Paulson and Bernanke May Have Reversed the Information Cascade

Did Treasury Secretary Henry Paulson and Federal Reserve chair Ben Bernanke propose their bail-out plan because they got caught up in mob mentality? Or were they keeping their heads about them?

Market bubbles and panics are both kinds of information cascades, which is what happens when we eat in a crowded restaurant because it is crowded, as it was elegantly put by James Surowiecki in "The Wisdom of Crowds."

Behavioral economists have shown that information cascades can be reversed, sometimes quite simply. Once the bad information that set it off has been corrected, things tend to calm down.

It is clear that in the real world, information cascades are not so easy to reverse. Many have looked at the quickly assembled bailout plan and derided it as an act of two people caught up in the throes of saving their friends. Indeed, we've watched both men get pounded for taking care of Wall Street, not Main Street, despite repeatedly explaining how it is saving Main Street.

What they have done is gained the attention of the financial markets, which have been relatively calm since the bailout was announced. The crisis has continued because there's no good information about just how many bad loans are on the book, and who is exposed to them. There was, in short, no way to reverse the information cascade. There still isn't good information, but there is a number ($700 billion), and a promise of action. It was a shocking move, and seems to have dammed up the information cascade that was threatening to drown the financial system. If that dam holds, tuck away the idea of a bold action when you're faced with an information cascade of your own.