Bookmakers for the Bomb-Makers

The Pentagon scraps its startling plan for a terrorism futures market.

Just a day after two Democratic senators reported the existence of the Policy Analysis Market, the Pentagon pulled the plug on it. The PAM was intended to be a kind of turmoil exchange. Investors would place bets on events in the Middle East occurring by a certain time—say, a biochemical attack on Israel before June 2004—and collect real money if they happened.

Based on entities like the Iowa Electronic Markets, in which investors trade futures contracts on presidential candidates—click here for an “Explainer” on such exotic markets—the PAM was supposed to harness the interest, knowledge, and collective wisdom of thousands of “investors.” By ponying up actual cash to back their opinions, they would “price in” the likelihood of events and thus help the government ward off future shocks.

On its face, the market is not a preposterous idea. Economist Robert Schiller has already proposed using derivatives to ensure against global instability. Surprise events in the Middle East can shake the global economy, and it would be excellent to anticipate and hedge against such turmoil.

The havoc exchange could have provided a delightful opportunity for foreign policy gurus to reposition themselves. Brookings Institution types would have held forth on the importance of diversification: “Next on CNBC: Steven Emerson is bearish on Prime Minister Abdullah Gul of Turkey, so now’s the time to take a serious look at King Hassan of Morocco.” CNN geopolitical analysts would have been forced to disclose positions and conflicts of interest, just as brokerage analysts do on CNBC: “William Kristol is long on Saudi Arabian monarchy calls dated 2006 and owns Hosni Mubarak 2004 puts. His magazine has a significant stake in the outcome of the war on Iraq.”

But the prospect of such an exchange raised several troubling questions. Set aside for a moment the cognitive dissonance of a conservative, faith-based administration using government-sponsored gambling to set policy. And forget that the market represented an effort to meld two secretive cultures that have been discredited for their recent catastrophic failures—Wall Street securities analysis and Washington intelligence analysis.

More important, a havoc market wouldn’t benefit from the rationality that regular financial markets require. By and large, markets for futures—as well as stocks and bonds—are presumed to be efficient and rational, Internet bubble notwithstanding. This collective rationality is precisely what the Pentagon was hoping to harness by creating a market for geopolitical events.

But in the Middle East, many of the figures who would have driven the pricing of PAM securities are not what international relations types refer to as “rational actors.” Suicide bombers almost by definition are irrational, or at least not governed by a rationality with which we are familiar. We routinely refer to the main players with terms that place them beyond the field of reason—Saddam Hussein is “the Butcher of Baghdad,” Osama Bin Laden is a “madman.”

By contrast, while Federal Reserve Chairman Alan Greenspan may be inscrutable, and many executives engage in short-term behavior that causes long-term damage, almost all market movers—chief executives like Warren Buffett and Michael Dell, mutual fund managers—collectively exhibit a far higher level of rationality than, say, Mullah Omar. It’s far easier to get inside the head of Sandy Weill (he wants to acquire more banks) than it is to plumb the Machiavellian depths of Yasser Arafat’s mind. How can we expect rational people to make sound bets on minds that may be unsound?

Another potential problem was that the market might defeat itself. The Pentagon wanted to create the PAM in order to gather information it could use to stop terrorism and reduce instability. If it saw, say, that people were betting heavily on the assassination of Iraq’s interim president, the Defense Department would start searching for some assassination plot in the hopes of rooting it out. But preventing the assassination would cause all the people who bet on it to lose their money. Insofar as the market helped the United States stabilize the region and prevent terror, investors would suffer. The more it succeeded on policy, the more it would fail as a market, and the sooner it would collapse.

Information—much of it accurate, some of it rumor—is fuel that enables investors to price financial instruments properly. But the PAM wouldn’t have had good information. The Policy Analysis Market said it planned to use the Economist’s Intelligence Unit as a source of underlying data. But if you think it is difficult coaxing clarity from Freddie Mac’s balance sheets, try deciphering the various strains of Islamic radicalism.

Oddly, the hope of the PAM might have been the ignorance of investors, rather than their intelligence. Policy market day-traders who don’t speak Arabic or have access to classified information wouldn’t necessarily make worse bets than the professionals who spend their days sifting through Al Hayat and humintel reports. This is a seeming paradox called the “dumb agent” theory—one of my esteemed predecessors in this box explicated it a few years ago. Walk up to a traveler waiting in an airport, ask how many minutes late the plane will take off, and you’re likely to get a wrong, uninformed answer. Ask 75 more of your fellow passengers the same question, and you’ll get 75 more similarly wrong, uninformed answers. But throw them all together and take the mean, and you’re likely to get something pretty close to the right answer.

It may seem cavalier to place national security in the hands of dumb agents in the future markets. When professionals rely on laypeople for their intelligence, the results are usually poor. But the recent Congressional report on Sept. 11 leads one to conclude that the government has been relying on its own dumb agents for far too long. *

Correction, July 30, 2003:Gross originally wrote that: “When professionals rely on laypeople for their intelligence—as Britain did with its Internet-downloaded treatise on weapons of mass destruction—the results are usually poor.” This sentence incorrectly characterized an incident involving a British government dossier on Iraq. The government plagiarized portions of an article from the Middle East Review of International Affairs by scholar Ibrahim al-Marashi. Al-Marashi’s article did not deal with Iraq’s weapons of mass destruction. Rather, it concerned the structure of Saddam Hussein’s regime. For more on the issue, see here. For the article itself, see here.