Even the experts missed the housing bubble

by Robert J. Shiller

Mar 05, 2008

http://www.ohio.com/editorial/commentary/16246947.html?page=all&c=y

This article starts out by summarizing how Alan Greenspan failed to predict the recent housing bubble, and how it is responsible for the collapsing of financial markets in the United States. The article explores how something like this could slip under the radar of the experts. The article raises the point that it is highly unlikely that everyone is making irrational decisions. Instead, Shiller makes reference to an article written in 1992 describing information cascades and how perfectly rational people make bad decisions because of the information presented to them by past decision makers. Shiller writes that information cascades are to blame for the housing bubble because rational investors were making good decisions that were based on poor or misleading information provided by previous investors. Finally Shiller writes how at this point a downward cascade will develop, in which investors are overly pessimistic and cautious.

This article is very relevant to our recent studies of information cascades and their presence in the world. In this case the result of an information cascade is the housing bubble, in which the pricing of houses rises above a sustainable level relative to income. This means that buyers have invested in a house that they will lose money on. Even experts such as Alan Greenspan failed to predict this housing bubble because they assumed that rational investors would be able to spot a poor investment before they buy. As the article points out, this was not the case because of information cascading. The investors were in fact rational and making the correct decisions based on the information provided. However, this information was misleading because of the nature of the information cascade. The article explains that there is a chance that a person will make the wrong decision given a signal. In this case it is possible that someone made an incorrect decision to make an initial investment. The next person to make a decision could have gotten a “low” signal but since the person before him chose to invest, they would be indifferent and could essentially flip a coin to decide whether or not to invest. If they arbitrarily chose to invest, then an information cascade begins. The next person, regardless of what signal they have, will choose to invest because the first two people invested, and he can only assume that it was because it was the correct thing to do,. In reality the first person was mistaken and the second worked off the first persons error.

As we have found out in class, information cascading is the explanation for the housing bubble situation described in this article. Although we have not yet discussed downward cascading in lecture, I believe the author of this article correctly predicts what will happen after an information cascade has been recognized. It makes sense that people will be very cautious in their investments after seeing what will happen if previous decisions are used as a primary factor in personal decision making.