Politicians vs. Information

Martin Devon comments thoughtfully about an innovative approach to evaluating geopolitical risk. He also quotes a couple of idiot pols who are agin’ it.

If you can create a real-money market in risk evaluation, it’s usually a good idea to do so, if only for price-discovery (in this case, risk discovery) purposes. People in the aggregate, voting with their own money, generally make better bets than do individuals who are merely writing position papers. And creating a market in risk assessment facilitates the pooling and hedging of risk. Of course these are the same principles that underlie insurance markets, which may be why some pols don’t like them. Imagine: individuals and businesses dealing with risk on their own, without needing politicians to “help” them. Too bad there’s no organized market for hedging away Congressional risk.

UPDATE: From Instapundit’s post on this topic and the comments here, there seem to be several objections to this idea. I paraphrase some objections (italics), below, and then respond. (Feel free to leave additional comments if I left anything out.)

Moral hazard: terrorists or other bad guys might cash in by betting in advance of their own terror attacks, or by committing terror attacks solely to make money. There is also incentive for govt officials, journalists, et al to manipulate the market by hyping nonexistent risk and then taking the other side of trades made by people who are betting on an attack.

There may be reason for concern, but it’s already possible to bet on terrorism: all you have to do is buy a large quantity of stock-index puts. And trades of this type, especially in a market dedicated to terrorism risk, would serve a valuable function by telling the world that something was up (in much the same way as an out-of-nowhere jump in the price of a stock may suggest that a takeover bid is imminent). The more narrowly tailored the market was — e.g., an assassination market for a particular leader — the more useful the information so transmitted would be. I think the benefit would probably outweigh the moral hazard, though I may be wrong.

With respect to people falsely hyping nonexistent terror attacks, markets are effective at discriminating this kind of false alarm. The first time it happened the market would probably move significantly, but after one episode of crying wolf the same tactic might not work again. It might also be possible to create legal penalties for false alarms. Such penalties wouldn’t deter everyone, but would at least impose a high expected cost on anyone who had something to lose, e.g., government officials and journalists, who are also the kinds of people most likely to be able to move the market by hyping terrorism concerns.

Innocent people might avoid participating in the market because there is a hypothetical risk that they would be arrested for knowing too much if they profited from terrorism predictions.

I don’t know. Whether this is an issue probably depends on how many people use this market and how much sense the government has. And it’s only a problem if they arrest innocent people. If they arrest guilty people it’s a benefit.

Information about pending terrorism is by nature private, and therefore public markets such as the envisioned terrorism-futures market would not be useful to predict attacks. As Glenn Reynolds put it:

An InstaPundit reader who is too smart to be in Congress emails with a more meaningful criticism: the futures market won’t identify “unknown unknowns,” since the betting — as with ordinary futures markets — must take place within the context of standard “products.”

It’s true that a public market would not discount private information, a.k.a. “unknown unknowns.” That’s generally true of markets. However, markets have a good record of making predictions based on publicly available information. The mistake is to compare a futures market to a crystal ball. The real comparison should be between the futures market and “expert” analysts who have no accountability for their biases. Markets look good by this standard, and the government could still do its own private research, much as financial firms do proprietary research in stock and futures markets, to supplement what it learned from public terrorism-risk markets.

Also, private information may become public if there’s money to be made. That’s a big advantage of markets in this case, as publicizing incipient terror attacks brings better countermeasures or the possibility that the terrorists will call off their attack.

It’s wrong to bet on misfortune and people’s deaths.

If this assertion is true, insurance is immoral, as are futures markets in agricultural commodities (betting on crop failures!) and stock indices (betting on, um, misfortune and people’s deaths). These markets are insurance by another name and are just as useful.

The reinsurance industry already does what terrorism futures are supposed to do.

This is partly true, though the reinsurance market operates largely out of the public eye and therefore may not transmit information as well as a futures market would. But if it’s really true that a futures market is unnecessary, then a futures market won’t succeed. It’s impossible to know for sure without trying.

If we’re lucky, someone overseas, like Tradesports, will start offering systematic opportunities to bet on terror-attack odds. Unfortunately, DARPA’s idea has unleashed so much demagoguery by American pols that it may be some time before anyone will be willing to set up such a futures market, even outside of the U.S. Pity.

Virginia Postrel has additional relevant links here.

20 thoughts on “Politicians vs. Information”

  1. This would give terrorists a way to be huge premium sellers in the market, abstain from any new terrorist attacks, and rake it in as vol collapses. That assuming too much intelligence on their part, I know.

    Congressional risk market vol would be a little high, don’t you think?

  2. Terrorists couldn’t safely sell premium because they couldn’t know if other terrorists were planning attacks.

  3. Now that the project has been killed at the federal level, isn’t this the kind of project that lends itself to creation by a university or an entrepeneur ?

  4. It has been already done, in a sense. Tradesports currently lists some world events/politics contracts. If the demand were there, I think they would list it. The biggest problem I see with this idea is defining the contract terms. What qualifies as a terrorist event? How widespread? Or are the contracts on very specific, single acts?

  5. Andy, the point is that terrorists couldn’t manipulate the market unless they could monopolize the supply of terrorism, which seems unlikely.

    Fingerowner, that’s a good question.

  6. Just because the supply cannot be monopolized does not mean that there is not a compelling premium selling opportunity, ask Fossett about that. I am not arguing against this idea, I think it could work on several intelligence levels, which helps explain why Wyden, Dorgan, and Daschle do not get it.

  7. Don’t we have this – or at least a disaster futures market – in the re-insurance trade? Or do we have the moral hazard problem of governments guaranteeing the damage?

  8. LB you are 100% correct — which is why we should shut them all down and round up those Al Qaeda operatives at Chubb and Swiss Re.

    Boy, when dimbulb Congressfolk impugn DARPA’s smarts, something aint right…

  9. They certainly caved quickly. It appears that they, being reasonable people, were blindsided by the Democrats’ demagoguery. What a shame that they didn’t attempt a principled defense.

  10. Yeah, well, this shows you why the Gov’t should stay out of things like assessing and assigning risk. This should be done privately. There is no reason why it could not be.

  11. Lex,

    A couple of points:

    First, DARPA is a research outfit. This seems like a legitimate research topic for them even if you believe that this sort of thing is better implemented in the private sector.

    Second, there IS a reason why this can’t (currently) be implemented in the private sector. It’s illegal everywhere in the US, and probably in much of the rest of the world. See Robin Hanson’s Idea Futures page for more about the concept (including the legal issues) and lots of good links.


  12. Actually, assessing risk and doing cost-benefits analysis are two things the government ought to be involved in. Assuming that government’s only valid purpose is to defend the country from foreign attack, wouldn’t risk assessment be part of the task? I mean, Mali probably poses less of a threat to the U.S. than China; defense policy should reflect that.

    As for the terrorists trying to make a killing, being too dumb or too smart…

    First of all, the market depends on aggregation of prices. A futures market based on middle eastern events, with 10,000 investors minimum, would encompass a lot of folks with information advantages. Brokerages employing ex-Saudi intel and security members as consultants, former Israeli Mossad operatives or Likud members as analysts, and so forth. Maybe it wouldn’t be inside information, but these brokerages would act out of very enlightened self interest. Not everybody would move in the right direction — but in the aggregate, the market would get the price right a lot of the time.

    Aggregated futures contracts prices, predicated on the emergence of a Palestinian state, the breakup of OPEC, whatever, could be useful predictors of major action.

    In the alternative, if terrorists did invest in this futures market (to “make a killing”) the money trail would quickly out them. Don’t forget, most people go along with the market to get along, and rely on slow accretion of value to make a profit. Those making a killing almost invariably act counterintuitively – ask those who sold when MCI was at $100, and expected to go to $200 about counterintuition. As usual, the SEC (or other government elements) would be on the case of anyone who made a big counterintuitive move just prior to a major market shakeup. That’s how a lot of insider trading investigations get started…

    Finally, state sponsored terror is big business. Anybody remember the suspicion about the big European investment houses divesting a lot of American reinsurance company stock just prior to 9/11? Ever wonder why we haven’t heard back that it was all innocent? Somebody knew, or got wind of the attacks by watching Yassir Arafat’s or the Bin Laden family’s portfolio.

    Either that, or the market itself predicted the attack.

  13. OK you guys are right. I surrender.

    I was not so much making an argument as putting a smiley face sticker on my disappointment that this very interesting and potentially valuable project was annihilated so quickly and thoughtlessly.

  14. Bill, I am one of the people who made a windfall off 9/11. There were just so many short opportunities in the weeks leading to it, I was net short. Including Marriott and other travel related shares. This is a factor that is often overlooked; would the market have cratered like it did for a week had it already been bottoming ? Nope. Lots of people were short and make a “killing”. Including big institutional players who had no means of knowing anymore than you and I.

    I never imagined I’d feel bad about making money. And I never bothered to figure out if those bad feelings were justified or rational. (They probably weren’t). I gave it all to the FDNY and NYPD charity funds and moved on. Sounds dumb today in many ways (why should I feel bad, and why would a couple of checks fix it…) but those were weird emotional times, as you know.

    All things being equal, the simpler explanation is the most likely in most cases. Several market sectors were due for a pullback and many market participants had set themselves up accordingly. When it finally happened, hugely amplified and accelerated by the events, large net short positions became immediately suspicious, if not instantly assumed guilty until proven innocent depending on the nature or location of the firm.

  15. I’m not saying it’s a perfect predictive device, or a perfect detection device. I’m just saying that the market in the aggregate often has better information on a specific issue than the dozen or 20 CIA analysts assigned to think about it.

    And not all short selling is innocent. Yassir Arafat has a couple billion in assets – I’m guessing that money isn’t stashed under his bed. Bin Laden is supposedly worth between $50 million and $150 million – I’m guessing it isn’t stashed in the rock he uses for a pillow. International terrorism is big business, and what better way to launder money and to help fund it than to keep a bunch of cash “offshore” from Iran or Saudi, in a stock market.

    The idea of markets as predictors is at least worth exploring.

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