1. Herds, Houses and the Crisis* Andrew Oswald *Many thanks to Danny Blanchflower and Amanda Goodall for valuable ideas.

2. "Men … think in herds; they go mad in herds, … they only recover their senses slowly, and one by one." C. Mackay

3. Extraordinary Popular Delusions and the Madness of Crowds, by Charles MacKay, published in 1841.

4. Far from the Madding Crowd, by Thomas Hardy, published in 1874.

5. Extraordinary Popular Delusions and the Madness of Crowds, by Charles MacKay, published in 1841. Far from the Madding Crowd, by Thomas Hardy, published in 1874. (in which a herd of sheep plunge to their doom from a cliff).

6. Herd behaviour is very often natural and individually rational. But it has the potential to be disastrous for the group.

8. On a technical note To economists and any mathematicians here:

9. On a technical note To economists and any mathematicians here: I have in mind a class of problem where utility depends on relative actions.

10. A general point about the mathematics of imitation

11. Caring about relative things is not sufficient to give us Keeping-up- with-the-Joneses.

12. Imagine a person is choosing an action a to solve: Maximize u(a) + v(a – a*) – c(a) where a* is what everyone else is doing.

13. Then if v is concave (convex) in status, it is rational to act similarly to (deviantly from) the herd.

14. The main point can be made without any mathematics.

15. Subconsciously, humans are frightened of falling behind:

16. Home buyers paid extraordinary prices in order to keep up. Bank lenders and brokers felt they had to match rivals. Money managers -- rewarded on relative performance against other managers -- copied what the others did.

17. When rewards depend on your relative position it will routinely be

18. When rewards depend on your relative position it will routinely be (i)dangerous to question whether the whole groups activity is flawed (ii) rational simply to compete hard within the rules that govern success.

19. When rewards depend on your relative position it will routinely be (i)dangerous to question whether the whole groups activity is flawed (ii) rational simply to compete hard within the rules that govern success. Before the dotcom crash, the analysts who got sacked were the ones who correctly said this bubble cannot last.

20. Hence the pressures for conformity are strong.

21. To students here These psychological forces are powerful and will come around again, a number of times, in your lifetime.

22. Now to house prices, which started our problems.

23. Real house prices in the United States over the century

24. Real house prices in the UK 1975-2006

25. So all the historical data suggested that house prices were unsustainable.

26. Yet -- even two or three years ago near the peak -- few people spoke up about the apparent likelihood of a crash.

27. Plus continuing propaganda: 13 December 2006 House prices will continue to rise over the next two years. Council of Mortgage Lenders

28. One of the simplest principles

29. In most systems, including economic ones, there is a tendency to go back to trend.

30. The tendency to trend-reversion

31. This has a good side to it. We will bounce back even if we have a few rather bad years after this one.

32. Excessive gloom can create herd behaviour and over- shooting in the negative direction

33. Excessive gloom can create herd behaviour and over- shooting in the negative direction (just as it did in the upward direction).

34. But we do need some lean years

35. Trying to sum up

36. 1. For economists, I believe we will have to integrate herd behaviour into our subject.

37. 2. For students, it may be helpful to you to remember that the madness of crowds will be back in your lifetime.

39. 3. For citizens, herd behaviour means more regulation is required. [because there are spillover externalities across people]

40. Points to take away We need to integrate herd behaviour into economics. The madness of crowds will be back. Herd behaviour means that some regulation is required.

41. Herds, Houses and the Crisis* Andrew Oswald *Many thanks to Danny Blanchflower and Amanda Goodall for valuable ideas.