Information Cascades and the Housing Bubble
In the late 2000s, the United States experienced its worst economic recession since the Great Depression. One of the primary causes of this recession was the collapse of the housing market that took place around 2007. In the few years prior to its collapse, the housing market was thriving. Prices were rapidly increasing in the early part of the decade, peaking in 2006. This housing bubble and its ultimate collapse played a significant role in causing the recent recession. But how did it happen? Robert J. Shiller, an economics and finance professor at Yale, discusses this question in a 2008 New York Times article.
In this article, Shiller considers why herds of people began investing greater and greater sums of money in the housing market, in spite of all the risks involved. Shiller provides a plausible explanation in terms of information cascades. He postulates that each individual or group of individuals interested in the housing market has some information about the market. Of course, for each group, this information is incomplete and there is only a certain probability that it is correct. Based on this information, a group or individual will make a decision about whether or not to invest. Not after long, however, people will have not only their own information to go by, but they will also be able study the decisions of other people before them. Say, for instance, two people decide to invest in real estate. A third person comes along with negative information about the market. But seeing that the two previous people invested, the third person is likely to believe that the first two people’s information outweighs his or her own. Thus, a cascade begins, with more and more people ignoring their own private information and simply following the crowd. This is precisely what Shiller believes to be the cause of the housing bubble. Clearly, just as we discovered in class, we can see here that it doesn’t take a whole lot of false information to initiate this cascade. Additionally, Shiller suggests that a similar cascade resulted in the housing bubble’s collapse, leading up to the recession that the U.S. is still recovering from today.
Source: http://www.nytimes.com/2008/03/02/business/02view.html?_r=1&ref=business&pagewanted=all&oref=slogin
-bobsacamano