Information cascades as a cause of financial crises
An information cascade is characterized by an instance in which an people view the behavior of others and engage in the same behaviors despite possibly having information or preferences that would influence them to do the opposite. Put simply, information cascades are cause when an individual ignores their own personal inclinations and follows the larger group. When people see that others are making a certain decision, they can rationalize it by assuming that it must be a good decision. With the global media and publicized experts weighing in on issues, it is very easy for people to set aside their personal beliefs to follow the masses. This type of behavior is arguably one of the foremost contributors to the worsening of crises and recessions.
To understand why an information cascade can lead to a financial crisis, lets first examine the 2008 subprime mortgage crisis and the associated investments. By the time the housing bubble bursted in 2008, Americans had been investing in seemingly reliable mortgage-backed securities for years. The media and ratings agencies had touted these securities as a safe investments and many individuals and businesses, for fear of missing out, had decided to invest their money into these risky securities. As an example, let’s say that individual 1 had decided to invest a large portion of their retirement savings into mortgage-backed securities. Individual 2 knows this and they trust individual 1 to the same extent the trust themselves. They had originally hoped to invest their money into U.S. treasuries instead, but, because they trust both options equally, they were indifferent to the situation. So, they use a 50/50 probability tool on their computer to make the decision and ultimately decide to do the same as individual 1. Now individual 3, who trusts individuals 1 and 2 as much as themself, had also wanted to invest their money into U.S. treasuries. However, they see that individuals 1 and 2 decided to invest in mortgage-backed securities instead of bonds and come to conclusion that investing in bonds must not be the best option. Even though individual 3 knows that bonds will offer steady and consistent growth, they assume that mortgage-backed securities are a better option simply because 1 and 2 invested in them. Preceding the subprime mortgage crisis, many people and businesses saw that their peers were throwing large sums of money behind mortgage-backed securities. Because they either valued expert opinion or the opinions of those around them equal to their own, they acted against their own information and made poor investments. As more individuals did so, it created an information cascade and ultimately exacerbated the impact of the crisis because so many lost their entire investments when mortgages defaulted and the entire value of their securities were reduced to zero.
Today, experts are concerned that an information cascade can create a similar problem and deepen a potential incoming recession. However, it is difficult to pin point exactly where there may be a major default. Some are unnerved by the amount of capital flowing into funds comprised of technology equities which are perceived to be high growth. There could potentially be an information cascade in that as one business or person throws capital into technology funds, another that trusts them will do the same and so on. In the event of a shock to the technology sector of the economy, many investors will lose entire investments. This is just an example and not necessarily likely, but it is a possibility. This is why investing experts, especially following the 2008 crisis, are more likely to use their own findings when making investments rather than relying on the broader opinion of multiple individuals.
Source: https://www.theguardian.com/business/2019/oct/20/world-sleepwalking-to-another-financial-crisis-says-mervyn-king