Information Cascade model’s role in financial crisis
Financial crisis in 2008 that lasted for several years, some of the sectors still affected to nowadays, was a huge deal in the 21st century. This was the biggest crisis after the Great Depression in the 1930s and many individuals were greatly affected by the event. While the main cause for the crisis was from high default rate in the subprime home mortgage sector, the negative impact was further precipitated by failures of financial institutions, unreasonable bailouts of these institutions offered by government, and the overall slowdown of the economy, not limited to stock and housing market.
So what fundamentally caused defaults in the subprime home mortgage sector? Why was the sector, left alone that caused no problem, suddenly resulted in high default rate? The answer could be found behind a concept covered in class, ‘Information Cascade.’ Information cascade is the phenomenon where the decisions and choices an individual make are influenced by other individuals and information they possess. Because there is no effective stop to this phenomenon, information cascade often produces population-wide, collective outcomes.
Information cascade model is often used to explain movements in stock market. Stock prices move based on demands of the stock. And the demands of the stocks could be based on various factors: company’s profit generating ability, movement of management team, or information. Oftentimes, sudden jump or fall of stock price are not accompanied with reasonable justifications. In those cases, it is most likely that the price movement was due to information cascade – individuals making decisions and changing demands of the stock based on information they were able to gather from the broader crowd.
Financial crisis can also be explained using similar logic. Looking at the historical jump in housing prices in 1997 to 2004, a trend was observable: people thought that it was in the nature of home prices to increase over time and they started to act accordingly. However, the popular belief turned out to be false and many people who acted on it suffered. Similarly, it was the public psychology and social interactions that led financial crisis in 2007. Not proven and not corrected public information that was magnified by information cascade brought the tragedy upon individuals. While it is uncertain how to put an effective stop to such phenomenon in case another crisis looms in, it is to be noted that policymakers should step back from policy stance and consider information crisis to be scarier than it is deemed as of now.
http://economistsview.typepad.com/economistsview/2008/10/informational-c.html