Inspired by Daniel Kahneman, it’s become popular to think of our brains as dual-track systems. Whether referred to as our Fast and Slow brains, System 1 and System 2 or First Order and Second Order thinking, they all describe the same thing—an intuitive, rapid, ancient ‘reptilian’ brain very good at roughly working out consequences most of the time; and a slower, uniquely human, neo-cortex driven brain that takes more deliberate effort to fire up but that is much better at solving unique problems and consequences of consequences.
Perhaps I’m overly sceptical, but unprecedented actions by central bankers around the world—zero interest rate policy (ZIRP) usurped by negative interest rate policy (NIRP), asset-buying programs being extended into corporate bonds and even shares, a ‘whatever it takes’ mentality—strikes me as firmly first order thinking.
Take the dreaded deflation, or ‘everyday lower prices’ as Jim Grant once put it. Deflation itself is nothing to be feared—the US had some long and deep periods of deflation in the back half of the 1800s, a time that coincided with its rise to global superpower.
In a high tech world dominated by Moore’s Law, deflation in some important parts of your consumer basket is assured. In some respects, deflation is the very essence of capitalistic progress.
But wider, entrenched deflation is hell for borrowers. In an inflationary world, your future interest payments deflate away in real terms. In a deflationary world, the converse happens—your future interest payments inflate. Meanwhile, your levered asset is probably dropping in value too. So deflation is acutely painful in an over-leveraged economy.
First and Second Order Thinking
First order thinking around deflation looks something like this:
Deflation is terrible news for anyone who has previously borrowed in order to bring forward consumption or investment. Its negative effect on them is much stronger at the margin than the positive effect of deflation for those who’ve saved by delaying consumption or investment. The near-term economy will be in tatters. Therefore, central banks should act decisively to prevent deflation.
Second order thinking, in my opinion, looks more like this:
An implicit promise by central bankers to act decisively to prevent deflation reduces the risks (perceived and real) to borrowers, encouraging them to further gear up. In such an environment, ‘whatever it takes’ action might not achieve its desired effect, or might create new and more severe consequences down the track.
There’s little hard evidence backing up my suspicion which, let’s face it, suggests central bankers are naïve at the least. But Scandinavia provides some soft evidence. Households in Scandinavia weren’t as deeply impacted by the global financial crisis as many other nations (although post-GFC hasn’t been great for Finland, in particular). One possible explanation for that is that following 1980s excesses, the early 1990s was a period of wretched deleveraging in the region, deeper than elsewhere in the developed world. Once bitten and twice shy, the early 2000s excesses were nowhere near as frothy as in places like Ireland, Spain, Netherlands and Denmark.
But in recent years Scandinavia has become ground zero for new central bank interventions like NIRP and the push to a cashless society (chiefly, I suspect, so one can have even lower negative interest rates).
Maybe negative interest rates and the assassination of savers will have its intended effect—perhaps the banking system will escape unscathed (no sure thing) and borrowers won’t fall into a pessimistic slump and destroy the economy.
Or maybe the problem has just been pushed out a few years.
Arguably, a rise in household debt levels is exactly what central bankers want. Perhaps they are second and third order geniuses and I’m the naïve one here. Time will tell.
All I know for sure is that household debt continues to march higher year by year in Scandinavia. For a region that remembers the pain of deleveraging better than most, that must be unnerving to some.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.