Robert Shiller’s article in the New York Times relates the recent housing bubble to information cascades. The recent housing bubble wasn’t even seen by the Chairman of the Federal Reserve, Alan Greenspan. But why couldn’t a person, as knowledgeable as Greenspan, see the bubble before if popped? He, like the rest of the market, didn’t see any of the risk. As a result of failing to recognize the bubble people continued to invest in the housing market expecting big returns.

To explain why experts failed to recognize the bubble, Shiller points to information cascades. One of the fundamental problems of information cascades in this case is the need for people to rely on the information and judgment of others. People see the actions of those before them and base their own decisions on those actions. As a result, if the first person made the wrong decision, it is possible for that decision to be copied, as people think that person made the correct decision. As more and more people start copying the decision, it seems as though since everyone is making the decision, like investing in the housing market, it is the correct decision.

But why does an information cascade start? Shiller states that each individual’s information is incomplete. Suppose we make the correct decision 60 percent of the time based on our information. That means that 40 percent of the time we are making the incorrect decision. If the next person, who observes our decision, has information supporting our incorrect decision, he will have no problem making the same incorrect decision. If his information contradicts our decision, then he must decide whether to go with is own decision or go with a decision those before him made. This results in a 50-50 scenario of the person making another incorrect decision or breaking the trend and making the correct decision. As a result, the incorrect decision can start to gain momentum as more and more people see others making that decision. This is how the information cascade can create a bubble like the recent housing bubble.

New York Times Article