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NoVolume 23, Number 11
November 2003

What's Wrong with Terror-Futures Markets?
Casey Khan

A growing recognition of the superiority of markets over planning has created an unviable hybrid: the planned market, one created not by property owners by the state and for the state. Planned markets bear close enough resemblance to the real thing as to fool even astute observers who are otherwise friends of genuine market forces. And yet the designed "market" is responsible for a whole range of recent economic failures, such as electricity shortages and blackouts, and will cause more if the idea is taken to areas like predicting terrorism.

The appearance of real markets is as spontaneous as it is unpredictable. Back in summer of 1998, for example, I was working as an over-the-counter broker dealing with forward electricity contracts in New York. Our office was located on the 10th floor of 1 World Trade. One summer day when the market was slow due to a credit meltdown in the Cinergy market, two brokers started making some bets. They were betting on the temperature displayed on a digital clock across Liberty Street. In similarity to an option contract where the price is derived from an underlying commodity or index, they bet on the clock temperature rising above or below a particular "strike" at a particular time.

One could bet that the clock "temp" would be above the 102 Fahrenheit strike by 10:15 expiration or below 99 by 11:30. Since the sun was shinning directly on the clock causing volatile swings in the temp by the minute, and we were bored out of our minds, interest began to grow in this market for clock temp bets. It eventually sounded like just another busy day on the trading floor. It got so complicated at one point that some were trying to make spread trades between different temp strikes. Out of thin air, a market was created the speculative market for clock temp bets. Kind of sounds crazy, but it was fun. Of course, when the sun stopped shinning on the clock, interest waned and the market was over.

The above represents an excellent example of a market economy. Individuals freely contracted to make mutual gains from exchange. Granted that the payouts in the clock temp market are zero-sum in a monetary sense, and it only lasted for three hours. Consumers in the market were able to trade some of their money for the boredom of that slow summer day. And when the consumers were done, the market for clock temps bets ceased to exist.

The government did not design or create this market. It was part of the market process that exists independently of the actions by the state.

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.

Proponents of the initiative argued that it would be an effective way to gather intelligence and combat terrorism. According to Hal Varian in the New York Times, markets can be great "predictors" of future events. He cites evidence of online betting markets, like tradesports.com, which is similar to the DARPA proposition and the earlier example of clock temperature bets. Pat Buchanan argues that a bettors' market might have predicted some of the greatest strategic disasters in the last century.

In a Wired news article, Noah Shachtman quotes proponent David Pennock, who has done extensive surveys on the reliability of such markets. "'The very fact of the terrorist doing that (investing money in an attack) would reveal his hand,' he said. Prices would rise as the terrorist invested his cash, and that would tip leaders off to the potential for strike. 'The market would know something is going to happen that people never would have known otherwise," Pennock added.

It is important to note that futures markets are not necessarily good predictors of future events; rather they are the best estimate of a future market price now. It is a market's effectiveness in dealing with events as they arise due to their roots in property rights that make them desirable. With this ability to freely exercise private property rights comes the potentially rewarding prospect of increased profitability.

Where all of these proponents fail in their analysis is that markets are effective means of information dissemination because they are decentralized institutions rooted in property rights.   Even with their own examples of sports betting or the Hollywood stock exchange, they fail to see the fundamental difference between freely functioning markets and a creation of the state.

The state's idea of terror futures is so bad, that only the use of force could sustain it. 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. For an annual subscription to an Economist Intelligence Unit's (a major sponsor of the DARPA market) country report it would cost $470 a country.

If one went long the potential overthrow of the Jordanian monarchy, and decided to use an EIU annual subscription to track it, one would hope the monarchy was overthrown at least five times before meeting information costs.  Just to get a good two to one risk reward on such a trade, the poor Hashemite king would have to be overthrown at least ten times. I guess one could hire some disgruntled policy analysts from DARPA for $20 bucks a month, but even that would put a big dent into profit margins. What DARPA, EIU, and the state fail to see, is that you can't have the benefits of robust market information, while limiting the profitability of a trade.

The one positive aspect of the terror futures market proposal is the implicit admission by DARPA that the state's current means of intelligence gathering is as ineffective as every other means it uses in protection of its tutelage. To further justify the state's roll in intelligence gathering and protection, the DARPA developed a scheme under the auspices of "market" economics. Unfortunately, such a measure will fail to meet the demands of consumers because it is not market economics. Fortunately, this means the state's ineptitude is becoming more obvious.

While things like terrorism futures are overtly grotesque, economic thinkers need to be intellectually disciplined in understanding the fundamental differences between the market and the state. In more subtle examples like EPA emission credits, US Treasuries, or Federal Reserve Open Market Operations, economists need to realize the roots of these creations and how they affect the market economy. It cannot be stressed enough, that the state cannot create its antithesis, the market. Markets are rooted in private property; states are rooted in theft. Don't be fooled by squared circles.

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Casey Khan works as a risk analyst in the energy industry in Phoenix, AZ. Casey.Khan@pinnaclewest.com

 

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