I’m so glad that John Q. brought up the terrorism futures markets, because I’ve been dying to talk about them. The proposal to open a market in “terrorism futures” only lasted a day before it was retracted, and captured the imagination of many libertarians and libertarian-sympathizers. It was sharply criticized by Congressional Democrats, who felt that it was abhorent that the government would open a market that would allow terrorists to earn a monetary profit off of their terrorist actions. But there’s an answer to that:
“Why wouldn’t terrorists just hop online and start betting if they couldn’t either mislead American authorities about their plans or make money to fund more al Qaeda operations?” Wyden asked. Why not indeed? If terrorists were trying to use PAM to make money that “would mean that they are giving up information to gain money,” says Hanson. “In other words, we’re bribing them to tell us what they are going to do. That’s kind of like normal intelligence gathering when we bribe agents for information.”
I agree that the idea is fascinating, and it was probably retracted too soon. Nonetheless, I don’t see any way that it could work.
A) Betting parlors minimize transaction costs by only taking bets on unambiguous, discrete events. The ball is in the red or the black. The Chargers beat the spread or they don’t. The house isn’t going to engage your argument about why the black space is really just a very dark red.
Futures markets are so liquid and frictionless because they deal in standardized commodities. That is, if you want to buy a contract for a million shares of Microsoft in March, it makes no difference whether you’re buying it from one seller, ten sellers or a hundred sellers. The quality of the shares is identical. It isn’t necessary to speak to the sellers, or even know who they are. You know exactly what you’re buying and exactly what you’re selling.
I don’t see how the terrorism market can capture these efficiencies. Let’s say you have a contract that says “The Sears Tower will be the subject of a terrorist attack in February.” Would you get paid if:
– Someone throws a cherry bomb in a toilet.
– Someone throws a cherry bomb in a toilet. It creates a panic, and someone breaks their neck on the stairs as people flee.
– Spores from a biological attack on the Chicago Mercantile Exchange drift into the Sears Tower and infect some workers.
– John Smith comes to work and shoots his co-workers.
– Khalid Mohammed comes to work and shoots his co-workers.
– The FBI finds plans to shoot a missile at the Sears Tower and arrests the man holding the plans.
– The plans are later discovered to be a prank.
– A truck full of explosives is discovered in a parking lot downtown. The destination is unclear.
– An amateur pilot crashes a small plane into the Sears Tower, killing only himself. There’s no note, and it’s unclear whether it was an accident.
– The government of North Korea blows up the Sears Tower.
And so on. When the time comes to settle up, it’s easy to imagine events which would leave contract holders arguing about whether the outcome qualifies as terrorism or not. Some of the arguments will be more valid than others, but with a lot of money on the line, rational actors will often find the value in a legal challenge.
This is not necessarily an insurmountable problem. Participants can deal with this problem by writing more detailed contracts. But transaction costs in a market would be unreasonable if every participant in the market had to negotiate for every sale. The virtues of commodification would disappear. A buyer couldn’t effortlessly group ten standardized contracts to gain $1 million in protection; he or she would have to have lawyers read and negotiate each of the contracts.
In theory, people with assets that are possible targets of terrorist actions might enter into this market to hedge their risks. In practice, though, they can greatly reduce transaction costs by skipping the market and buying insurance.
B) I don’t see any way out of the “terrorists could profit off of their own terrorism” problem. It’s a big world, with hundreds of thousands of potential targets, and the odds of any one of them being hit are very small. An efficient market would greatly reward a small bet on an unlikely target. The bets could be small enough that they wouldn’t need to tip anyone off, and still pay off handsomely. (This assumes that there would be sufficient liquidity in the market to cover the contract on the (Blank) Tower in Capital City. If there isn’t, that’s another problem.)
C) Furthermore, it would provide an incentive for traders, who are not notorious for their incorruptability, to create their own luck. I could imagine the defense: “Was it irresponsible to phone in a phony bomb threat to the airport? I submit that it would have been irresponsible to our shareholders not to.”
D) Let’s say that I’m wrong, and the market gets off the ground. Imagine that a speculator strikes it rich on the terrorism market: he correctly bets on a few terrorist attacks before they happen and makes a small fortune.
Would you want to be that speculator? I wouldn’t. At best, he won’t be brought into a windowless room to explain his powers of prognostication. At worst, he’ll be dragged into the streets and hung from a lamppost.
E) The point of the proposal is not necessarily to make anyone rich. It’s to harness the power of the market to produce actionable information. This information would allow the Department of Homeland Security to thwart terrorist actions before they happen.
But if it was working as planned, wouldn’t it short-circuit itself? Imagine that the invisible hand pushed the price of contracts on the Brooklyn Bridge up, as the market correctly senses an oncoming attack. (How it would be sensed, I dunno.) If the DHS could use this information to foil the attack, then the people who are holding contracts predicting an attack don’t get paid.
Wouldn’t the market include this information in its calculation? If actionably high prices mean that the terrorist attack won’t happen, then the prices won’t rise to actionable levels. Which defeats the ostensible purpose of the proposal.
Tell me why I’m wrong.
{ 23 comments }
John S 12.19.03 at 6:57 pm
Well I’ve exhausted myself trying to argue for the use of futures markets in the post below by John Quiggin. I think they’re an interesting idea. Others obviously don’t. Well, why don’t we experiment? Not necessarily in terrorist futures, as that seems to give everyone the heebie geebies. Experimenting would let us see whether or not they are useful tools to improve information and policy-making. Why’s everyone so dogmatically opposed?
Jeremy Osner 12.19.03 at 7:05 pm
“Betting parlors minimize transaction costs by only taking bets on unambiguous, discrete events. The ball is in the red or the black… The house isn’t going to engage your argument about why the black space is really just a very dark red.”
This is a fine, fine statement that helped me see my way clear to a prolonged outbreak of laughter. Thanks!
Dan Goodman 12.19.03 at 7:07 pm
No, it lasted MUCH longer than a day. The press release saying that a report had been given to Congress was put up on May 20th 2003, as I recall. (The only press release of that date now at http://www.darpa.mil was edited in late October.
The Democratic Senators who “uncovered” this “secret” project
weren’t the wonderful sleuths they
claimed to be. The White House shock at being informed may not have been entirely truthful.
And the news media did a very poor
job of investigating the story.
Decnavda 12.19.03 at 7:16 pm
Ted –
with regard to A, check out the Foresight Exchange claim on this page as an example:
http://www.ideosphere.com/fx-bin/Claim?claim=USTerr
Decnavda 12.19.03 at 7:21 pm
As for B & C there are already incentives for corporations to break laws and ways for terrorists to profit from their terroism on the stock market. That’s why we have police, and I do think a futures market would make this worse.
Ted Barlow 12.19.03 at 7:28 pm
John,
I don’t think that I’m dogmatically opposed. I think that it’s a creative and innovative idea. I just don’t think that it would work, for reasons that I’ve laid out.
Decnavda,
That link seems reasonably taut, although there would be some wiggle room if some of the newspapers called it terrorism, some didn’t, and the President never said “This was a terrorist attack.”
But it doesn’t provide much by way of useful information. If the price of this spiked, what could law enforcement do about it?
Decnavda 12.19.03 at 7:29 pm
As to D, if he obviously had nothing to do with the attacks, the speculator would probably, and rightly, be hired to help prevent attacks.
E is a more interesting one I do not have a specific answer for. But even if this happened, I do not see it as disqualifying, since the dynamic could only take place if the system worked.
Decnavda 12.19.03 at 7:31 pm
“But it doesn’t provide much by way of useful information. If the price of this spiked, what could law enforcement do about it?”
Presumeably we could take security concerns in general a lot more seriously than we were before 9/11.
James Surowiecki 12.19.03 at 7:45 pm
I posted in the previous thread, but it seems relevant to Ted’s questions, so forgive the repetition:
The vast majority of the contracts that would have been offered on PAM. They had to do with changes in civil, military, and economic conditions in the Middle East. This was the point of PAM’s partnership with the Economist’s Intelligence Unit. Indices of civil stability, military preparedness, and economic health would have been constructed, and the contracts would have been pegged, effectively, to changes in the indices. These are not contracts that could have been gamed by traders or used by terrorists to make money or that would demand a visit from the FBI.
There would have been some contracts offered in discrete events — like, say, a coup, I gather — but they would have been more the exception than the rule. And again, I think most of them would not have been things that were obviously preventable or gamable, but that would nonetheless be very useful for the U.S. government to know about. At the same time, it’s probably true that a contract in something like “will a major terrorist attack occur on U.S. soil in the next two years” would have been offered. I don’t think the real problem to this one is B or D. There would be no contracts offered in anything as specific as “the TK building will be hit,” so there would be no chance to place small, long-shot bets and clean up. As for D, anonymity was, at least in theory, guaranteed. And if the market was useful, I’m not sure why it would be in the CIA’s interest to wreck it. I don’t really understand C, but if you mean that a speculator could manipulate the market by sending false signals, it’s of course a possibility but I doubt a profitable one.
A) I don’t think was a problem, because PAM was going to be “the house,” effectively. It was going to take any trade, and I think it was going to construct standardized contracts which presumably would have defined what was meant by a “terrorist attack” or whatever
The one real concern, I think, is E, though it applies, as I said, only to the discrete-event contracts. But I assume, as Ted suggests, that the market would price the possibility of an attack being foiled into its calculations. This wouldn’t defeat the purpose of the market because the intelligence agencies would be looking not just at the absolute level of prices but also, and perhaps more important, changes in price.
James Surowiecki 12.19.03 at 7:46 pm
Sorry, the first sentence of that post is nonsensical. It should read: “The vast majority of the contracts that would have been offered on PAM had nothing to do with predicting specific terrorist attacks.”
Jonathan 12.19.03 at 7:59 pm
The whole idea seems to be based on a basically religious belief in “The Marketplace” as a source of Truth. It seems to me that the originators of this didn’t see the information content as coming from real terrorists (since as Ted makes clear it would be very easy for fakes and frauds to dominate), but as coming from the marketplace–from the millions of decisions of millions of investors who, legend has it, always do the right thing in the aggragate. There is no more real evidence for that assumption than for the existence of God. It is simply one of the pseudo-religious beliefs of the neo-cons.
James Surowiecki 12.19.03 at 8:23 pm
I disagree that this has much to do with the “marketplace” per se. I think it has to do with a faith that the collective judgment of a large group of motivated, diverse, relatively independent individuals is more likely to be correct than the judgment of a single expert or a small number of experts, no matter how well-informed. And I think the key is that it’s “more likely” to be correct rather than “always” right. (No economist would seriously argue the market is always right.) The real evidence for that proposition is overwhelming.
Futures markets happen to be good ways of determining a collective judgment, because they provide incentives for people to uncover information, because the price of a futures contract is the weighted average judgment of all investors in the market, and because prices, if the contracts are written right, become direct representations of probabilities.But at its core (and I realize this is a somewhat heretical proposition) the logic behind PAM is roughly analogous to, for example, the logic behind Google.
decnavda 12.19.03 at 9:12 pm
jonathan-
This “belief in markets = religion” smear from anti-market people has as much validity as the “belief in science = religion” smear that theists sometimes hurl at atheists.
First, there are theoretical reasons, laid out above by james, as to why markets are efficient amalgamers of information.
Second, belief in markets produces testable hypothoses. The Iwoa Electronics Market is one such test, and much of what we are doing here is debating the evidence that and other tests have provided.
Tell me the theory is wrong, and why. Explain to me how I am misreading the evidence. Do not smear me as “religious”, or worse, “neocon”.
carlos 12.19.03 at 9:47 pm
Having some former “terrorists” in my family (Uruguay, South America, 1968-1973) and knowing their organization and methods, I frankly found this idea ridiculous.
The key of fighting “terrorist” organizations is good intelligence, secret information from an extremely small number of persons. ¿Can someone explain why markets can be more efficient in doing this than intelligence agencies? Unless you have a source inside, all the guesses in the world are useless. Besides, the terrorists themselves could play this game in reverse (attack or abstain contradicting market trends to provoke confusion).
Decnavda 12.19.03 at 10:50 pm
Carlos-
The markets would not produce new information, and all the methods you describe would still be needed. Rather, the markets would provide an honest amalgamation of the opinions of those with the access to the information you describe.
The idea that the terrorists might invest losing money against their plans to throw people off the track is interesting, but it contradicts fears that they might try to use the markets to profit from their terrorism. These ideas are competing, but do not cancell each other out, and the best way to test them is to run an experimental market.
Carlos 12.20.03 at 3:47 am
Decnavda: My point is that markets are very good at producing new information (the prices of goods and services for example), especially when there is a lot of information to deal with and especially when participants in the market are influencing the probability of events (same example). When the markets work as pure analyists(sports gambling for example) my guess is that markets do much worse. I agree with the testing part, (science only progresses this way) but frankly I think that a futures market on serial killers would have a better chance.
self 12.20.03 at 5:58 am
joseph stiglitz, from http://www.commondreams.org/views03/0731-08.htm
“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.”
John S 12.20.03 at 9:41 am
“If this is such a good idea, why haven’t the markets created it on their own?”
Because gambling is highly regulated and creating such markets is often illegal even in the USA, never mind Europe.
Stiglitz’s point about the risk of market manipulation when there are few participants is true of all markets. That’s not a killer blow.
rapier 12.21.03 at 11:42 am
I didn’t look into the details of how this was supposed to work but in general anything traded by futures contract has to be fungible, meaning any unit has to be the same kind and quality. Corn is traded weight (54 pounds is a bushel), by grade, USDA #2, which specifies moisture content, weight per volume (density), amount of broken kernels and other quality aspects.
So in this market a car bomb blowing up a newstand would be the same as bringing down the WTC? Maybe this was addressed in the plan but I don’t see how it would work.
The other nature of futures is that there are two kinds of participants. Commercial hedgers who take a position opposite one they have in the ‘cash’ market so as to lock in a price, and speculators. Hedging accounts for much of the open interest in futures contracts and acts as insurance for the commercials. A market in terrorism would be too small and inexact (see above) to provide any meaningful insurance so the market would be left to speculators. Without a practical use and therefore being simply a speculative tool a terror futures market becomes wrong on every level.
James Surowiecki 12.21.03 at 6:19 pm
There is no theoretical or empirical support for the idea that you need “commercial hedgers” in a market in order for that market to be efficient. There are no hedgers in the market for horse-racing results, yet that market is remarkably good at predicting the outcome of horse races. Again, there are no hedgers in the IEM and it’s good at predicting the outcome of elections.
Also, just as a side note: why not just look into the details of how PAM would have worked (some of the details were actually discussed in earlier posts on this thread and the previous one) before offering a critique of it?
Pierre Menard 12.23.03 at 7:09 pm
To Johnathan, who in the above post claimed that the whole idea is based on an irrational religious belief in markets:
There is some convincing evidence that U.S. stock markets are fairly efficient, i.e. that the price of a stock at any given time is a not-too-bad reflection of its true value.
For example, mutual funds fail spectacularly to beat the stock market in the long run. Mutual funds on average underperform the S&P 500, and there is in general no correlation between funds that outperform it over one period and funds that overperform it over the next.
Obviously, the stock market is not perfectly efficient — it tends to crash once in a while and fluctuates a bit too much. Most economists do not believe the strong form of market efficiency — but no one can deny that the failure of money managers to beat the market indicates that market is reasonably efficient. In other words, collectively human beings seem to be able to determine the true price of stocks a lot better than individually.
Which is why it might be a good idea to create a terrorism futures market: it could asses the risk of terror attacks better than any number of goverment analysts.
pierre menard 12.23.03 at 7:11 pm
About terrorists making money off the futures market: why not limit the participants to, say, all the publicly traded companies on US stock exchanges?
This way terrorists won’t be able to make bets. However, the market would have to be well-regulated to prevent collusion among the players (as there are only about 10,000 publicly traded companies)
pierre menard 12.23.03 at 7:19 pm
Ted,
About E: it is not necessarily a weakness. Lets say the price goes up as the market correctly senses an attack; the goverment makes some strong security increases.
If these increases are insufficient — if the goverment is not doing enough — the price of the contracts will remain high.
On the other hand, if the price drops the goverment can conclude that the security measures undertaken werent too bad.
Yes, the price at any point will reflect future goverment actions. Its a good thing — a large spike in the price means that the market things the goverment is woefully unprepared and even if it takes some security measures as a result of this spike, an attack remains imminent.
The point is that this gives the government some feedback — some ideas about how well its policies are faring. Its not getting that feedback now as the administration sees reflexive support from Republicans and reflexive criticism from Democrats.
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