Arnold Kling  

Terrorism Futures

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Comment of the Week, 2003-07-3... The Long-term Budget Outlook...

A number of economists and others are defending the idea of a futures market to predict terrorism. This idea was abandoned after Senators objected to it. Hal Varian writes,


The Iowa Electronic Markets 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.

...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.


Justin Wolfers and Eric Zitzewitz write,

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.

James Pethokoukis writes that the idea for the futures market came from Professor Robin Hanson of George Mason University.

As Hanson concludes in his analysis of these markets: "Betting markets, and speculative markets ... seem to do very well at aggregating information. To have a say in a speculative market, you have to 'put your money where your mouth is.' Those who know they are not relevant experts shut up, and those who do not know this eventually lose their money, and then shut up. Speculative markets in essence offer to pay anyone who sees a bias in current market prices to come and correct that bias."

Brad DeLong also has a series of posts on the subject.

For Discussion. What do you think of the idea of a terrorism futures market?


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TRACKBACKS (3 to date)
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The author at fishrush in a related article titled In a different form it might have been an interesting idea. writes:
    A slightly tweaked version of the quickly scrapped DARPA catastrophic hedging mechanism would have been interesting. In the right form, it might provide a conduit (marketplace?) for insurance companies, speculators, hedgers, arbitragers, businesses, ph... [Tracked on August 1, 2003 12:04 PM]
COMMENTS (18 to date)
David Thomson writes:

“What do you think of the idea of a terrorism futures market?”

Why not ask me what I think about auto or medical insurance? I see absolutely no inherent problem with insurance programs dealing with terrorism. A futures market is simply another way of dealing with financial risk. Is it suppose to be particularly gouhlish that I entertain the possibility that I might end up in an awful automobile accident---or the outside chance that terrorists may destroy the City of Houston?

Hillary Clinton is merely making a total fool of herself. Of course, that’s nothing new. She has repeatedly proven her incompetence in understanding basic economics.

Bernard Yomtov writes:

I agree that the criticism was a touch hysterical. Still I wonder whether this owuld have had more than entertainment value.

Markets aggregate information for two reasons, I think.

First, they enable those who have information to reveal it (through their trades) for a profit.

Second, the profit potential makes it worthwhile to expend resources to obtain information, which can then be capitalized on.

Given that the size of trades was to be severely limited the second reason really wouldn't apply. Who's going to spend a lot of effort understanding Jordanian politics in order to maybe make a $100 trading profit?

So we're left with people who already know something about these issues, plus the noise traders. Given the complexities, and lack of broad general information, like that available to the public about presidential elections, for example, how accurate will the prices be?

David Thomson writes:

The futures market is a dangerous way to earn a few bucks. Only the very daring and knowledgeable need apply. This is true whether you are investing in corn and cattle futures---or the tragic results or terrorist activity. The nonchalant and lazy bettor will almost always lose their money in the long run.

I must concede that I see some humor in a futures market premised upon terrorism. Those who normally would avoid the websites of Daniel Pipes, National Review, and The Weekly Standard, might now spend their mornings reading their offerings.

Jim Glass writes:

What do you think of the idea of a terrorism futures market?
~~~~

I think calling it "terrorism futures" was really bad marketing.

They could have called it "international stability futures" and it'd be up and running.

Anton writes:

Of course the logic behind such a plan is that this effectively enables the Federal Government and law enforcment agencies to tap a knowledge base of potentially tens of thousands of informed traders.

The problem in this is a PR issue. One of the scariest thoughts is members of a terrorist group or a participating federal government using these statistics to play the markets. For instance a foreign government could place huge orders to sell short on airlines weeks before an attack.

This sort of economic warfare has already been contemplated by the Chinese military, and others.

Bernard Yomtov writes:

Anton,

Who are these tens of thousands of traders who know things about Middle Eastern politics, or whatever?

My suspicion is that the trading would be all noise.

dsquared writes:

I seem to dimly remember that Richard Roll's analysis of the question did not support the conclusion that the orange juice futures market was "a better predictor of the weather in Florida than the National Weather Service". I'd be interested if anyone can dig up the source for the claim that it is. I'm not particularly concerned either way, except that if Roll did say this, my memory is going.

Bill Brown writes:

Without rehashing my opinion and since Blogger doesn't do TrackBacks, here's what I think:

www.bbrown.info/blogs/bblog/2003_07_27_diamonds.cfm#105965742106869779

Basically, I think it's little more than legalized gambling. It might work well for markets with lots of data (orange juice futures has lots of weather data available), lots of interested professional investors, or lots of predictable patterns. I think the event futures market (as they should have called it and no one would have even noticed) lacks all three of these.

Boonton writes:

"This security shall pay $100 if an act of terrorism or war performed between XX/XX/XXXX and XX/XX/XXXX causes damage inside the US of at least $10M as certified by the Dept. of Homeland Security"

I think it would be fascinating to see the above types of securities trade in a futures market. One immediate use I can see is that it may resolve the terrorism insurance problem. Companies having difficulty getting insurance companies to write policies could partially or fully insure themselves by purchasing future contracts like the one above. An added bonus would be that they would pay off whether or not the damage was done to the property owner.

As far as predicting terrorism? It would be a useful indicator but honestly, would anyone here really say a one week run-up in a particular stock *predicts* a company that will have a great year in 2004? For every accurate prediction there will no doubt be plenty of bubbles, false alarms etc.

Nevertheless, it seems like it can be a good idea.

Bernard Yomtov writes:

"One immediate use I can see is that it may resolve the terrorism insurance problem. Companies having difficulty getting insurance companies to write policies could partially or fully insure themselves by purchasing future contracts like the one above. "

This is an unrealistic hope. Who will be the guarantor of payment? On actual exchanges there is a "clearing corporation," often backed by the exchange members, which takes on itself the obligation to perform on the contract. This is what makes it safe to buy carloads of wheat from anonymous strangers. At the end of the day (literally) the clearing corporation becomes the counterparty.

So who will take this on in a serious terrorism futures market? The government, I suppose. So that leaves us where we are. And by the way, another important issue is definition of the contract. What is a "terrorist act," anyway? Would the act of a random lunatic with no political agenda count? And if our RL has any sort of agenda, no matter how incoherent, does that make him a terrorist?

Boonton writes:

The organizers of the exchange would be the clearing house. Payment on the contract could be guaranteed by them. Who would supply such contracts? Insurance companies for one, anyone who wanted to bet that a terrorist attack would not happen between those two dates. The exchange could require that contract writers post enough collateral (say 75% of the contract) to cover payoffs.

Likewise as long as one party would act as an official judge of what is or is not a terrorist act the problem could be solved. For example, the Dept. of Homeland Security could declare an act officially terrorist in nature.

Assuming the contracts are for large losses (i.e. $10M or even greater), we will not have to worry about whether many small scale incidents qualify as terrorist attacks.

Mark Anderson writes:

I agree with the idea that the market is most efficient at predicting catastrophe, but the problem here is failing to understand that the market transcends the use of property in some sort of futures market. Having the Pentagon come up with some sort of futures market does nothing whatsoever to re-create market forces, especially while the state is left perfectly intact.

What is required is freedom - i.e., the freedom to react. On the market, if a threat is perceived, measures of protection will be taken. Statism interferes with this. Just look at September 11, where no pilots were allowed to carry firearms due precisely to federal statutory law.

I would argue that we already have an idea futures market, and it is called journalism.

Additionally, it seems to me that participants in any such scheme would be getting their information from where? Ummm.., the government - i.e., Pentagon - itself. So, let's get this straight. The government issues a "terror alert," speculators then purchase futures based on THAT information, and this is supposed to reveal what, exactly, to the government?

The money dumped into the program so far would have been better spent by giving it to Gulf War veterans who are ill due to the experimental and deadly shots and drugs that the Pentagon made them take.

The entire scheme sounds like a VERY roundabout way of collecting opinions. That is funny, being the Pentagon isn't exactly interested in any opinions except their own. Why not just start an opinion collection department at the Pentagon? Probably because the opinions of patriotic, freedom-loving, Americans would just end up in the circular "filing cabinet."

The real tragedy is that these pseudo-market, statist, schemes fuel hostility towards genuine free market activity.

Boonton writes:

"Additionally, it seems to me that participants in any such scheme would be getting their information from where? Ummm.., the government - i.e., Pentagon - itself. So, let's get this straight. The government issues a "terror alert," speculators then purchase futures based on THAT information, and this is supposed to reveal what, exactly, to the government?"

If the contracts in the market are similar to the language I wrote previously, then the increase in prices would indicate that the market feels the gov't 'terror alert' was reliable. Not only would anyone betting his money in this market pull their information from gov't sources but they would also utilize all other available information including journalism, other gov'ts, etc. I also still maintain that such a market would be a useful way for companies to insure themselves against a terrorist strike, especially if there are still problems getting insurance companies to write such policies.

"The entire scheme sounds like a VERY roundabout way of collecting opinions. That is funny, being the Pentagon isn't exactly interested in any opinions except their own."

It's more than that since those in the market would be putting down their own money for or against opinions. IMO it would be a useful tool to evaluate the quality of opinions coming from the Pentagon, Dept. of Homeland Security etc.

"The real tragedy is that these pseudo-market, statist, schemes fuel hostility towards genuine free market activity."

In what way is this market not free? Anyone can participate (within reason, bin Laden should be excluded) and participation is voluntary. The cost of the market can be covered by fees on the transactions passing through it just like other exchanges cover their cost without taxpayer funds. In fact, there seems to be no barrier to opening such an exchange without any gov't involvement at all.

Matt Young writes:

David Thomson has it right.

Ronnie Horesh writes:

For some years I have been working on a new financial instrument that combines the market's pricing efficiencies and incentives with social goals. The 'Social Policy Bonds' concept is described on my website. Applied to terrorism or conflict it would involve: government [or philanthropists] issuing non-interest bearing bonds redeemable for a fixed sum only when conflict had been reduced to a sustained, low level. The bonds would be floated at auction and tradable at any time thereafter. Their market value would generate the sort of information that the 'terrorism futures' would have, but the bonds would be more directly linked to the goal of reducing conflict. A short outline appears at http://www.geocities.com/socialpbonds/wpbsshort.html.

dsquared writes:

>>Insurance companies for one, anyone who wanted to bet that a terrorist attack would not happen between those two dates

If insurance companies didn't want to write insurance on this risk, why would they buy contracts offering the exact same exposure?

Boonton writes:

First they may not be able to write a short term policy. One element that probably irks insurance companies is that while the world may seem safe now, a year from now it could be a different story and they will be locked into long term policies.

Second any sort of person or company issue such contracts provided they demonstrated they have the resources to honor them. This means that anyone from 401K accounts to pension plans to companies and investors could take on the role of the insurance company as a part of a diverse portfolio.

David Thomson writes:

“Who are these tens of thousands of traders who know things about Middle Eastern politics, or whatever?

My suspicion is that the trading would be all noise.”

Not in the least. I previously was only being slightly facetious when saying that many terrorist future players would read Daniel Pipes ever morning. One doesn’t absolutely need to be able to contact the CIA and FBI to stay on top of the game. I’m sure that “thousands of traders” would quickly learn what is necessary---if they were financially motivated to do so. Heck, how many people knew anything about pork bellies before entering the trading profession?

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