Information Cascades in Economic Bubbles
Information cascades, as discussed at length in class, can be used to explain many phenomenon in economics. Information cascades can even be used to explain irrational human behavior associated with economic bubbles. Economic bubbles are characterized by an extraordinary up-bid in the price of an asset that is followed by a rapid decline. Often times, when analysts look back on historical bubbles and attempt to find an explanation, they are astounded by just how out of line asset prices had been at the bubble’s peak. In fact, they often find that asset prices have appreciated on nothing more than irrational human behavior. For example, people might bid up the stock price of technology companies, not based on future cash flow, but simply on the optimism of others. The spread of misinformation through an information cascade can be used to explain the 2008 financial crisis as well.
In spite of drastic increases in housing prices from 1997 to 2007, prices continued to creep up each year. Alongside this, packages of mortgages known as collateralized debt obligations continued to grow in popularity while the very core mortgages inside the CDO’s tended to be subprime. One might be tempted to ask why people continued to bid up home prices and buy CDOs even though anyone that bothered to analyze the CDO’s in depth could see that the prices were out of line with reality.
In the case of misinformation spread in an information cascade, it was explained in class that even though one may hold a certain opinion of the price of an asset, he/she often makes decisions based on the opinion of others even if it contradicts their own views. Thus, it is possible to sustain misinformation in asset markets, especially if there are enough people who believe this misinformation. This was the case in the housing crisis as well. Though some may have known that the real estate market was not quite as strong as popular belief, they may have acted or misinformation (other people’s optimism about real estate), and continued to bid up prices. In this way, the irrational behavior exhibited in the housing crisis can be explained largely by misinformation spread through an information cascade.
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