The Housing Bubble - an information cascade.

New York Times: How a Bubble Stayed Under the Radar

From the article:
"Suppose houses are really of low investment value, but the first person to make a decision reaches the wrong conclusion (which happens, as we have assumed, 40 percent of the time). The first person, A, pays a high price for a home, thus signaling to others that houses are a good investment.

The second person, B, has no problem if his own data seem to confirm the information provided by A’s willingness to pay a high price. But B faces a quandary if his own information seems to contradict A’s judgment. In that case, B would conclude that he has no worthwhile information, and so he must make an arbitrary decision — say, by flipping a coin to decide whether to buy a house.

The result is that even if houses are of low investment value, we may now have two people who make purchasing decisions that reveal their conclusion that houses are a good investment."

The article talks about this as being an example of "rational herding," with incorrect assumptions resulting 37% of the time.

I think what's most interesting is that in social psychology, the social nature of humans is emphasized time after time. We look to others for information because we often believe that the group/others know more than we can know by ourselves. This is an adaptive trait that has helped us reach the state that we are in today, but it is clear that sometimes this fails, leaving us with what ultimately was a poor decision.

http://online.wsj.com/article/SB122298982558700341.html

In a significant way, the government started this information cascade:

"Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target -- 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005."

Government policy encouraged "Person A" and "Person B" to invest, which lead to a huge increase in demand for housing and an increase in housing prices.

"Greedy investors obviously played a part, but investors have always been greedy, and some inevitably overreach and destroy themselves. Why did they take so many down with them this time? Part of the answer is a political class greedy to push home-ownership rates to historic highs -- from 64% in 1994 to 69% in 2004. This was mostly the result of loans to low-income, higher-risk borrowers. Both Bill Clinton and George W. Bush, abetted by Congress, trumpeted that rise as it occurred."

It wasn't a few independent speculators who started the information cascade, but average people acting as a direct result of government policy.