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The impact of Information Cascades on the Financial Crisis

When a given individual observes the action of other individuals and then engages in the same action, despite possible conflicts with his/her own private information, then we have an information cascade. The whole idea is that the individual completely ignores their own private information “signals” and just follows the actions of many. The thought process that fuels information cascades is, “It can’t be a poor decision if this many people made the same decision before me.” The actions have to be observable, otherwise the individual will just make the decision based on their own private information, because that would be the only information available to them. Essentially, an individual with weigh the opinion of a group over his own person opinion, if the group is large enough.
It has been said the U.S housing bubble that happened around 2008 is one of the major contributors to the recession. Information cascades can explain why this housing bubble got out of control so quickly. Let’s say Person A wants to invest in real estate, and thus decides do so. Person B sees Person A make this decision. Let’s say Person B trusts Person A just as much as he trusts himself. Let’s say Person B wants to invest in the stock market. He is therefore indifferent to what decision he makes because he trusts both decision equally. He flips a coin to decide, and he ends up investing in real estate as well. Person C has seen Person A and B make a decision, and Person C trusts Person A and B as much as he trusts himself. Person C was planning on investing in the stock market as well. Person C now think to himself that investing in the stock market surely must be a mistake if Person A and Person B did the opposite. Despite having personal information that incentives him to invest in the stock market, Person C invests in the real estate. This is an information cascade. This can continue to snowball and result in many people investing in real estate despite having a personal signal to invest in the stock market.
One ignorant decision can lead even informed individuals to make a poor decision. People were expecting house prices to continue to rise, and thus this trend continued. Some people tried to advise against this behavior, stating that housing prices are normally stable and do not rise as rapidly as people think. Housing prices then sharply declined starting in late 2006. This led to housing bubble, and the extremely high foreclosure rate is believed to be the primary cause of the recent recession. There is a reason why financial experts highly favor their own personal signals than the opinions of a large group. Ignorance can lead to a snowball effect of poor decisions.



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