A plan to predict terror

By STEVEN PEARLSTEIN
The Washington Post

Hey, want to make a killing shooting Yasser Arafat? What odds will you give me on a terrorist attack this summer on Western tourists at the Pyramids?

No, it’s not a hoax. It’s all part of a scheme the Pentagon cooked up for a futures market on geopolitical outcomes in the Middle East. Anyone with a credit card, a password and Web access would be able to buy or sell contracts that this or that might happen over the next year. By setting the price for those contracts, the market would be able to predict the future better than all those spies and experts out at the CIA.

Tuesday’s cancellation of the project is the latest political embarrassment for an intelligence establishment already accused of ignoring warnings about a terrorist attack and allowing itself to be manipulated into providing justification for an Iraq war.

The plan is also the latest and loopiest manifestation of a near-religious belief within the Bush administration in the power of markets to solve all problems -- or at least those that can’t be cured by tax cuts.

You’ll recall Vice President Cheney’s stubborn defense of deregulated electric markets in the face of overwhelming evidence that his pals at Enron and other energy companies were manipulating prices in California.

And since then, we’ve been told that only private markets are capable of cleaning up the environment, reforming education, saving Social Security, bringing Medicare costs under control and keeping Rupert Murdoch from abusing his media monopoly.

Don’t get me wrong: It’s often a good idea to bring competition and market discipline to public policy. But the Bushies invariably take things too far, embracing questionable theories about efficient markets and rational expectations while downplaying the role of government, even when it actually does things well.

The idea for using futures markets to predict world events originated at the Defense Advanced Research Projects Agency. Program Officer Michael Foster, I’m told, was intrigued with the political futures market run by the University of Iowa that seemed to be better at predicting the outcome of presidential elections than pollsters and pundits.

He also had tapped into a creative cabal of economists who had used laboratory experiments to show that decentralized markets were better than bureaucratic processes in making policy decisions. In the end, two small firms -- one in Alabama working with the Iowans, another out of Caltech, working with George Mason’s Robin Hanson -- got $850,000 to get test markets running by this fall.

The logic behind all this is that markets are wonderful vehicles for aggregating all the information and insight that people have about a subject. Since it works reasonably well in allocating capital (on Wall Street), setting prices (on eBay) and predicting winners (at the racetrack or the polls), why not use a market mechanism to estimate probabilities of coups, assassinations and peace?

In effect, the idea was to set up a market with the express purpose of attracting and rewarding people with inside information -- something spies have done for centuries.

But one of the reasons we don’t allow insider trading on Wall Street is that it invites market manipulation by executives who can actually affect the company’s profit or the market’s perception of the company’s prospects. And that’s precisely the problem here: Would-be assassins and terrorists could easily use disinformation and clever trading strategies to profit from their planned misdeeds while distracting attention from their real target.

Clever insiders like Jeffrey Skilling and Dennis Kozlowski made millions by fooling markets and manipulating prices, and I suspect Osama bin Laden could do the same with the Pentagon’s proposed futures market.

The war against terrorism is not likely to be won by hiring more economists. It is going to have to be won the old-fashioned way, improving the government’s intelligence network one spy at a time.

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STEVEN PEARLSTEIN/TODAY