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.
So true… It’s going to be interesting to see the effects of all of this extra borrowing. Even in Australia debt seems to be increasing…
Thanks Gareth, excellent thoughts.
In these household debt to income figures, what do they represent in general?
The ABS site has Australian household debt at 180% of income, and do we have any knowledge about if this is lifestyle consumption or an attempt to invest in income producing assets?
In general I still don’t really get the deflation fear. Cheap petrol, cheap cars, cheap homes sounds pretty good.
There would be / will be a period of adjustment with liquidations of companies / projects that were / are of marginal viability, but ‘kicking the can down the road’, in terms of continuation of ZIRP / NIRP / QE, may just be adding fuel to this bonfire (of vanities).
I don’t know the split in Sweden, Finland and Norway. In Australia it is predominately mortgages (80%+ I think). Of that, I think owner occupier is about 60% and investor loans 40%, or thereabouts.
“The ABS site has Australian household debt at 180% of income”
Are these debt figures reported on a gross debt basis?
As some would know there are taxation advantages in Australia for not making principal repayments on a primary place of residence (PPOR) loan and instead making such deposits into a mortgage offset account. This is because if the owner later decides to turn their PPOR into an investment property they are able to withdraw the cash from the offset account and claim all of the associated interest costs on their outstanding loan as a tax deduction (because the deductibility of interest costs are capped to the lowest principal balance the loan has ever been at whilst the property was a PPOR) whilst using the cash to offset against the new PPOR mortgage which is generating non tax-deductible interest.
Would there be a sizable difference, if the ABS reported debt figures are gross debt figures, if mortgage offset cash holdings were taken into account?
You need to distinguish between supply-led deflation and demand-led deflation
Supply-led deflation (i.e. costs coming down) is good. It is demand-led deflation (i.e. not enough demand relative to capacity) which is bad and what central banks are concerned about
Fair comment, it’s not a terribly sophisticated thought process here. But who’s to decide what insufficient demand is? And if too many factories are built in Asia (partly because of central bank supplied cheap money) so that now there’s insufficient demand relative to capacity, is that a demand or supply problem? But I get your distinction and think it’s useful.
My broader thoughts are that the world has become relatively less commodity intensive and relatively more technology intensive (generally deflationary), and I’m not sure central bankers (or indeed overeager borrowers) have quite caught up to that yet.
However Andrew, demand may be low due to the excessive leverage that current policy has encouraged. Encouraging it further is unlikely to solve this issue, other than for very short bursts.
FYI, Scandinavia is actually Sweden, Norway and Denmark.
Scandinavia + Finland + Iceland + Greenland + the Faroe Islands and perhaps Estonia = The Nordic Countries.
Agree with your comments about central bankers though. A bureaucrat is a bureaucrat, irrespective of whether (s)he works in a ‘computer says no’ capacity, or leads a central bank.
One of the things that I still cannot fathom, is why interest rates need a group of vogons to set them, whilst almost every other price or rate in the world of finance, agriculture, mining, and everything else is set much more efficiently by the market.
Very true, and I should have known that – I got suckered by an incorrect map circle on google which incorporated Finland. The Scandinavian Peninsula would have been more accurate, but still missed half of Finland. Please reread ‘Scandinavia’ in this article as ‘those really cold countries right up the top of Europe’. Thanks
Much of what I write here also applies to Denmark – although it has much higher levels of household debt to income (300%+, highest in the world I think) and they had been slowly deleveraging over much of the past 8 years but that seems to have stopped for now. Apparently there are a few mortgages now with negative interest rates there, though I’m not sure if that’s true or media hype, after counting fees etc
Vogons! Laughing out loud here. Your point is one that Jim Grant has been making for 15+ years. Agreed.
As a net saver, I’m fed up with pissy miserly term deposit rates that I’m getting. I like to have fair chunk of cash around and I’m too risk averse to stick the whole lot into the market. (and I like to keep some powder dry for events like Brexit and weird flash crashes that seem to happen ever more frequently).
And I’m annoyed that I can’t take advantage of negative rates ! Why can’t I borrow $10K and repay $9.95K ? Instead , it seems to simply be encouraging corporations, particularly in the US, to buy back shares, and not necessarily at advantageous prices. Investment doesn’t seem to be happening much.
Not sure if this is first, second or third order thinking, but I’m trying to save a bit more because of these miserly rates. I suspect I’m a rare exception and this behaviour isn’t extrapolated, but what if it is ? And I wonder whether people in the developed world have simply got to the point where they have enough ? Do we get to the point of ‘max consumer’ when we’ve simply got enough TVs, laptops, iPads, running shoes, bicycles, cars etc ? Birth rate isn’t going up !
I’ll get off my soapbox now.
I too wonder what the interest rate would be if it was left to the market ! Obviously much higher.
This has been David Einhorn’s point for 5+ years, I saw him make it at a Grant’s conference in 2012. I’d agree with you both. If an investment decision doesn’t stack up at 2% borrowing rates, is it likely to at 1%? Borrowers have sort of already had their fill. But if you move rates from 2% to 1%, watch the savers cut their spending. It’s perfectly rational response from those saving for retirement or something else.
My understanding is that first, second, third order thinking model is based in individual decision making. Add “committee” add “policy” add “short term political environment” and I wonder if the whole thing is cooking it’s self up into one huge mutant Keynesian Beauty Contest.
No idea how it will turn out of course, but I have this bad feeling in the reptilian part of my brain.
Ultimately what I can at least be reasonably certain of is here being authoritative, justified and rational explanations from those involved – after the fact.
Completely agreed Gareth.
The other problem I have with central bank policies is that they are prioritising juicing (or attempting to juice) the economy in the short term, through the so-called wealth effect of higher asset prices and borrowing, ahead of maintaining long term financial system stability. That is imprudent at best, and reckless at worst.
At some point in the past half century, a belief seems to have formed that a recession need be avoided at all costs – long term financial system stability be damned. If avoiding a painful recession requires zero or negative interest rates that juice up asset prices and force investors – through financial repression – to reach for yield and take more risk than they should, then – so the wisdom of today’s central bankers’ goes – so be it.
I think this is dangerous. There is nothing wrong with periodic recessions (depressions are another issue). They are healthy for the economy in the long term. It’s a bit like telling a smoker no – you must continue to smoke, and indeed smoke more, because if you quit you will experience a temporary recessionary period of a depressed mood and energy. It is very short sighted.
In addition, while I can understand the risks systemic & hard deflation can cause in a leveraged economy, nobody has explained why price stability – i.e. zero CPI – ought to be seen as a bad thing. To the contrary, it is a perfect situation. The Fed is anxious because inflation is only 1.4%, and wants at least 2%. Why? Keeping rates at zero for too long because inflation is ‘unacceptably low’ at 1.4% strikes me as extremely irresponsible behaviour.
I wouldn’t be surprised if there is eventually some pushback, politically, to all of this activity. It seems like central banks are wielding too much power and have stepped too far outside of their mandates.
We like a little bit of inflation because nominal wages are “sticky”, i.e. people are extremely reluctant to accept a cut in their weekly pay check, so 1 – 3% inflation allows REAL wages to adjust downwards when necessary by simply not increasing nominal wages. This is an important adjustment mechanism in the economy as wages are usually the largest cost faced by businesses and explains for the most part why central banks around the world have targets of 2 – 3% inflation.
Central banks first order thinking – negative interest rates and QE will stimulate the world’s economies.
Result – Chaos and the destruction of wealth when the buck stops
Central banks second order thinking – the Chaos and the destruction of wealth was unexpected and could not be foreseen
Pingback: Found: A Central Bank that is a Second Order Thinker - Forager Funds