NY times: How a Bubble Stayed Under the Radar (Information Cascade)
Starting from late 2007, U.S. Economy headed into a recession, which still continues as of today. No one knows when U.S. will step out of current recession, even though government and Federal reserve is trying there best with launching policies such as quantitative ease, operational twist, and recently targeting growth rate of nominal GDP. The spark of current recession was the subprime mortgage, which was failure of financial intermediates, lending money to individuals and companies to buy houses. Until the late 2007, one of the great investment that people made was buying an house, because the price of the houses were driving up so high, that it was safer than stock and bond with a understandable return by the price different from the time that one bought the house and the price of the house at the time of the selling.
However, the price of the houses gone up more than it’s actual value, in which we defined it as ‘Bubble.’ The article from NY Times, How a Bubble Stayed Under the Radar, tells us how these bubbles created, overvalue of the houses. This article’s explanation matched exactly with the concept called Information Cascade what I have learned in Info 2040 at Cornell University. Basically, the concept explains that how people’s choices behave depending on others actions and choices. It explains that a person will make the same decision or take the previous information that others have made by observing, and these previous information will affect his or her own decision, even if he or she was the most rational person. This concept exactly explains why the Bubble was created in housing just as explained in NY Times article: “How a Bubble Stayed Under the Radar.” The author of this article, Robert J Shiller, States that “people sometimes nee to rely on the judgment of others, and there in lies the problem… group of individual must make an important decision, based on useful but incomplete information.” When one bought the house with a higher price there is a higher possibility that others will think that the house is a good investment, and causes others purchase it with higher price. This momentum drove the housing price higher than the actual value when one starts the investment with housing and others who observe did the same.
This behavior caused by information cascade challenged to the “efficient markets” view of the world, which is an idea that investors are like independent minded voters, relying only on their own information to make decisions. But this theory of information cascade showed that “efficient market theory is flawed because it does not recognize that people must rely on the judgments of others.”
In conclusion, this theory of Information Cascade causes the bubble in economy, and it is hard to observe, just like the subprime mortgage, which was a spark of the current recession. Also because of information cascade, theory of efficient market in economy does not work in reality. Thus in my opinion, even though information from other is useful, investor should not take the information of others into his or her own account to make one’s own decision.
www.nytimes.com/2008/03/02/business/02view.html
In Sung Ahn
ia56@cornell.edu