Housing Bubbles and Irrationality

Robert Schiller, the economist who has penned two books on the existence “irrational exuberance” writes about the US housing bubble and bust in today’s New York Times. In doing so he introduces us to another aspect of behavioural economics - the impact of information cascades which shape the decision making of people who are seeking to act entirely rationally when making a call about the investment value of putting money into property. The cascade effect kicks in when people have incomplete information and tend to rely on the experiences and judgements of others.

Schiller writes that

“The failure to recognize the housing bubble is the core reason for the collapsing house of cards we are seeing in financial markets in the United States and around the world. If people do not see any risk, and see only the prospect of outsized investment returns, they will pursue those returns with disregard for the risks…... The efficient-markets view holds that the market is wiser than any individual: in aggregate, the market will come to the correct decision. But the theory is flawed because it does not recognize that people must rely on the judgments of others.”

‘How a Bubble Stayed Under the Radar’ can be read here (free registration and login to the NYT site is required)