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The Furor Over 'Terrorism Futures'

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By Justin
Wolfers and Eric Zitzewitz
Thursday, July
31, 2003; Page A19

Betting on human lives seems ethically questionable. Yet if it helps
save lives, surely the moral questions are mitigated. Not so, according to
those in Congress (and elsewhere) who created such a furor this week over
a planned Pentagon program to project geopolitical risks that the program
was quickly shut down. The plan was to use markets to "price" such risks,
and it was quickly dubbed a "terrorism futures market." Unfortunately, in
hastily ending this program, the government may be closing the door on an
important source of information and a promising avenue for research.

The idea was simple: By creating a market in which people can buy and
sell contracts that pay $100 if certain political events occur in the
Middle East, we can infer from the price of such securities the
probability of these outcomes. By explicitly pricing such risks, we can
better understand them and better respond to them.

Financial markets are incredibly powerful aggregators of information,
and are often better predictors than traditional methods. The examples are
numerous. The futures market in orange juice concentrate is a better
predictor of Florida weather than the National Weather Service. The Iowa
Electronic Markets outperform the opinion polls in predicting presidential
election vote shares. Hewlett Packard ran a market forecasting printer
sales that outpredicted any of its analysts. The Defense Department should
be applauded for admitting to its own limitations. Last winter we studied
a market in "Saddam Securities" that proved to be a good predictor of the
probability of war in Iraq.

The reason markets work so well is that they reflect our collective
wisdom. And your opinion will be reflected only to the extent that you are
willing to put your money where your mouth is.

While the joke about military intelligence being an oxymoron is an old
one, it bears repeating here. It's no coincidence that we don't have the
same doubts about financial markets. Recent events have underscored the
difficulty of aggregating information from lower levels of the
intelligence bureaucracy. Imagine if a "Niger Uranium sale" contract had
been trading in January; our guess is that this would have been close to
valueless, reflecting the hard intelligence available at the time that
such sales never occurred.

Political critics contend that betting on political disruptions not
only is distasteful to many but that it also provides an incentive to
create political strife, because an assassin might be able to bet that
political strife is likely and then go out and cause the strife himself.

But those opportunities and incentives to make trouble already exist.
The stock market fell 2.8 percent following President Kennedy's
assassination; it fell 4.9 percent following the attacks on the World
Trade Center; and the oil markets gyrate wildly with each assassination
attempt in the Middle East.

Terrorists determined to profit from their actions can easily buy
derivatives to cash in on their actions. Of course they will leave behind
a paper trail. But more to the point, all that these prediction markets
will do is make the information content of such trading more transparent
for policymakers.

A more serious concern raised is that terrorist organizations might
trade in the market to create disinformation. But terrorist organizations
already have lots of channels for disinformation, and the profit motive in
these markets provides incentives for those who know the truth to correct
such disinformation. The one thing that economists actually agree on, is
that people do respond to such incentives.

Legislatures are not the best institutions for directing research,
economic or otherwise. The banished Pentagon program didn't deserve this
sort of treatment.

The writers are assistant professors of economics at Stanford
Graduate School of Business. They are co-authors (with Andrew Leigh of
Harvard) of a study titled "What Do Financial Markets Think of War in
Iraq." Eric Zitzewitz will answer questions about this column in a Live
Online discussion at 12 p.m. today on www.washingtonpost.com.

© 2003 The Washington Post Company

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