Terrorism Futures Market: Con

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

COMMENTARY/L.A. TIMES

Terrorism: There's No Futures in It
Administration has taken market fundamentalism to an absurd low.

By Joseph E. Stiglitz

Joseph E. Stiglitz, an economics professor at Columbia University, was
chairman of the Council of Economic Advisors under President Clinton. He
was awarded the Nobel Prize in economics in 2001.

July 31, 2003

The Bush administration's naive belief in free-market economics reached
a new level of absurdity this week with the proposal to create a futures
market in terrorism. The argument behind the proposal was simple:
Information is valuable, and information about a possible terrorist
attack is particularly valuable. 

One of the often-lauded virtues of futures markets is their ability to
bring together disparate economic information and add it up together (or
"aggregate it," as economists say). 

In a futures market, participants agree to trade, at a pre- negotiated
price, commodities that have not yet been produced. Buyers hope that on
the day of delivery the price they've paid will turn out to be low -
lower than the prices then prevailing on the market -- while sellers
hope just the opposite. 

Studies have shown that in some instances prices negotiated today on a
futures market can serve as a reasonably good predictor of what the
price will be on the day of delivery. Consider the futures market for
wheat in September. If today's price in that market is $3.39 per bushel,
then $3.39 is a good prediction of what the price for wheat will be.
Economists refer to this as the "price discovery" function and believe
such markets may not only predict the price of corn or wheat but also
election outcomes.

Almost 30 years ago, Sanford Grossman and I investigated theoretically
the validity of these claims. We focused on competitive markets in which
we assumed participants had some relevant information. For instance, a
farmer knows something about his own crop, so if he participates in a
futures market he will bring his knowledge to bear on that market.
Voters who participate in a futures market also bring relevant
information - whom they and their friends are voting for - and that is
why futures markets may predict presidential elections reasonably well. 

But there are severe limitations in the ability of markets to provide
accurate predictions; for instance, where markets have few participants
and can be easily manipulated, or where there are large asymmetries of
information, with some participants (the few large international
chocolate producers, for example, in the cocoa futures market) having
far more information than others.

Futures markets provide insurance as well as information: They enable a
farmer/trader to reduce the risks he faces resulting from the
fluctuations in commodity prices. But by providing "insurance" for
participants, futures markets can also create the long-noted "moral
hazard" problem - the notion that insurance can alter incentives.
Someone who has insured his house for 110% of its value has an incentive
to set it afire.

What, then, are we to make of the short-lived proposal by the Pentagon's
Defense Advanced Research Projects Agency for a terrorism futures
market? Did it reflect a brilliant breakthrough, an extension of market
processes into an area where markets, by themselves, feared to tread? Or
did it represent market fundamentalism descending to a new level of
absurdity?

Under the proposal, which the administration disowned almost as soon as
it became public, participants would have been betting, in effect - and
perhaps profiting - on such potential events as an attack by North Korea
or an assassination of Yasser Arafat.

Of course, no one expected DARPA's John M. Poindexter - notorious for
his eventually overturned conviction for lying to Congress about
Irangate - to approach the problem from the perspective of economic
theory. But what was he thinking? Did he believe there is widespread
information about terrorist activity not currently being either captured
or appropriately analyzed by the "experts" in the FBI and the CIA? Did
he believe that the 1,000 people "selected" for the new futures program
would have this information? If so, shouldn't these people be
investigated rather than rewarded? 

But there are more fundamental problems with the idea. If trading is
anonymous, then it could be subject to manipulation, particularly if the
market has few participants - providing a false sense of security or an
equally dangerous false sense of alarm. If trading is not anonymous,
then anyone with information about terrorism would be, understandably,
reluctant to trade on it. In that case, the market would not serve its
purpose. 

Now consider the second function of futures markets - insurance. The
Pentagon's proposal would have allowed those with the sophistication and
money to "hedge" against the threat of terrorism, financially at least,
leaving the rest of Americans fully exposed! Though we have come to
expect such inequities from the Bush administration's tax policies,
surely the U.S. government should be concerned with the exposure of all
Americans to terrorism. 

Notice that in proposing this idea, at least the Bushies are recognizing
the limitations of the innovative capacity of markets. If this is such a
good idea, why haven't the markets created it on their own? 

Interestingly, the group promoting the idea, DARPA, had - before Bush
took over - a credible record of promoting some important innovations,
including an important role in the early days of the Internet. 

In its own peculiar way, the administration has once again recognized
the limitations of markets - as it did with the airline bailouts, steel
tariffs and agriculture subsidies. But once again, the lack of
intellectual foundation or a firm grasp of economic principles - or the
pursuit of other agendas - has led to a proposal that almost seems a
mockery of itself.

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