by Calculated Risk on 3/01/2008 08:45:00 PM

Professor Shiller writes in the NY Times: How a Bubble Stayed Under the Radar

Shiller discusses “information cascades” that can lead rational people to make investment errors (like not realizing there was a bubble in the housing market).

Last year, in response to a speech by Minneapolis Federal Reserve President Gary H. Stern, I wrote:

Stern's subject was economic education. He appears to suggest policy makers overestimated the skills of American consumers, and therefore underestimated the need for more regulation - obviously referring to the housing slump.

This assertion seems absurd.

It was the policy makers who didn't recognize rampant speculation in the housing market. While we joked about "liar loans" here on Calculated Risk, the policy makers were congratulating themselves on the "ownership society". I'd argue home buyers who used no money down option ARMs were making a rational choice: they were balancing the odds of a big payday with little financial risk - if the property continued to appreciate - with the stigma of a foreclosure on their record. Obviously many home buyers felt the stigma was worth the risk. I don't see that as a lack of economic education, rather a rational choice given the circumstances.

But I can't think of a good excuse for the inaction of the policy makers.

Shiller provides a possible explanation for the inaction of policy makers.