A different look at information cascades. System cascades are often viewed as one way that complex systems get put down. Small problems in one node, tumble the next node, until a wave of collapse brings down the central core, and with it the entire periphery. It is the fear of this cascading effect that is the primary stated reason why our government hands lots of money to failing large banks. But there is another cascading mechanism that can work toward instability: somewhat in reverse. What happens when a cascade of ideas and opinions stops?
The power and the terror of Irrational Expectations
Noah Smith, Noahpinion, 29 January 2013 (hat tip: NC)
But to me, that's not even the most disturbing implication of Malmendier's finding, and of this type of expectations model in general. In most theories of non-rational expectations, like Bayesian learning or rational inattention, expectations evolve in a smooth, stable way. And so these models, as Chris Sims writes, look reassuringly like rational-expectations models. But there is no guarantee that real-world expectations must behave according to a stable, tractable model. I see no a priori reason to reject the possibility that expectations react in highly unstable, nonlinear ways. Like tectonic plates that build up pressure and then slip suddenly and unpredictably, expectations may be subject to some kind of "cascades". This can happen in some simple examples, like in the theory of "information cascades" [pdf] (In that theory, people are actually rational, but incomplete markets prevent their information from reaching the market, and beliefs can shift abruptly as a result). In the real world, with its tangle of incomplete markets, bounded rationality, and structural change, expectations may be subject to all kinds of instabilities.
In other words, to use Lucas' turn of phrase, expectations might just make themselves up...and we might get any result that we don't want.
In both of the links, the idea at work, inattention/information cascades theory, works on the idea that people simply don't have time to work out every possible decision for themselves. To a varying degree, mostly a very large one, we tend to follow along with the group because enough members of the group have made a decision to go in a certain direction, and we have not received any, or enough negative feedback to change our minds. We go to work following along with the rest of the vehicles until we hear a traffic report on the radio, or until we hit an impasse.
Sushil Bikhchandani, David Hirshleifer, Ivo Welch; Journal of Political Economy, Vol. 100, No. 5 (Oct., 1992), pp. 992-1026
This paper offers an explanation not only of why people conform but also of why convergence of behavior can be idiosyncratic and fragile. In our model, individuals rapidly converge on one action on the basis of some but very little information. If even a little new information arrives, suggesting that a different course of action is optimal, or if people even suspect that underlying circumstances have changed (whether or not they really have), the social equilibrium may radically shift. Our model, which is based on what we call "informational cascades," explains not only conformity but also rapid and short-lived fluctuations such as fads, fashions, booms, and crashes. In the theories of conformity discussed earlier, small shocks lead to big shifts in mass behavior only if people happen to be very close to the borderline between alternatives. Informational cascades explain why society, on the basis of little information, will systematically tend to land close to the borderline, causing fragilityFragility. Hmmm...