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Behavioural MacroeconomicsReviewed by Ronald L. Moy, CFA

Behavioural Macroeconomics. 2012. Ian M. McDonald.

The worldwide financial crisis that began in 2008 has sparked renewed interest in macroeconomic policy. Debates over intervention versus free-market solutions have abounded. Should the market be left to adjust on its own or should governments use monetary or fiscal stimuli to foster economic growth? Also subject to debate is whether traditional economic theory provides the answers or whether economists need to look outside mainstream thought to gain a better understanding. Behavioural Macroeconomics proposes that psychology and behavioral economics can help answer these questions.

For many financial economists, the origins of behavioral economics and finance lie in Daniel Kahneman and Amos Tversky's pioneering work on prospect theory. Traditionally, behavioral economics has been considered a microeconomic topic, focused on certain types of logical errors made by individuals. In an effort to broaden the perspective of mainstream behavioral economics, Ian McDonald of the University of Melbourne has assembled an enlightening and diverse collection of 24 articles, featuring surveys, theoretical modeling, and empirical testing.

McDonald begins with an article by Luigino Bruni and Robert Sugden, first published in the Economic Journal in 2007, on the origins of behavioral economics. Bruni and Sugden present the case that for much of history, psychology played an important role in economic theory. However, the work of Vilfredo Pareto in the early 20th century began a "Paretian turn" that removed psychology from the field, a movement completed in the 1930s and 1940s with the work of John Hicks, Roy Allen, and Paul Samuelson. It is only through the more recent work of such researchers as Kahneman and Tversky, as well as Richard Thaler, that behavioral factors have returned to the forefront of current research.

McDonald has done a good job of reaching beyond the mainstream work in behavioral economics, which focuses on such issues as cognitive biases, heuristics, and framing. One topic widely ignored by economists that McDonald brings into the discussion is the notion of happiness. By no means new to policy, the concept of happiness is found in the U.S. Declaration of Independence, in which one of the self-evident truths is the "pursuit of happiness." More recently (in 1972), Bhutan's leader, Jigme Singye Wangchuck, coined the term "gross national happiness" to measure his country's well-being.

Happiness and well-being seem far removed from economists' traditional concerns, yet Bruno Frey and Alois Stutzer point out in "What Can Economists Learn from Happiness Research?" that making Pareto-improving proposals requires a determination of the net effects of individual utilities. That, in turn, requires an understanding of the impact of different policies on happiness within society. Cast in this light, incorporating the concept of happiness into economic models does not seem all that far removed from traditional utility theory. Economists have customarily striven to quantify utility in very different terms, but ultimately, utility is really about happiness or well-being.

Recognizing the importance of an improved understanding of the persistence of unemployment following the global financial crisis, McDonald has included a number of articles on the labor market. Since the days of John Maynard Keynes, the labor market has perplexed economists because labor prices do not adjust to clear the market, as with most goods and services. Behavioral factors point to possible reasons for the persistence of unemployment.

One explanation for the lack of adjustment of wages can be found in the equity/efficiency wage model of George Akerlof and Janet Yellen (1990), in which workers proportionately withdraw effort as their actual wage falls short of the fair wage. These results are supported by a survey conducted by Truman Bewley (1995). In a series of interviews with employers during a period of high unemployment, Bewley found that they were hesitant to reduce wages because of the likely impact on morale. One insight that policymakers can glean from this research is that owing to the impact of money illusion, a small amount of inflation may be desirable because it could allow the real wage to decrease sufficiently to permit labor markets to clear.

Another issue confronting many countries is the solvency of retirement systems - for example, Social Security in the United States. The excessive reliance on Social Security by many individuals can be traced to the consumption-and-savings decision they face. Why do people not save enough for retirement? Why do they not adjust their consumption in response to expected decreases in income? Three articles provide potential explanations for the failure to adjust consumption and offer suggestions on how employers can encourage workers to save sufficiently for retirement. These insights may enable policymakers and businesses to take actions that will help workers become more financially self-sufficient in retirement and thereby allow the government to pare back benefits for future generations of workers.

Surprisingly, in the aftermath of the global financial crisis, few articles have discussed the human decision making that led to the crisis. Much of the trouble appears to have resulted from errors easily identifiable through rational analysis. On this point, a short article that McDonald published in Economic Papers shows how various biases previously identified by behavioral economists contributed to the speculative bubble and, ultimately, the financial crisis.

In light of the recent Occupy Wall Street movement and the current debate on income distribution, McDonald chooses to close the book with an article by Robert J. Oxoby titled "Cognitive Dissonance, Status, and Growth of the Underclass." Oxoby presents a general equilibrium model that points to systematic expansion of an underclass. Surprisingly, the pressure to compete, rather than leading people to work harder to move up the social rankings, may force many to drop out of the mainstream, causing the underclass to grow. Among the policy implications of Oxoby's analysis is the possibility that some income redistribution can be valuable in keeping the poor from becoming disenfranchised and, contrary to popular belief, may raise their incentive to exert effort.

McDonald concludes, "The applications of behavioral economics to macroeconomics contained in this volume tend to be a rather gloomy view of capitalism." In defiance of conventional wisdom, he finds that economic growth does not increase happiness and results in an increasing proportion of people in the underclass. McDonald suggests that principles of behavioral macroeconomics can shed light on how to tackle some of the problems of capitalism.

The articles selected by McDonald are likely to spur intense debate among economists. Many readers may well view the book as unduly Keynesian - or, in the current political context, unduly liberal. However, given the inability of the "new classical" economists to explain much of what has taken place in the global economy, the profession should perhaps consider returning to the behavioral explanations of Keynes and the economists who preceded the Paretian turn.

Policymakers may also profit from reading this provocative collection of articles. As world leaders consider economic policies in the aftermath of the recent financial crisis, they might do well to consider the impact of behavior on the economic policies they plan to implement. Policymakers who ignore the insights in Behavioural Macroeconomics may find that their policy outcomes prove less than desirable.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Source: Ian M. McDonald's 'Behavioural Macroeconomics'