present consumption goods.
7) Money is a vehicle to facilitate trade, and credit is a transfer of a present claim to command labor and materials from one party to another.
8) The only viable amount of credit is that amount which is backed up by valuable economic goods and services. The process of all credit misallocation begins with the multiplication of credit by the banker.
9) Through 1917-1932, the United States loaned over $15 Billion of private and public funds to Europe in order for European countries to save their own currencies, fund public works, withdraw gold from American banks, avoid taxation of their own citizens, balance their budgets, and to make payments on their loans from the U.S.

Important Quotes

• “The beginning of all modern credit phenomena is this act of multiplication, performed by the banker.”
• “That debt need never be paid, that it may be infinitely postponed, that a creditor nation may pay itself by progressively increasing the debts of its debtors — such was the logic of this credit delusion.”
• “In the nature of economic consequences strange to say, the motive does not matter. A pyramid is a pyramid still.”
• “Money is not things. It is merely the token of things. Destroy the token and there are the things still, physically untouched by a financial crisis.”
• “While American banks had been putting deposits in European banks, especially German banks, because the rate of interest was high, Eurpoean banks at the same time had been putting deposits in American banks for an opposite reason. They wanted safety.”
• “But in the view of the American Treasury at the time almost anything tending to promote the morale and welfare of the Allies, even the welfare of their industry and commerce, were considered germane.”
• “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 to 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.”
• “The overbuilding of industry beyond any probable demand for the product represents devoured credit”
• “It should be borne in the mind that the investor is the man who has done without something.”
• “We had only ourselves to blame. One-way grace; no means of self-protection reserved. We were caught by our gold heel in a trap we had built for ourselves. We made it and walked straight in.”
• “But of all the ways in which the lending of american credit in Europe did not increase American export trade, the one most extraordinary was that of lending our debtors the credit with which to make payment to us on their debt.”