Robert Schiller, an economist at Yale, explains why the experts missed the housing bubble. “Were all these people stupid?” he asks. “It can’t be. We have to consider the possibility that perfectly rational people can get caught up in a bubble. In this connection, it is helpful to refer to an important bit of economic theory about herd behavior.” He points to this paper (PDF) on information cascades, which explains why people follow fads. Assume that three people (A, B and C) want to bid on a house and no one has perfect information on prices (no one ever does). Let’s say A decides to bid 20% over the list price for the house. Even if B believes that is a high price, he doesn’t know A is wrong. Instead, the fact that A paid more can influence B into thinking that his hunch is wrong, and maybe A was right. Let’s say B decides to bid 25% for the house. Now C, who also thinks this is a high price, sees that both A and B believe the house is worth much more. That’s a much stronger influence on C to believe his original estimate is wrong and follow the herd. So a few bad decisions can snowball and influence the herd, thus creating a housing bubble. Even the “experts” fall for this. The paper generalizes the idea and puts a little mathematical rigor on it, but the idea is that when we aren’t sure about something, we can easily be influenced by other people’s decisions. That’s also why we had the Internet bubble.