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The Terror Gamble
Betting on terrorism isn't as crazy as it sounds.


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Less than a day after two Democratic senators criticized the proposed Policy Analysis Market, the Defense Advanced Projects Research Agency (DARPA), announced that it would pull the plug on the $8 million project Tuesday afternoon. Although the idea for a terrorism-betting market focused on the Middle East may appear outrageous at first glance, DARPA’s knee-jerk reaction will end a promising research program while cutting off a source of information that would help to make America much safer.

Under DARPA’s proposal, traders would, in effect, bet money on propositions about events in the Middle East. These prediction (or idea futures) markets would function a lot like the longstanding commodities markets that Wall Street firms and agribusiness have used to predict the prices of everything from frozen orange juice to silicon chips. Instead, of trading agricultural and industrial commodities, however, the market would allow the purchase and sale of contracts for futures predicting events ranging from the trivial (resignation of a cabinet minister) to earth shattering (nuclear war). A person believing, for example, that the government of Israel would fall by a certain date could purchase a contract that pays off when and if the event happens. A trader who believed that the same event wouldn’t happen could sell the contract. When the price of such a contract rose in response to events (or, for no apparent reason at all) policymakers would know that something was going on. (A lot more information on how these markets would work is available here.)

North Dakota Democrat Byron Dorgan’s had a typical response to the program, “Spending millions of dollars on some kind of fantasy-league terror game is absurd and, frankly, ought to make every American angry. What on Earth were they thinking?” Even deputy Defense Secretary Paul Wolfowitz, normally a sensible wonk, lashed out with anger when he found out about it. Critics of these prediction markets, however, are simply attacking something they don’t understand: Such markets have a good track record, could help tremendously in protecting the nation from terror, and pose no moral quandaries that Americans don’t already grapple with.

To begin with, there’s a good reason to think that idea futures would work pretty well when it comes to predicting terrorist attacks. Consider the following existing prediction markets:

The play-money Hollywood Stock Exchange (run by bond-trading firm Cantor-Fitzgerald) is much more accurate than movie studio’s own models in predicting movie’s box office grosses and stars’ career trajectories.
The now defunct play-money Foresight Exchange accurately predicted that the Y2K computer glitch wouldn’t be a big deal as early as 1997.
The Iowa Electronic Markets, which take real-money bets on political candidates, frequently outperform polls when it comes to predicting election outcomes. Several months before the 2000 elections, even as Al Gore showed a significant lead in the polls, his stock and Bush’s traded at the same levels in the markets.

Markets work well for predicting events for the same reason they work well in setting stock prices. Prices, as any financial-market economist can explain, are a terrific way of aggregating available information. Through the 1990s, for example, Microsoft and Bethlehem Steel had assets worth roughly the same amount, but Microsoft’s stock was worth far more. The reason: Everyone knew that Bethlehem Steel was a declining company in a declining industry while Microsoft’s offered almost unlimited growth. In short, using prices to determine the likelihood of a terrorist attack makes just as much sense as using them to determine the value of a company.

When it comes to predicting terrorist attacks and political instability, prices could aggregate information just as well (maybe better) as they could for stocks. The markets could produce consensus estimates as to the likelihood of events that almost nobody can predict with certainty. Since investors would stake real money on the propositions, they would have an incentive to gather the best possible information. If terrorist groups were foolish enough to play the markets they would, in effect, give policymakers a tip-off as to when they planned to attack and, thus, actually make the nation safer. People who made bad or ill-informed bets would loose money and therefore drop out of the market over time: The quality of information available to policymakers would therefore steadily improve

And why should any of this pose a moral problem? After all, people make money by selling tombstones, hospice care, and security services. Making money off of bets about terrorist activities and political instability should not prove any more troubling than the actions of a funeral-home owner who stocks up on coffins after a hurricane. And, indeed, all of the money involved in the markets would come from voluntary participants. Those who don’t like the idea could stay out the same way some investors refuse to spend money on companies that sell tobacco, run casinos, fund abortions, oppose gay rights, or pollute the environment. Making money off of prediction markets, in fact, does not pose even the limited moral quandary faced by a hardware store owner who boosts snow shovel prices in the middle of a storm.

From a strategic standpoint, proponents of idea futures almost certainly made a mistake by launching the concept’s first major test with a market about terrorism. But allowing bets on substantive issues could improve the way America does everything from run corporations to set municipal policy. As American laws (even in Nevada) outlaw bets on substantive issues, however, it may be years before the idea gets a fair hearing.

Eli Lehrer is a homeland-security manager for a Fortune 500 company and associate editor of The American Enterprise.



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