Diminishing Returns

[...] the human bias to keep doing more of what worked so well in the past leads to doing more of what failed even as results turn negative. The dynamic in play is diminishing returns: the yield on the policy that worked so splendidly at first diminishes with time.

Credit offers a cogent real-world example. When credit becomes available in a credit-starved economy, it generates a rapid, sustained expansion as credit-worthy borrowers borrow and spend on new productive capacity, consumer goods, housing, etc., all of which further drives expansion. But once credit has saturated the entire economy, the only pool of borrowers left are uncreditworthy (i.e. at risk of default), and the only projects left unfunded by credit are laden with risk. Either way, credit expansion stops: either lenders prudently refuse to issue credit to risky borrowers and ventures, and credit expansion grinds to a halt, or they foolishly lend money to borrowers and ventures which predictably default, triggering a credit crisis that brings imprudent lenders to their knees and triggers cascading defaults as declining asset prices push marginal borrowers into bankruptcy. Doing more of what was successful [...] -- expanding credit -- is now doing more of what's failed. Expanding credit in a credit-saturated economy only sets up cascading defaults.

The human response to the failure of what worked so well is disbelief: the problem, we reckon, is we didn't do enough the first time. So the answer to the failure of extending more credit is to extend even more credit and lower lending standards so anyone who can fog a mirror can get a loan. At this point, diminishing returns become negative returns: doing more of what's failed is now not just unhelpful--it's actively destructive. Cramming more credit down the throats of risky borrowers and ventures guarantees a full-blown credit crisis when the defaults start taking down lenders and crushing asset prices that were dependent on credit expanding into eternity. -- Charles Hugh Smith