I have long been fascinated by how we humans make decisions across various domains of our lives, from the micro decisions which affect our weight and bank balances to, on a grander scale, the pursuit of optimal public policymaking.
My interest has often been sparked by an observed tendency in my own life to make decidedly suboptimal decisions, hence my desire to not only understand how we make decisions but– crucially – how we might then make better ones.
Water for Reserve Bank governor Philip Lowe, champagne for me – for now. Credit:Alex Ellinghausen/iStock
There’s a broad tendency within economics to assume the decisions we make as humans are inherently guided by a set of fixed traits. So-called “behavioural economists” pop human beings in Petri dishes and observe us making all sorts of crazy decisions.
For example, we engage in “hyperbolic discounting”, which means assigning a disproportionate weight to the pleasure we will enjoy from consuming something today, versus consuming the same thing tomorrow. We are also “loss averse”, meaning we fear a financial loss far more than we value the prospect of receiving an equivalent gain.
All in all, we fail repeatedly to live up to the traditional economic model of a utility-maximising individual: one who knows they face a certain “budget constraint” and goes about ruthlessly calculating the costs and benefits of various courses of actions, invariably choosing the optimal path which maximises the pleasure experienced with the scarce resources we have.
In real life, we overspend. We fall into debt. We fail to save adequately. We live for today and tomorrow be damned. So, as we hurtle towards our first Christmas season free of restrictions in three years, but also amid a cost of living crisis and rapidly escalating interest rates, it will be interesting to see how we all behave.
The Reserve Bank in Sydney’s Martin Place. Credit:AP
I, for one, am choosing to ring out 2022 with a committed YOLO (“You only live once”) mindset. That’s despite the rather worrying prospect of my home loan interest rate roughly tripling mid-next year, which is set to whisk away my entire current cash flow surplus each month.
I am not alone.
An extraordinary number of Australians are about to suffer severe “mortgage shock” in 2023 as they roll off ultra-low fixed interest rate loans, often secured at sub-2 per cent rates during the height of the pandemic.
From their ivory tower in Sydney’s Martin Place, the boffins at the Reserve Bank are watching closely to see how borrowers respond. According to the RBA’s latest Financial Stability Review, just one in five home loans outstanding in Australia were on fixed interest rates in the lead up to the pandemic – the remainder being loans with variable interest rates. However, during the pandemic this rose to two in five loans being fixed, as borrowers took advantage of unusually cheap fixed rates.
The risk for the RBA is that those of us who fixed are acting as if we are much more immune to the message the bank is trying to send, namely to stop spending so much and adding to inflation.
We are perhaps acting more like our American cousins, of whom about 90 per cent are on fixed interest loans at terms of 30 years – making them far more sanguine about the US Fed’s aggressive rate hike campaign.
Unlike our American friends, however, Aussie borrowers will soon be hit with a giant “fiscal cliff” as fixed terms end. Around two-thirds of existing fixed-rate loans are set to expire over the course of 2023 (with a lucky third having fixed until 2024 or beyond).
Based on current market pricing, that’s likely to entail a jump in the average mortgage interest rate from 2 per cent to about 5.5 to 6 per cent for such borrowers (including myself). Ouch.
So, should we be diligently saving hard and cutting our cloth to meet our future repayments straitjacket? Some households with wafer-thin savings buffers no doubt are and should be, either increasing their voluntary repayments or adjusting their spending habits in advance. But for me, the answer is a definite: not yet.
As a keen student of optimal decision-making, I am only too aware of my budget constraint. Over time, I have learned to make decisions that maximise my happiness from a given set of resources at any point in time. When my budget constraint changes, so will my decisions. For now, however, I’m heading into summer with my spending and holiday plans intact.
If I am the norm, this could imply a rather sharp decline in household spending when fixed rates roll off. I suspect, however, I am not and many will be tightening their belts a little this festive season, either by choice or necessity for those already affected by rising prices and variable rates.
The bigger your savings buffer, of course, the greater your ability to cope with fluctuating cash flows and smooth out your consumption. Reassuringly, the Reserve Bank has observed that cohort of borrowers who fixed during the pandemic have higher incomes and greater buffers than those who historically have fixed.
So enjoy your hot girl and hot boy summers, my friends – pestilence and extreme weather events permitting, of course. Even the boffins at the RBA are expecting a mini spending blow out this summer as we embrace our longed-for freedoms. We’re only human, after all.
Jessica Irvine is a senior economics writer.
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