Folks:
Prof. Robert Shiller has written an interesting piece for the New York Times examing from one perspective how the housing bubble came to be.
Some of the good stuff:
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.
...
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.
Mr. Bikhchandani and his co-authors present this example: Suppose that a group of individuals must make an important decision, based on useful but incomplete information. Each one of them has received some information relevant to the decision, but the information is incomplete and "noisy" and does not always point to the right conclusion.
Mr. Shiller speculates that "information cascades" played a role in the way the housing bubble formed.
People make decisions based on the information that they get from other people. When people saw their neighbors paying exorbitantly high prices for housing, they not only processed this information but also concluded that, since their neighbors were doing it, there must be some sort of underlying argument that this high price was a good investment.
Unfortunately, the "underlying" part was not there.
Mr. Shiller further speculates on whether or not bubbles can be prevent simply by providing better information to participants in the market. He thinks that it is unlikely ... The kind of "national town hall" discussion on home pricing issues (or any sort of issue, one supposes) simply cannot happen.
The conclusion that I drew from this particular piece of commentary is that, in a "free market" with little regulation, bubbles are always going to happen.
People are always going to act using the pack mentality, because we are forced to get our information about market movement by observing what other people do.
Every person in the country cannot spend ten hours a day researching technical details on whether or not today's price of butter (or cheese, or bread) is merely a temporary price spike, or represents a long term trend ... The amount of time that that requires simply exceeds the amount of time available to each person for labor. (Not to mention other obligations.)
We're never going to be able to increase the amount of information about markets that the average person can process ... And this seems to be part of the phenomenon that leads to bubbles like the current one collapsing in housing.
Yet we know this type of bubble can have an extremely negative effect on the economic health of a society.
Indeed, we seem to be tottering at the precipice now.
So, what is the answer?
If "free markets" are naturally predisposed toward results that harm our national economic well-being, why are we so slavishly dedicated to them?