Pentagon drops plan for terror futures ; Theory has its fans, but many are cringing Mike Blahnik 30 July 2003 Minneapolis Star-Tribune 1A Futures markets have accurately predicted oil prices, interest rate changes, presidential winners and Super Bowl champions. But the idea of using futures markets to predict terrorism was too unpalatable, the Pentagon conceded Tuesday when in the face of strong criticism it dropped plans for such a market. The online futures exchange, which had been planned to start Oct. 1, would have allowed anonymous participants - including terrorists - to profit by accurately predicting events including the assassination of foreign leaders. "I think it was such an unbelievably bizarre, harebrained scheme that once it saw daylight, the Pentagon didn't have much choice but to kill it," said Sen. Byron Dorgan, D-N.D., who along with Sen. Ron Wyden, D-Ore., revealed the plan on Monday. The "Policy Analysis Market" Internet site, which Defense officials had hoped to use to gain insights about potential terrorism, was deactivated Tuesday. The company that had been contracted to run the exchange, San Diego-based Net Exchange, dropped mentions of it from its Web site. Confronted by a congressional outcry and widespread disbelief after news of the program emerged, Pentagon officials appeared at a loss to explain how it got as far as it did. Deputy Defense Secretary Paul Wolfowitz said at a Senate hearing that he learned of the program from a newspaper story he read en route to the hearing, which dealt with postwar reconstruction in Iraq. "I share your shock at this kind of program," he said. "We'll find out about it, but it is being terminated." Dorgan called for the Pentagon officials responsible for the plan to resign. "These people are just goofy. How else do you describe them?" he said. "I hope they're no longer on the public payroll when the dust settles." The Pentagon at first defended the plan, created by its Defense Advanced Research Projects Agency, saying that futures markets have a history of predicting events better than experts because of "efficient markets theory." "The belief is that a market with many hundreds or thousands of participants, making many tens of thousands of decisions, generates an equilibrium price that will hold more wisdom than any one individual expert or team of experts," said John Delaney, chief executive of TradeSports.com, an Internet futures exchange. "Reasonably you would say if you have 20,000 people from 111 countries all trading on whether [Saddam] Hussein will be caught by the end of September, that's probably going to give you a very good real-money predictor." TradeSports.com, a Dublin-based company, offers about 125 contracts on geopolitical, legal and current events. More than 13,000 contracts on when Saddam will be captured or killed, worth $10 apiece, have traded on the exchange. Traders think there's a 61 percent chance Saddam will be "neutralised" by Sept. 30. The exchange, which processes more than $10 million in transactions some days, also has contracts on the capture of Osama bin Laden, but none regarding terrorism or assassinations. "The basis of efficient market theory is that information is . . . valuable, so you get hundreds of people searching for information and reacting to new information so that the information flows into securities market prices very quickly," said Tim Nantell, the Gelco Professor of Finance at the University of Minnesota's Carlson School of Management. In fact, the idea of index mutual funds came about because of efficient markets theory, which explains why a majority of mutual fund managers fail to outperform the stock market averages. "The theory generally refers to highly developed, very liquid securities markets like the New York Stock Exchange and Nasdaq," Nantell said. "Once you get to markets where the trading doesn't happen very often, then no one would suggest that the market is efficient." He also noted that a camp of academicians disputes efficient markets theory even in the world's biggest markets, citing events such as the October 1987 crash and the Internet stock bubble. Dorgan said the idea of using a market to gather terrorism information had no merit. "I used to teach economics and think the marketplace is wonderful," he said. "Judge Judy makes $25 million a year in the marketplace. A Texas Rangers shortstop makes the equivalent of 1,000 elementary school teachers each year. That's the marketplace. "Do I think there's intelligence to be gained by betting on the assassination of a foreign leader, or a bet on the number of U.S. soldiers to be killed in the coming year? No, I think that's preposterous. Shame on those who believe it." Futures markets have proved accurate at predicting presidential elections. Over the past five U.S. presidential elections, the University of Iowa's futures market has predicted candidate vote shares within an average of 1.37 percentage points. "The market summarizes the information of lots of traders that we have in the market who view things potentially very differently, and it comes up with one market price that aggregates the information and serves as the forecast," said Thomas Rietz, a finance professor at the school and a director of the Iowa Electronic Markets. The program has about 4,000 active participants, with $98,000 invested by traders. "People have an incentive; they're putting their money behind the actions they take in the market," Rietz said. . The Washington Post contributed to this report. Mike Blahnik is at mblahnik@startribune.com. . HOW IT WOULD HAVE WORKED The Pentagon on Tuesday dropped its plan to establish a futures market on terrorism, Middle Eastern assassinations and similar events. Here's how the market would have worked, using an example from a current futures exchange, TradeSports.com. Saddam September futures: Bettors who think Saddam Hussein will be captured or killed by Sept. 30 buy the contract; those who think he won't sell it. Value: Each contract is worth $10 if the event happens and zero if it doesn't. Prices: The prices, from 0 to 100, reflect buyers' and sellers' opinions on the percentage chance of the event occurring. A week ago the Saddam contract was trading at 25; after U.S. troops made progress and captured a key bodyguard, the contract on Tuesday traded at 61. In other words, a buyer is betting $6.10 to get back $10 (a $3.90 profit) if Saddam is caught. Conversely, a seller receives $6.10 and keeps it if Saddam isn't caught.