Friday, March 05, 2004

Walking the Walk

Belmont Club reader and retired pathologist WP thinks a futures market would be better than committee hearings at estimating the probability of finding Iraqi WMDs. He writes:

You should establish a futures market to evaluate the chance of finding these things. It would be brilliant and you could make some dough. Allow the world, especially including the Iraqis, to bet. You want people on the 'know' to affect these bets! Thus, we might actually find them. See the Iowa electronic market site  We need such a market to rip politics aside and settle into real beliefs. ...E.g. I would bet a thousand bucks at 2.5:1 odds that we find--within 5 years--that Iraq either had these or has these now. I'll give you 5% for placing my bet.

DARPA created a stir in 2003 by proposing a futures market in terrorist attacks to better determine their likelihood. The principles of such a market are described here. In simplified form, reader WP is offering to pay a net of $1,500 if Iraqi WMDs are found within 5 years. If he could trade this contingent contract on a futures market for $1,000 it would imply traders believed there was a 67% chance it would come true (1,000/1,500=0.67) The price on this contract would fluctuate as new information came to hand. Any insiders who actually knew the truth (say Saddam was free to trade) would bid the price up or down depending on what he knew. A "find" of material or the capture of incriminating documents, for example, would push the price up. A dearth of any findings would force the price down.

The idea is not without its problems. Casey Khan describes how the DARPA market, as proposed, would not offer enough incentive for serious investors to gather enough information about the existence of WMDs to make the game worth the candle.

Which leads us to the case of the government's terror futures "market." With the precedent of other phony markets—the market for US debt securities, EPA emission credits, or power market designs—it should be no surprise that the DARPA (Defense Advanced Research Projects Agency) under the Information Awareness Office tried to mold such a monstrosity as the market for terror futures. In essence the market would be purely speculative unlike most futures markets which have large hedging interests. Profits in the market would also be restrained to $100 a trade thus keeping would be terrorists from having massive windfall profits on an event's occurrence.

The prospect of earning a whopping hundred dollars on a futures trade is not very lucrative. It is highly doubtful that traders would expend large amounts of capital towards better systems and information gathering to reap a hundred bucks. Since there are few restrictions on profitability in a normal futures markets, futures players are willing to expend their private capital toward all sorts of detailed information in the hopes of future profit maximization. For instance a monthly subscription to a Bloomberg or Reuters news service can run in the thousands. Some companies have paid meteorologists six figure salaries to help with their weather risk management. With the potential profitability on a terror futures trade of a hundred bucks, the prospect of any relevant intelligence arising in such a market is highly unlikely, since information is an expensive commodity, particularly on military intelligence and political instability.

Payoff caps in the DARPA-proposed futures market would remove the incentive to make the right predictions. It would be "purely speculative" and unlikely to attract serious trading and analysis. But other markets, such as for terrorism insurance, can encapsulate the degree of belief in certain sorts of events. Terrorism insurance premiums skyrocketed immediately after September 11, 2001, especially for airline carriage and "marquee" buildings in major cities, reflecting the perception of the increased risk. But using insurance rates as a direct measure of the market's belief in the WMD threat (let alone specifically Iraqi ones) is hampered by the elimination of coverage for radiological, biological and chemical losses from many policies. That avenue blocked, it might be possible to use Manhattan office rental rates as a crude measure the likelihood of terrorist WMD threats (not necessarily Iraqi ones) on the theory that Manhattan would be a prime target and rentals reflect that information. Market statistics show high Manhattan office vacancy rates which are not expected to improve much. Nobody is in a rush to move there. Although the effects of other economic factors like high prices, congestion and alternative locations need to be separated out, there is no obvious "sigh of relief" in the Manhattan rental market at not finding WMDs in Iraq, which may indicate that despite partisan political pronouncements, investors are not wholly convinced that the danger of WMDs has passed or that it was manufactured by President Bush. On the other hand its important to note that more than 6 million square feet of new office space are under construction. That might suggest a rosier long-term outlook.

No one would seriously use Manhattan office vacancy rates to quantify America's risk of a terrorist WMD attack. But it does provide a weak form of reality check. Belmont Club reader WP is right. If the politicians who now claim that President Bush 'inflated the threat' or that the war against terror pits us against an imaginary foe would invest in Manhattan office space or undertake to insure against radiological, chemical or biological  losses  with their own money they might be more believable.