Richard Thaler, the 2017 recipient of the Nobel Prize in economic sciences, might very well be labeled the “father of behavioral economics.” His work seems all the more relevant given the tremendous gyrations of the stock market in 2018 and the likelihood of continued volatility in 2019. In the past year, the market has swung about 5,000 points — enough for many investors to lose the confidence they were slowly regaining since the Great Recession.
Even though the origins of economics were not mathematical but philosophical, it didn’t take long for mathematicians to gain a stronghold on the discipline to the exclusion of psychology, sociology and theology. The main concept behind behavioral economics is that we are not solely economic men and women making decisions based on data in a logical cost-benefit type of way, but that we are humans in the fallible, sometimes irrational, sense of the term — both whimsical and easily influenced by both others and circumstances.
Behavioral economics was not part of mainstream economics until the 1990s, although research was being done prior to that. While Nobel winner Gary Becker argued human behavior is rational and utility maximizing, Thaler searched for behavioral answers to economic problems that lie outside the bounds of rationality. He was joined by others in his quest, such as Nobel winner Robert Shiller. Shiller wrote the incredibly worthwhile book “Irrational Exuberance,” associating “animal spirits” to the tech, housing and stock market bubbles. However, Alan Greenspan coined the phrase “irrational exuberance,” which occurred to him while writing a speech in his bathtub.
Arguably, current markets are behaving somewhat irrationally given that economic fundamentals remain relatively solid. That is, we have high employment, low inflation, solid GDP growth and even now some wage growth, all of which should provide support for a continued upward trend in the major stock indices. Nonetheless, volatility has and will continue throughout the year in that human behavior, as it has done many times, and will trump economic fundamentals.
Former Federal Reserve Chair Janet Yellen and current Chair Jay Powell are quasi-good examples of behavioral economics in that while engaging in data supported decision-making, they understand the emotions of the markets and the behavior of consumers. Otherwise, Powell would not have recently softened his stance on further hikes for the remainder of 2019.
President Donald Trump has influenced the markets both by his behavior and his policies. The tax cuts have clearly impacted company profits and individuals’ net income. But the ups and downs of the markets can’t be explained merely by policy changes. The behavioral side of economics also is a factor, just as the housing crash of 2008 was not merely a result of higher prices, subprime loans and maxed-out mortgages, but fearful homebuyers.
While rationality and the use of data have their limits, irrationality might very well be unbounded.
Insurance companies know that we aren’t rational and can tell us with great precision when we are going to die, when our homes will burn down, when we will get in an auto crash and recognize that we misbehave particularly when it comes to saving for our retirement. Thus, knowing that irrationality has few if any bounds. We need something or someone to keep us in place, someone else helping me plan or regulating me — maybe not to the full extent of Sarbanes-Oxley or Dodd-Frank, but some restraint. Whether you’re the president or just a regular person like me, we need guidelines.
So when it comes to morality and ethics, it makes absolutely no sense — that is, it is not rational — for any person, business, politician or preacher to misbehave. We’re daily reminded of the consequences of such actions. Thus, it is necessary to set up behavioral bounds for ourselves and our businesses in order to provide forward guidance limiting our actions so that we might not harm ourselves and those around us.
It makes sense to use data in our decision-making and forecasting, both on a business and personal level, but not to the exclusion of sociology, psychology and theology.
Dr. K. Brad Stamm is a professor of economics and received his Ph.D. at Fordham University in New York City. He is the former chair of the Business Division at Cornerstone University.