Why policymakers need to understand psychology as much as economics to solve the financial crisis.

To get a sense of how cascades work, imagine that a group of people is deciding whether to invest in real estate or instead the stock market. Assume that group members are announcing their views in sequence. From his own knowledge and experience, each member has some private information about what should be done. But each member also attends, reasonably enough, to the judgments of others.

Andrews is the first to speak. He suggests that real estate is the way to go. Barnes now knows Andrews's judgment; it is clear that she too should want to invest in real estate if she agrees independently with Andrews. But if her independent judgment is otherwise, she would--if she trusts Andrews no more and no less than she trusts herself--be indifferent about what to do, and she might simply flip a coin.

Now turn to a third person, Carlton. Suppose that both Andrews and Barnes have favored investing real estate, but that Carlton's own information, though not conclusive, suggests that this is a definite mistake. Even in that event, Carlton might well ignore what he knows and follow Andrews and Barnes. It is likely, after all, that both Andrews and Barnes had reasons for their conclusion. Unless Carlton is pretty confident, and thinks that his own information is better than theirs, he should follow their lead. If he does, Carlton is in a cascade.

Now suppose that Davis, Eagleton, and Franklin know what Andrews, Barnes, and Carlton said. On reasonable assumptions, they will do exactly what Carlton did: favor investing in real estate regardless of their private information (which, we are supposing, is relevant but inconclusive). And all this will happen even if Andrews initially blundered. Here is the kicker: That initial blunder can start a process by which a number of people end up making really terrible decisions. Human beings are not exactly lemmings, but they too can lead one another to disaster. (By the way, lemmings do not really commit suicide by following one another into the ocean; the widespread belief to that effect is the product of an all-too-human cascade.)

I have given a highly stylized example, but informational cascades are pervasive in the real world. Why do restaurants suddenly become immensely popular, when equally good restaurants are collapsing? Why do some songs, books, and movies become huge hits, when similar songs, books, and movies do really badly? Why do some candidates for public office become immensely successful, when others fail miserably? A large part of the answer involves the power of some initial sparks, which initiate a cascade.

Even among specialists, cascades are common. Every doctor knows that doctors rely heavily on what their colleagues have done, and the result can be surgical fads (such as tonsillectomies) and "bandwagon diseases." Ideas spread rapidly among lawyers and judges, and sometimes they become entrenched, simply because of the influence of a few early movers. Fund managers and investment analysts have themselves been found to cascade. If a number of managers make certain trades, their peers become more likely to trade as well.

Turn in this light to the current crisis. By historical standards, home prices jumped spectacularly from 1997 to 2004. In that period, many people thought, and said, that it is in the nature of home prices to increase over time, and people’s behavior tracked their belief. But the belief was demonstrably false. From 1960 to 1997, home prices were relatively stable, until the unprecedented boom that began in 1997.

As behavioral economist Robert Shiller has shown, the best explanation of the real estate bubble greatly overlaps with the best explanation of the stock market bubble of the late 1990s: In both cases, people were greatly influenced by a process of social contagion that amounted to an informational cascade. This belief produced wildly unrealistic projections, with palpable consequences for home purchases and mortgage choices.

In 2005, Shiller and Karl Case conducted a survey among San Francisco home buyers. The median expected price increase, over the next decade, was nine percent per year! In fact, one-third of those surveyed thought that the annual increase would be much higher than that. Their baseless optimism was based on two factors: salient price increases in the recent past and the apparent, and contagious, optimism of other people.

Of course the stock of public knowledge depends not merely on word-of-mouth and on visible sales, but on the media as well. In the late 1990s and early 2000s, it was widely reported that home prices were rapidly increasing (true) and that the prices would continue to increase over time (not true). If the apparent experts confirm "what everyone knows," then seemingly risky deals, of the sort that have led so many people to disaster, will seem hard to resist.

With respect to investments, we are now in the midst of a cascade of a different kind. In the entire month of September, American investors removed $19 billion from mutual funds investing in American stocks--a very large amount, to be sure, but one that was matched by just the first six days of October. The lack of confidence has proved contagious. Massive stock sales, no less than speculative bubbles, are a product of the perceived beliefs and actions of others. Many investors are selling stocks simply because of their belief that other investors are getting out of the stock market. Just as cascade-driven optimism inflated housing prices, cascade-driven pessimism is producing serious losses in stock prices.

In the current situation, however, there is a wrinkle. Behavioral economists have shown that people are “loss averse,” meaning that they hate losses more than they like corresponding gains. People are made more miserable by losing $20,000 than they are made happy by gaining $20,000. The prospect of significant losses is strongly encouraging people to follow the investment signals of those who are scrambling to what appears to be safety.

The problem, of course, is that, for a time, an informational cascade, whether "up" or "down," can be a self-fulfilling prophecy: The very fact that people are buying or selling can make it sensible to buy or sell, even if people's decisions are based on the anticipated decisions of others. The good news is that cascades can be fragile, precisely because people are not relying on their private information. What is true for political candidates and movie stars is true for investors as well: Once public signals start to shift, unfavorable cascades can be stopped or even reversed.

It is far too soon to know if we are in the midst of a full-fledged panic. The credit crunch is real, not an illusion. But if the stock market continues to plummet, one significant cause will be that many investors, including many experts, are reacting not to economic fundamentals, but listening to the informational signals of other people. For public officials, a simple point follows: An essential task is not merely to make good economic choices, but also to be perceived as doing so, in order to halt a potentially devastating cascade.

It is true that an understanding of informational cascades does not by itself compel any specific set of policy prescriptions. But it does suggest that policymakers need to have a sense of not only of economics but also of public psychology and of the power of social interactions--and their potential role in shaping them. The nation’s greatest leader during a time of economic distress, Franklin Delano Roosevelt, famously said during his first inaugural address, “The only thing we have to fear is fear itself.” Throughout the Great Depression, Roosevelt showed a keen intuitive understanding, not of economic theory, but of the need to inculcate a sense of public confidence and to stem public panic. His own success stemmed largely from his ability to assure the nation that it was in the hands of a leader who was at once competent, organized, confident, and calm. The Bush administration does not appear capable of following his example. The next administration had better try.

Cass R. Sunstein is a contributing editor to The New Republic and co-author of the Nudge: Improving Decisions About Health, Wealth and Happiness (2008).

Subscribe to The New Republic for only $29.97 a year--75% off cover price!


By Cass R. Sunstein