Tuesday, July 29, 2003

Creating a Market for Counter-terrorist Intelligence

The Pentagon is setting up a commodity-style market to use real investors -- putting down real money -- to help its generals predict terrorist attacks, coups d'etat, and other turmoil around the globe. Under the program, disclosed yesterday by two of its critics in the Senate, investors with knowledge of the Middle East and other hot spots would be lured, by the prospect of making money of course, into using their expertise to buy and sell futures contracts on world events. -- Boston Globe

The Democrats, predictably, think that a government agency can do better at analyzing information that the market. Democratic Senators Ron Wyden of Oregon and Byron Dorgan of North Dakota said: "Spending taxpayer dollars to create terrorism betting parlors is as wasteful as it is repugnant ... ''The American people want the federal government to use its resources enhancing our security, not gambling on it."

But using the market to assess risk is so common and acceptable that we barely think about it. For example, insurance premiums are very good indicator of risk. The insurance industry insures against a great deal of phenomena which require very sophisticated analysis. Examples include satellite launches and therapeutic drug liability. No Democrat Senator would object to farmers taking out crop insurance, even though the weather is difficult, and perhaps impossible to predict. But the insurance market assesses the risk better than any other method. A futures market is mathematically equivalent to insurance. In both cases investors calculate an expected return, adjusted for risk, based on continuously updated information.

One consequence of the simple existence of an insurance or futures industry is to create a vast market for gathering and analyzing factors which may bear on risk. Armies of statistical analysts, technical evaluators, innovative quantiative methods, and revolutionary imaging methods have been employed in order to better understand risk. Without the futures or insurance markets, information gathering would be underfunded because the information would have no market value. Left to the government, large scale risk analysis would simply not exist. Why not apply a proven method to the phenomenon of terrorism instead of relying on the wisdom of empty-headed liberal politicians?

Yet there are genuine objections to the the Pentagon proposal, none of which have anything to do with the brain-dead reservations of the Democrat Senators. The most obvious is the possibility that it will create an incentive to manipulate the terror market. If investors buy or sell a contract on a massive terrorist attack, they have a vested interest in the possibility of it eventuating or not eventuating, depending on their positions. The other objection is to ask why the insurance market, as presently constituted, cannot provide the right instrument for making these assessments. If one is mathematically the equivalent of the other, then the market the Pentagon seeks already exists.

One of the nice things about Republicans is that they can think big: Lincoln freed the slaves, Teddy Roosevelt created the national park system, Ronald Reagan destroyed the Soviet Union and George Bush has remade the Middle East. This idea has possibilities, but it deserves a closer look.