Information Cascades in Housing Markets
An information cascade occurs when people continue to make the same decision in sequential fashion, starting from an initial decision that’s usually binary (Accept/Reject). People’s decisions and behavior are informed by the visible actions of the people who have acted before them.
This can be applied to the fall of the US housing market in 2008. Of course, the hedge funds and banks were at fault for the subprime mortgage crisis with mortgage-backed securities that were covered with credit default swaps. When interest rates rose, housing prices fell drastically, and Americans were forced to default. However; it is both interesting and important to look at the role that information cascades played in this crisis. In this case, there was an ‘Accept’ cascade when in reality this might not have been the correct path because the information was useful but incomplete and inconclusive. This downward cascade started when people began to make the wrong decision of buying homes that were being overvalued. Each person that followed would determine that the information of the buyers before them was more powerful than their own. People concluded that continuing to follow this ‘safe’ investment was a good idea, so more and more people bought houses which continued to inform others. The bubble grew because individuals felt more confident investing in homes knowing that others were also doing it – leading them to feel safer than they really were.
That is the problem – relying on the judgement of others in order to form your own conclusion. This goes to show that the decision making of rational human beings can be affected very easily by the behavior of others and the information that’s readily available to them. People could’ve done more research to make better informed decisions rather than basing them off the behavior of others. This is obviously an extreme scenario that includes other factors where a large portion of the fault doesn’t fall on the homeowners.
LINK:
www.nytimes.com/2008/03/02/business/02view.html