Informational Cascades and the Financial Crisis in the Last Decade
I came across an article that discussed the role of information cascades in the financial crisis of the 2000s. It begins with a description of how cascades work with a investment example: a group of people announce in sequence on whether they would invest in real estate or the stock market. The first person to speak will make a decision based on his personal preference. Lets say he chooses to invest in real estate. The next person now knows the first person’s judgement. If his independent judgment is not the same as the first, then he will be indifferent and base his decision on his own preference. The third person is an interesting case. If both the first and second person favor investing in real estate, the third person, regardless of his own preference, may choose to follow the decisions of the first two people. This means that the rest of the people in the sequence will have the same fate as the third person. Thus, the information cascade begins. Information cascades are the reasons why restaurants suddenly become popular while other equally good restaurants are collapsing, why songs, books, and movies become huge hits, etc. The reason is that there is “some initial spark, which initiates the cascade.”
What does this have to do with the financial crisis? Well, historically real estate prices jumped from 1997 to 2004. People believed that it is “the nature of home prices to increase over time.” So, the “salient price increases in the past and the apparent, and contagious, optimism of other people…led so many people to disaster” in the 2000s.
The article wraps up information cascades with a suggestion for policymakers: “policymakers need to have a sense of not only economics but also of public psychology and of the power of social interactions–and their potential role in shaping them.”
http://economistsview.typepad.com/economistsview/2008/10/informational-c.html