Financial Illusions?

This post follows on from my previous ones on behavioural economics and neuroeconomics.  I have always been fascinated by optical illusions - you can find Shepard's two tables (see figure below) and other famous examples here.

 


two tables
© 1990 Roger N. Shepard



The question, of course, is whether we can be fooled / duped whenever it comes to making economic decisions.  Are there such things as financial illusions?  With regards to the recent housing bubble, were those who bought in the boom years duped by a financial illusion?  Did they really believe that houses would keep appreciating? Why did they pay such a high price for their house whenever the long-run link between house prices, income, and rental yields suggested that house were overpriced?

One possible alternative to the financial-illusion hypothesis is that they were purchasing houses with borrowed money and therefore didn't care.  In the US, for example, mortgagees can walk away from their houses and are not liable to repay their mortgages, unlike in the UK.  If they were required to make a low or no down-payment, then they will not care about what they pay for their house - in essence, they are gambling with other people's money.

Another possible alternative to the financial-illusion hypothesis is that there was a massive government-supported con which was used to redistribute income from the squeezed middle classes (whose main asset is their house) towards the financial and political elite. 

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