Maybe we’re just stupid…

From the NY Times:

How a Bubble Stayed Under the Radar

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

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.

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.

Let’s update the example to apply it to the recent bubble: The individuals in the group must each decide whether real estate is a terrific investment and whether to buy some property. Suppose that there is a 60 percent probability that any one person’s information will lead to the right decision.

In other words, that person’s information is useful but not definitive — and not clear enough to make a firm judgment about something as momentous as a market bubble. Perhaps that is how Mr. Greenspan assessed the probability that he could make an accurate judgment about the stock market bubble.

The theory helps explain why he — or anyone trying to verify the existence of a market bubble — may have squelched his own judgment.

It is clear that just such an information cascade helped to create the housing bubble. And it is now possible that a downward cascade will develop — in which rational individuals become excessively pessimistic as they see others bidding down home prices to abnormally low levels.

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23 Responses to Maybe we’re just stupid…

  1. Confused In NJ says:

    Forrest Gump says; “stupid is as stupid does”. Acrually it’s irrational greed versus sanity.

  2. Good article. I dont think people are stupid, because they haven’t seen the bubble (ok, some of them actually are). Problem is, they haven’t realised how risky and quick the bubble could be! When the market is growing, you see the chance to make some nice bucks and you jast hope situation will last at least for some time more. And suddenly collaps is here and you just say:”damn, too late!” We in ReMax Vancouver are not in the same situation, because our market seems firm so far, but averybody has to be alerted…

  3. Cindy says:

    (1) Confused
    I am currently reading “Greenspan’s Bubbles”
    “The Age of Ignorance” by William A. Fleckenstein. Right off the bat – page 3.

    “Greenspan erred by continually picking an interest rate that was too low, then he solved the turmoil that resulted from that decision with another period of interest rates that were again too low. The result was that, during his reign, the United States experienced a bubble in stocks and then in real estate. These two massive bubbles emerged within 10 years of each other. Prior to Greenspan’s arrival at the Fed, excluding the brief mania for commodities and precious metals from late 1979 to early 1980, the country had been bubble-free for over 50 years.”

    When your Fed chairman creates a situation where savers, who are trying to stay ahead of inflation, can only earn 2% on a CD –
    they are bound to look elsewhere.

    Since Bernanke is following in Greenspan’s footsteps – Now where are all of the “stupid people” going to turn…?
    Are people now chasing after gold and commodities “without regard for the risk?”
    A lot of people are now relying again on the “judgement of others” possibly creating
    yet another “information cascade.”

    You can’t keep doing the same thing and expect a different result. Bernanke is doing just what Greenspan did…isn’t he?

  4. Cindy says:

    BTW -Confused – I am not trying to be a smart @ss…I am reading to try to understand today’s economy and those who run it. The more I learn the less I know.

  5. bollix says:

    “We have to consider the possibility that perfectly rational people can get caught up in a bubble.” To suggest that rational behavior can be found in the “Herd” is just stupidity. I agree Confused, take greed out of the equation and the stampede of sheeple begin to graze again.”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.” Uhmmmm, that would be greed… Moo.

  6. bairen says:

    #4 Cindy. your comment makes you more knowledgeable, wiser, and honest then most Wall St types and pols.

    I don’t know what’s going to happen either. Inflation, deflation, stagflation, other? I do believe it’s not going to be good.

  7. crossroads says:

    Cindy,

    have you asked yourself what is going to happen w/ a commodities bubble?

    It seems while Ben is blowing a commodities bubble the only thing that will come from it is higher prices. The last 2 bubbles created wealth in stocks which for people to benefit they had to invest, and housing which everyone who owned a home saw an increase in equity.
    I wonder what will happen

  8. Cindy says:

    (6) bairen – Thank you – I’ll keep reading! Asking questions here is like asking top-notch college professors.

    (7) crossroads -I have no idea if this is a bubble buildup. It just seemed like the rates would fly up to stop inflation and stem the dollar’s decline but that didn’t happen. So it appears we are headed down the same road Greenspan lead us….which created two bubbles in a ten-year span.
    So now I read.

  9. Cindy says:

    The newspaper runs a “$1,000 Derby” each week. It is a weekly update on what $1,000 invested on Jan. 1 would be worth today.
    “Investment returns are based on the performance of Dow Jones stock, bond and commodity indexes, which include reinvestment of dividends where applicable.”

    Soybean oil $1,375.00
    Silver $1,333.00
    Aluminum $1,283.00
    Coffee $1,208.00
    Corn $1,196.00
    Cotton $1,178.00
    Gold $1,160.00
    Zinc $1,158.00
    Crude Oil $1,064.00
    Latin American Stocks $1,024.00
    Corporate bonds $1,016.00
    Unleaded gas $996.00

    Well, you get the idea – at the bottom of the heap -Telecom stocks @ $818.00.

  10. crossroads says:

    Cindy
    I agree we are on course for another bubble led by our fed chairman Ben Bernanke. checkout books by Robert Prechter and the people over at the dailyreckoning.com
    happy reading

  11. Apple trumps PCs says:

    Is this where we’re headed?…

    http://www.torontosun.com/Money/2008/02/24/4872237-sun.html

    Remember when Greenspan was promoting the use of adjustable rate mortgages…and look where that got us.

  12. BC Bob says:

    apple[11],

    When you are bored, go back and read what AG said about derivatives, how they disperse risk. HMMM? Did he mention anything about counter-party risk? In addition to this, did he ever acknowledge that risk goes out the front door and comes back in house, thru the back door? The bottom line, don’t listen to these buffoons. I’d rather buy a life preserver than purchase what they are preaching.

  13. BC Bob says:

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

    The experts actually did recognize it. Problem was, they were only heard on this site. They were formerly known as wannabes and LOD’s. Now they are constantly asked, what did you observe that the pundits missed?

  14. Cindy says:

    (13) Hi BC Bob – I know I am listening..
    Thanks for all of the information you share.

    (10) crossroads – I’ll check out your suggestions. Thanks so much.

  15. Fiddy Cents on the Dollar says:

    Cindy-

    Does the Newspaper Derby track any other Foreign Stock Index?

  16. Shore Guy says:

    #5 “BTW-I closed on a condo in Asbury Park last week.”

    Was it in one of the new bacch/lakefront buildings, an older highrise, or one of the newer small conversions?

  17. Cindy says:

    (15) Fiddy Cents
    No, but the rest of the figures follow:
    (continued from #9)

    Unleaded gas $996.00
    Oil & gas stocks $961.00
    Consumer service stocks $937.00
    Asian stocks $932.00
    Mid-cap stocks $930.00
    small-cap stocks $914.00
    Large-cap stocks $911
    European stocks $910.00
    Financial stocks $898.00
    Tech stocks $838.00
    Telecom stocks $818.00

    It also states “Zinc, silver and soybean oil advanced most in a week marked by the continued outperformance of commodity investments over stocks. Soybeans drew support from anticipation of large orders from China. Telecom stocks are the year’s losers so far this year, following price cuts.”

    It is in the Fresno Bee – only on Sunday on the second page of the business section under “market extra.” A few weeks ago (2/10)
    Chinese stocks also showed @$820.00 coming in under technology stocks.

    I guess it depends on the week’s activity because the 2/10 paper shows wheat on top @
    $1,239., sugar $1,177., copper $1,166., then corn etc.

    Hope that helps.

  18. BC Bob says:

    Cindy,

    China is buying boatloads of soybeans. I think we should back our currency with grains. Remove the damn good faith and promise. It will be a quick cure, however the dictators would squirm.

  19. Cindy says:

    BC Bob

    Can you even believe Josh Brown left the Seahawks to play for the St. Louis Rams?
    First Holmgren – now this. The daughter in Wash. tells me they tried (matched the $14M but the up-front money ($4M) and his family in Oklahoma were too big a draw. We are up a creek. I thought he was one great kicker.

  20. Shore Guy says:

    Cindy,

    There is another team other than the Giants?

  21. Cindy says:

    (20) Shore

    You got me there. Eli, well they all really stepped up this year. I don’t know much about football but I love to watch it.

  22. Shore Guy says:

    As my wife says, whats not to like about a bunch of in-shape guys running around in tight satin pants, lol.

  23. bairen says:

    #22 Like the ice shows. Bunch of good looking women in great shape wearing spandex.

    Of course I don’t let my wife know i enjoyed it. this way when she’s complaining about me watching football I can say “come on, I took you to that ice thing”

    Leverage and love make the world go round.

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