http://www.nytimes.com/2008/03/02/business/02view.html?_r=1&oref=slogin

Robert Shiller wrote the article above in the NY Times earlier this month relating information cascades to the housing bubble of real estate investments. Shiller starts by criticizing economic experts and quotes Alan Greenspan as saying that he had “come to realize that we’d never be able to identify irrational exuberance with certainty, much less act on it, until after the fact.” This implies that the market bubbles are made by “irrational exuberance,” when in fact, it can be clearly linked to information cascades. Shilling makes this connection by pointing out that rational people also get caught up in these bubbles which he then makes evident through definitions and examples from the scholarly paper “A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades” by Bikhchandani, Hirschleifer, and Welch of UCLA , which you can find at: http://www.jstor.org/view/00223808/di980598/98p00557/0

The emergence of any information cascade is based on the fact that every individual’s private information is incomplete and that each individual only conveys their information sequentially through actions. The result of such situations is that rational people with information that is mostly accurate, will still create an incorrect collective conclusion. Shilling ends by describing that a downward cascade, like a market bubble bursting, is likely in response to such an upsweep of real estate investments.

Many bloggers responded to this article contesting Shiller’s claims of whether the housing bubble was in fact predicted or whether it is really a better thing to catch bubbles before they become too large. One points out that the recognition of a bubble is the very thing that causes the burst and so it really should not be sought out. This response can be found at: http://www.crossingwallstreet.com/archives/2008/03/the_bubblephobe.html Yet more blogs even argue with the existence of economic bubbles to begin with.

The Wall Street Journal today had an article similar to Shiller’s discussing Alan Greenspan’s commentary in 1999 about the need, or lack of, to prevent the impending bubbles. The article is called Wanted: A New Policy For Bubbles by Jon Hilsenrath and seems to suggest that if the government is going to intervene after the bursting of bubbles, that maybe they should take steps to prevent them in the first place.

Although there are many opinions on the status of market bubbles and what we should do about them, one thing is clearly uncontested. That is the fact that information cascades are the cause of bubbles and that it is an optimal choice for rational people to follow these trends. In order to prevent these bubbles, we would have to find a way to trick rational behavior in these situations, and that would be no easy feat. In fact, some wise investors may neither want the bubbles overtly detected nor prevented because they can exploit the cascade for economic gain.