Behavioral Finance and the Business Cycle

Abstract

Despite a century of economic scholarship, economists and central banks still cannot predict recessions. Part of this problem is that modern economics is based on the idea that consumers and policy-makers make rational decisions. Economic models are based on lagging indicators of economic performance that compounds the problem of prediction. Behavioral economics and finance are predicated on the assumption of mixed rationality; that is that many if not most decisions are not rational. In these disciplines, decisions are driven by innate and usually unconscious cognitive biases. This suggests that tracking cognitive biases may provide a new way to identify the phases of the business cycle. This has the added advantage that behavior is a leading indicator of outcome. This article provides such an approach. It is based on a proprietary model of cognitive biases that identifies the Financial Signature® of economic actors. This concept is the sum of two key cognitive biases, the status quo bias and the illusion of control bias; these respectively are proxies for innovativeness and value-adding and thus gross margin and resource utilization or the level of indirect expenses by a consumer or manager. The ratio of resource utilization to value-adding is the key metric. When this is high the economic environment is being driven by people with low business acumen who make bad economic decisions. When it is lower people with higher business acumen are driving collective economic decisions. An environment where most decisions are driven by people with lower business acumen marks the peak of the business cycle, or the boom. Where the ratio is tipped towards people with higher business acumen, the environment is being driven by people with more favorable outcomes. This is the nadir or the business cycle. We can track this metric to predict accurately the phase of the business cycle and to identify if we are near to the top or bottom of the cycle. The mechanisms to do this are a formal system of behavioral ratings, behavioral surveys and crowdsourcing. These might not necessarily replace current mechanisms for predicting business cycles, but would certainly complement them.