European Debt Crisis…of 1920s?

Think the sovereign debt crisis today is new? History tends to repeat itself as evidenced by the European debt crisis of the 1920s. The Wall Street Journal ran an interesting piece on March 14, 2012 about defaults and government debt to prove we’ve seen government defaults before.

The United States’ entered World War I on April 6, 1917 after trying to avoid it for a few years. The tipping point came as Germany sank seven US merchant ships and when the German Foreign Minister (Zimmermann) invited Mexico to join the war as Germany’s ally and in exchange for fighting against the US, Germany would finance their war and help Mexico regain Texas, New Mexico, and Arizona. This became known as the “Zimmermann Telegram”. The war ended in late 1918 but the losers of WWI (principally Germany) were flat broke and the winners (mainly Britain and France) had huge amounts of debts they could not pay. Britain and France borrowed vast sums of money from the US government to finance their war (1914 to 1918).

The Versailles Peace Treaty ended the war and forced Germany to pay reparations to Britain and France so they could then in turn pay back their debts to the US. It all seemed like a good idea, but by the mid-1920s, it became obvious Germany couldn’t make the payments since their economies were discriminated and was on the verge of default. In comes the “Dawes Plan”, crafted by US Vice President Charles Dawes, to save Germany from default. The solution (or so it appeared): more debt. Really, that is what the solution was.

Under the Dawes Plan, the US would lend Germany money so it could pay France and Britain, so they could pay off their debt with the US. Sound confusing and unsustainable? You’re right. The loans were 25 year notes financed by the US at 7%. Given the interest rate, it sparked an interest in US investors to get a piece of the action and now you have individual US citizens purchasing the loans given to Germany (which was the “popular” thing to do at the time). However, Germany ended up defaulting on their US loans in the 1930s due to the rise of Hitler and the Nazi party and values of those securities plummeted to zero…they chose not to pay and instead used the money to rebuild their military.

Many investors today seem to forget countries can default on their debt. Sovereign default is nothing new because risk and return are always related. If you are seeking a return above what an FDIC insured CD pays, there is risk. The best investment strategy diversifies across many different stock asset classes AND many different bond holdings.

You can read the article in its entirety be clicking here, but a WSJ subscription is required.