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How Information Cascades Created the U.S. Housing Bubble

https://www.nytimes.com/2008/03/02/business/02view.html

When the housing bubble burst in 2008, it led to devastating effects around the world; homes foreclosed at alarming rates, companies declared bankruptcy, and many people lost their jobs.

The failure to recognize this housing bubble is the main reason for the collapsing in financial markets; author Shiller writes, “if people do not see any risk, and see only the prospect of outsized investment returns, they will pursue those returns with disregard for the risks” (Shiller). A majority of people in the United States never knew what was coming. This can be explained by information cascades; people rely on the judgment of others; this can cause bubblelike phenomena even amongst the most rational and knowledgeable of people.

Shiller explained through the use of an example: “… individuals in the group must each decide whether real estate is a terrific investment and whether to buy some property. Suppose that there is a 60 percent probability that any one person’s information will lead to the right decision. In other words, that person’s information is useful but not definitive — and not clear enough to make a firm judgment about something as momentous as a market bubble… The theory helps explain why he — or anyone trying to verify the existence of a market bubble — may have squelched his own judgment” (Shiller). This makes it clearer how information cascades were integral to the real estate turbulence prior to the bubble burst.

The scary reality of information cascades is directly reflected in the housing bubble. For example, if someone erroneously paid a high price for a home of low investment value, they are mistakenly signaling to others that houses are a good investment. This is where information cascades come into play; as others make purchases at rising prices, more and more people will conclude that these buyers’ information about the market outweighs their own.

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