Wednesday, March 05, 2008

What Causes Bubble? Shiller's View

Greg Mankiw's Blog: Shiller on Bubbles

I met Prof. Robert Shiller in Japan four years ago. Today's topic is posted by him and about the recent housing bubble in the US. That's interesting.

Let me summarize this story:

Suppose houses are really of low investment value.

Taro, the first person to make a decision, reaches the wrong conclusion and pays a high price for a home, thus signaling to others that houses are a good investment.

John, the second person, has no problem if his own data seem to confirm the information provided by Taro’s willingness to pay a high price. But John faces a quandary if his own information seems to contradict Taro’s judgment. In that case, John would conclude that he has no worthwhile information, and so he must make an arbitrary decision — say, by flipping a coin to decide whether to buy a house.

The result is that even if houses are of low investment value, we may now have two people who make purchasing decisions that reveal their conclusion that houses are a good investment.
As others make purchases at rising prices, more and more people will conclude that these buyers’ information about the market outweighs their own.
This is what is called "information cascades".

The probability of the cascade leading to an incorrect assumption is 37 percent. In other words, more than one-third of the time, rational individuals, each given information that is 60 percent accurate, will reach the wrong collective conclusion.

Thus, we should expect to see cascades driving our thinking from time to time, even when everyone is absolutely rational and calculating.

Furthermore, these people are being influenced by agencies which are conducting a public-relations campaign intended to show that putting money into housing is a reliable way to build wealth. Under these circumstances, it’s easy to understand how even experts could come to believe that housing is a spectacular investment.

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.

As you know, Japan had a big asset bubble in the late 1980s. Now China also has been reported to be having the same experience of the real estate bubble as the Japan of the 1980s. A bubble is not an old story to us, but is worth reminding always. Anyway, this is not others' matter.

The interesting point of this theory is that it shows that even rational people are likely to make a mistake in judging the value of investment because the information they rely is incomplete.

The point I care is what policy is likely to avoid the birth and the burst of the bubble from the viewpoint of this theory.

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