Terrorism Futures Market: Pro

["Devine, James" <jdevine@xxxxxxx>]

July 31, 2003/New York TIMES
A Good Idea With Bad Press
By HAL R. VARIAN

THE Pentagon-sponsored futures market in terrorism indicators was
announced and squashed in all of two days. Too bad. It was a good idea,
killed by terrible public relations.

Consider the problem that intelligence agencies face. They have to
consider the likelihood of various destabilizing events - like
assassinations or terrorist attacks. That's a major part of their job;
there's no way around it.

In assessing such likelihoods they draw on expert opinion, but they also
make considerable use of market data - oil price futures, currency
exchange rates and the like - to see how market traders assess risks of
political instability.

Markets do an awfully good job of forecasting many events and trends.
The futures price for oil is about the best predictor available for this
critical commodity, and it is widely used for forecasting by both
political and economic analysts.

The question is whether speculative markets would work well for other
policy-relevant events.

There is lots of evidence that they do. The Iowa Electronic Markets,
www.biz.uiowa .edu/iem/, has been predicting election results for 12
years using a system very much like the one that the Defense Advanced
Research Projects Agency at the Pentagon proposed.

One of the markets the Iowa exchange offered was in vote shares: what
fraction of the vote went to the Democratic or Republican candidate. It
is particularly easy to assess the outcome of such a market and to
compare it with alternative forecasts, like public opinion polls.

As it turns out, these political stock markets provided somewhat better
forecasts than polls right before the election - and they provide much
better (and less volatile) forecasts several months before the
elections. Thus, markets do best exactly where the public opinion polls
and expert opinion polls are weakest.

This is not an isolated example. Similar markets have been organized to
predict shifts in Federal Reserve monetary policy, the outcome of
political conventions and sales of consumer products. The results are
that markets typically perform at least as well, and generally better,
than feasible alternatives, and they are much cheaper to organize.

An online betting site based in Ireland, tradesports.com, is currently
offering markets in "Kobe Bryant to be found guilty," "Next Supreme
Court justice to leave bench," and "Gray Davis to be California governor
on Dec. 31, 2003." Those concerned about the outcome of these events
might be well advised to take a look at the odds, which reflect bettors'
sentiments.

There is good reason to believe that a market set up to forecast the
sort of political instability that leads to terrorism might work well,
too. At least, there is enough reason to warrant an experiment, given
the high payoff to having better forecasts of these events.

This is why the Pentagon thought it was important to finance research in
this area.

The objections raised by politicians and opinion writers were generally
based on misunderstandings of what was actually proposed.

Take the claim that terrorists could speculate in their own future
activities and reap a windfall. First, the maximum gain from a trade was
restricted to less than $100. This would not be of much help to
terrorists' fund-raising activities.

Second, the market would have been monitored for evidence of insider
trading. If someone managed to circumvent the trading limits and made a
significant amount of money speculating on a terrorist attack, you could
be sure the C.I.A. would be right behind the I.R.S. in investigating.

If the federal authorities were alert enough to find enough evidence to
indict Martha Stewart, why would one think that Osama bin Laden would be
able to avoid detection?

There were also objections that the auctions were immoral.

Senator Byron L. Dorgan, a Democrat of North Dakota, asked what would
happen if another country set up a betting parlor where people wagered
on the assassination of an American political figure.

I'm sure he is right that there would be public outrage. But let's turn
the question around: If such a market were put in place, should the
Secret Service monitor it? If there were an assassination attempt,
should the authorities look for suspicious prior trading activity? And
the most important question of all: If the market indicated that the
probability of an assassination attempt went up, should the target take
extra care? If you were a potential target, wouldn't you want the best
possible forecasts of possible attempts on your life? I would.

I would also prefer that such forecasts not be quite so public. A
private market in the probability of specific assassination attempts -
say within an expert community like the C.I.A. - could make sense,
assuming, of course, that it provided useful information.

Would Mr. Dorgan object to such an internal market as a way of
aggregating expert opinion? I hope not.

In any event, assassination futures were not among the planned
securities, contrary to most press reports. The market design allowed
traders to propose securities in various events, and the Policy Analysis
Market Web site speculated that some traders might propose to add
securities in assassinations. That off-the-cuff speculative remark had
fatal consequences, alas.

The securities that were an essential part of the auction design were
indexes of political, economic and military activity. The most useful
such market would probably have been a market for futures in a
"political instability index," a weighted average of various political
indicators, like the number of mass demonstrations, unemployment levels,
arrests - and, yes, assassination attempts. (Type "political instability
index" into Google for some examples.)

If the markets had been pitched in this way, I doubt that there would
have been many objections raised.

But instead politicians, reporters and editorial writers mistakenly
jumped onto "assassination and terrorist attack futures" as a
fundamental part of the market design.

Given the public outcry, it seems clear that there will not be a public
market in assassination futures anytime soon. But there is no reason not
to have a futures market in political, social and economic indicators,
which is what the Pentagon's project was actually about.

We desperately need better ways to forecast political instability, and
the Policy Analysis Market had significant promise. It's sad to see poor
public relations torpedo a potentially important tool for intelligence
analysis.

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Jim Devine jdevine@xxxxxxx &  http://bellarmine.lmu.edu/~jdevine