Monday, March 03, 2008

Bubble Behavior

Robert Shiller's article in yesterday's NYT attempts to explain the housing bubble through behavioral economics. Shiller says that most "experts" didn't recognize the housing bubble:

ONE great puzzle about the recent housing bubble is why even most experts didn’t recognize the bubble as it was forming.

Alan Greenspan, a very serious student of the markets, didn’t see it, and, moreover, he didn’t see the stock market bubble of the 1990s, either. In his 2007 autobiography, “The Age of Turbulence: Adventures in a New World,” he talks at some length about his suspicions in the 1990s that there was irrational exuberance in the stock market. But in the end, he says, he just couldn’t figure it out: “I’d come to realize that we’d never be able to identify irrational exuberance with certainty, much less act on it, until after the fact.”

With the housing bubble, Mr. Greenspan didn’t seem to have any doubt: “I would tell audiences that we were facing not a bubble but a froth — lots of small local bubbles that never grew to a scale that could threaten the health of the overall economy.”

I think that says a lot more about the "experts" than anything else. There were plenty of people who recognized the bubble in housing. I suppose none of them qualified as "experts" in Mr. Shiller's mind.

Shiller then cites a study from 1992 about "information cascades" to explain how so many supposedly rational people got caught up in the housing bubble:

Were all these people stupid? It can’t be. We have to consider the possibility that perfectly rational people can get caught up in a bubble. In this connection, it is helpful to refer to an important bit of economic theory about herd behavior.

Three economists, Sushil Bikhchandani, David Hirshleifer and Ivo Welch, in a classic 1992 article, defined what they call “information cascades” that can lead people into serious error. They found that these cascades can affect even perfectly rational people and cause bubblelike phenomena. Why? Ultimately, people sometimes need to rely on the judgment of others, and therein lies the problem. The theory provides a framework for understanding the real estate turbulence we are now observing.

I suppose it is true that "all these people" were not stupid. On the other hand, those people who were lining up for a chance to purchase a preconstruction condo in Miami were clearly out of their minds. Or they were stupid. Or both.

This study essentially finds a way to blame dumb decisions on other people. You weren't stupid. You were duped by all those other idiots in the market. You were duped by the National Association of Realtors. I just don't buy it. The housing bubble (and every other bubble for that matter) is about greed and envy.

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