Second-order effects


Second-order effects, or commonly referred to as side-effects are not rare. These effects could be as simple as a medicine resulting in undesired effects or it could be much more severe like an economic disaster owing to radical policies. We are going to talk about one such instance today: The Great economic depression of 1930s in the USA.


The third decade of 20th century (1920+) was characterized as a high growth period in American history. This decade was popularly known as the roaring 20s. Stock markets were in a state of frenzy with people liquidating as much as possible from other asset classes to pump into the stock markets. Clearly, it was a bubble waiting to explode. The bubble did explode when the federal reserve decided to increase interest rates. Higher interest rates mean borrowing gets more expensive for corporates. This decision led to the beginning of a huge sell-off in the American markets. What was the need for the Fed to increase interest rates in the first place? Was the then-Fed chairman out of his mind to do this when everything was hunky-dory? Not really.


The action was taken to achieve the desired effect which we call as the first-order effect. As mentioned earlier, stock markets in America were roaring in the 20s. This roaring quite naturally influenced greed among people to speculate and make a quick buck. Greed & fear generally makes one completely ignore the risks of second and third-order effects. To limit this speculative leveraged activity in the stock markets, the Fed decided to hike interest rates in the country. The response to this action by the Fed was initially comforting for the Fed. Stock markets started correcting as expected by the board. But, little did they know what was coming their way. The Great Economic depression lasted for almost a decade starting from 1929. Famously, this is also termed as a lost decade. What began in 1929 was followed by a series of banking crisis in the early 30s. The downturn hit bottom in March 1933 when the banking system collapsed and then President Roosevelt declared a national banking holiday. Unemployment was in the range of 25% in America in 1933. The shocks were felt throughout the global financial system.


The Fed did achieve the first-order effect of restricting the speculative stock market activity, but at what cost? Unfortunately, they could not foresee the second or third order effects back then. What were the lessons from this decade of depression? The answer is simple. To date central banks across the world are wary of increasing interest rates. The learnings from this horrific experience has made us happy about having learnt from failure. Does this mean that we know everything about recessions and depressions? I am sure most economists would agree that economic policies are extremely susceptible to undesired second and third-order effects. Perceiving experience from failure as invincibility is the last mistake that any economist would want to do. Who knows what would be the grave second and third-order effects of the current passing phase of ever-increasing fiscal stimulus!


Experience does not mean invincibility

Let us come to 2020. This is something again unprecedented that we are witnessing. Talking about India, a nationwide shutdown of Indian Railways has created history. The first-order impact of this lockdown by the Indian Government is to win over the coronavirus. Talking again about the 1920s when the Fed decided to increase interest rates. Was this decision taken haphazardly without thinking about the 2nd and 3rd order effects? In all likelihood, not! The entire situation of coronavirus and lockdown is likely to have big 2nd and 3rd order effects. Some that I can think of are mentioned here:


  1. More people will turn vegetarians, at least for a few years/ months. Just like NAMASTE, our Indian food has a good opportunity if this happens.

  2. Hygiene standards across the board will improve, may it be infinitesimally. India really needs this improvement, especially in the densely populated states.

  3. We may face water shortage in the coming year. Imagine 1.3 billion people washing hands regularly. Again a historic event. Nobody really is talking about it at this point.

  4. Indian metros are likely to get decongested. Stranded laborers are going through a nightmare. The industry is likely to get restructured by way of more developments in tier 2 and tier 3 areas

  5. If the lockdown persists longer than expected, we are looking at huge defaults, not just defaults by businesses to banks, but also by businesses to other businesses. Trust in the financial system will surely be reduced at least for a few months.

  6. On the positive side, for India, the world would want to reduce its dependence on China as a manufacturing powerhouse. This will open up opportunities for India. Whether this will be grabbed or not is a matter of time.

  7. Once the storm is over, we can expect more compassion towards each other. Man is after all a social animal and people will start respecting each other more.

What else could be the positive/ negative second/ third order effects of COVID19/ lockdown for India?

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