The idea was simple: By creating a market in which people can buy and sell contracts that pay $100 if certain political events occur in the Middle East, we can infer from the price of such securities the probability of these outcomes. By explicitly pricing such risks, we can better understand them and better respond to them.
Financial markets are incredibly powerful aggregators of information, and are often better predictors than traditional methods. The examples are numerous. 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.
The reason markets work so well is that they reflect our collective wisdom. And your opinion will be reflected only to the extent that you're willing to put your money where your mouth is.
While the joke about military intelligence being an oxymoron is an old one, it bears repeating here. It's no coincidence that we don't have the same doubts about financial markets. Recent events have underscored the difficulty of aggregating information from lower levels of the intelligence bureaucracy. Imagine if a "Niger Uranium sale" contract had been trading in January; our guess is that this would have been close to valueless, reflecting the hard intelligence available at the time that such sales never occurred.
Political critics contend that betting on political disruptions not only is distasteful to many but that it also provides an incentive to create political strife, because an assassin might be able to bet that political strife is likely and then go out and cause the strife himself.
But those opportunities and incentives to make trouble already exist. The stock market fell 2.8 percent following President Kennedy's assassination; it fell 4.9 percent following the attacks on the World Trade Center; and the oil markets gyrate wildly with each assassination attempt in the Middle East.
Terrorists determined to profit from their actions can easily buy derivatives to cash in on their actions. Of course they will leave behind a paper trail. But more to the point, all that these prediction markets will do is make the information content of such trading more transparent for policymakers.
A more serious concern raised is that terrorist organizations might trade in the market to create disinformation. But terrorist organizations already have many channels for disinformation, and the profit motive in these markets provides incentives for those who know the truth to correct such disinformation. The one thing that economists actually agree on is that people do respond to such incentives.
Legislatures are not the best institutions for directing research, economic or otherwise. The banished Pentagon program didn't deserve this sort of treatment.
Justin Wolfers and Eric Zitzewitz are assistant professors of economics at Stanford Graduate School of Business. They are co-authors, with Andrew Leigh of Harvard, of a study titled "What Do Financial Markets Think of War in Iraq?"