Understanding Behavioral Finance Macro

This is the first in a series called Behavioral Finance and Macroeconomics. The inspiration for this series comes from the unexpectedly positive response the markets and businesses in general have had to President Donald Trump's proposed economic and tax policies. Why is it that markets have rallied since the election in an arguably fully valued market? Did actual market conditions warrant this? Or is this rally an example of applied psychology in action?

Why is it that businesses and individuals have so much confidence now in the economic prospects of our nation, even when there is significant tumult in Washington, D.C.? What effect does tax policy have on business and investment psychology? And what about deregulation--why is it that when people mention this word, business and industry respond so favorably? What causes bubbles and recessions?

Clearly, psychology and behavior have a large effect on the macroeconomy. In this series we will explore the effect behavior has on markets and the economy as a whole--and how advisors who understand this relationship can work more effectively with their clients.

Most economics textbooks pay little attention to the role that psychology and behavior play in how people make financial decisions and how this behavior impacts economic theory. These books include a myriad of charts and graphs that illustrate changes in employment, interest rates, output, prices etc., but they don't focus on the root causes of these changes. Although the study of macroeconomics does address some aspects of what causes recessions and expansion, the discussion mostly focuses on nonpsychological aspects of central bank policy, tax policy, fiscal policy, money supply, and the like.

What's missing is how the people who make economic decisions influence macroeconomic changes. Behavioral factors such as optimism (similar to what we are seeing now), pessimism, fear, greed, and fairness drive decisions in the "real" economy.

The good news is that over the past 20 or so years, the study of behavioral economics has gained traction as a way to explain some of what's happening in the real economy.

Interestingly, the study of psychology in economics is nothing new. One of the most insightful economists of all time, John Maynard Keynes--who wrote arguably the best economics book ever called "The General Theory of Employment, Money, and Interest" in the aftermath of the Great Depression--delved into behavior and psychology in his work.

Keynes observed that in the wake 25%-plus unemployment in the U.S., people's states of mind matter. It took many, many years to recover from that period's economic depression in part because people lacked optimism about the future. If people are not optimistic, the economy stagnates. But once World War II kicked in, people felt optimistic again (i.e., patriotic), which stimulated the economy.

Macroeconomics is the subsector of the study of economics examining how the aggregate economy behaves. In macroeconomics, a variety of economy-wide factors are examined, such as: inflation, price levels, rate of growth, national income, gross domestic product, and changes in unemployment. Macroeconomics focuses on trends in the economy.

Macroeconomics differs from microeconomics, which studies choices made by individuals and companies--but these two branches influence one another. For example, the unemployment level in the economy is in part driven by the supply of individual workers in the system.

Macroeconomists develop models explaining relationships among a variety of factors such as consumption, inflation, savings, investments, international trade and finance, national income, and output.

Here we've laid the groundwork that we’ll build on in subsequent articles in this series. Next month's article discusses what effect psychology and behavior have on the business cycle.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.