Policy Analysis Market: Positive and Normative Perspectives

By Daniel O'Connor of Integral Ventures, LLC

Thanks to Bryan Caplan of EconLog for reminding us of the fascinating little 2003 scandal surrounding the U.S. Defense Department's Policy Analysis Market, popularly known as the "terrorism betting market."  At the time this story broke, I happened to be writing about the distinctions between positive and normative validity claims in economic policy, leading to the following commentary on the Policy Analysis Market.

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As Milton Friedman famously argued, positive economic analysis is designed to answer the question what is? with respect to economic development.  It is concerned with understanding how the economic system has behaved in the past in order to predict how it will behave in the future.  Normative economic analysis, in contrast, is designed to answer the question what ought to be? with respect to economic development.  Therefore, it incorporates value judgments that are not necessarily grounded in the positive economic theories.

For example, positive economics might claim that a minimum wage law will tend to increase unemployment among those low-wage workers whom the law was designed to help.  We can expect this because when the state intervenes in the market and sets a minimum price that is above the market’s natural equilibrium, this higher price will tend to discourage demand and encourage supply, thereby creating a surplus of the good—in this case, low-wage labor looking for work.  However, the question of whether the state should pass such a law to support some low-wage workers at the expense of others who will, according to the positive theory, suffer from unemployment is considered to be a matter for normative economics.

Therefore, the debates over economic policy are often framed in terms of positive claims vs. normative claims that are difficult to reconcile, because one set of claims calls for empirical validation to ensure the policy works, while the other calls for ethical validation to ensure it is appropriate.  Moreover, this framing is typically only implicit as the protagonists often have a difficult time differentiating the positive claims from the normative claims, thereby undermining their attempts at validation.  Worse yet, many debates over the state’s economic policy are entirely based on competing normative claims that pit one ethical perspective against another ethical perspective, or one political philosophy against another political philosophy, with little or no recourse to positive theory and empirical evidence.  Thus, in trying to follow the political debate over minimum wage laws and other attempts to manage the market, one may never hear the positive economic arguments over the endless din of normative allegations, from the “economic injustice” attributed to the Republicans to the “class warfare” attributed to the Democrats.

An interesting example of the conflict between positive and normative validity claims arose with the discovery by politicians on July 28, 2003 that the Defense Advanced Research Projects Agency, the research and development branch of the U.S. Department of Defense, was exploring the potential to develop what they called a Policy Analysis Market to support the assessment of various political and security risks.  According to the official webpage at http://www.darpa.mil/iao/FutureMap.htm, the DARPA FutureMAP (Futures Markets Applied to Prediction) program would “concentrate on market-based techniques for avoiding surprise and predicting future events.”  These market-based techniques might support “analysis of political stability in regions of the world, prediction of the timing and impact on national security of emerging technologies, analysis of the outcomes of advanced technology programs, or other future events of interest to the DoD.”

Although the official webpage was rather vague about the specific form that these market-based methods might take, it was reported in the press (Hulse, 2003) that initially “the market would focus on the economic, civil and military futures of Egypt, Jordan, Iran, Iraq, Israel, Saudi Arabia, Syria and Turkey and the consequences of United States involvement with those nations.”  Several politicians who were critical of the initiative claimed that this market might have allowed traders to buy and sell futures contracts that would reflect their own expectations for, say, a major terrorist attack in Israel or a North Korean missle attack.

So what are the positive validity claims of this Policy Analysis Market?  As the Defense Department said in its statement to Congress, “Research indicates that markets are extremely efficient, effective and timely aggregators of dispersed and even hidden information."  For example, “futures markets have proven themselves to be good at predicting such things as elections results; they are often better than expert opinions" (Hulse, 2003).

Indeed, one of the great virtues of a market is its unmatched ability to assemble in one spacio-temporal pattern of price data the private expectations of a great diversity of people whose opinions might not otherwise be factored into the experts’ assessment of the future.  It is believed that those people who actually participate in such a market, putting their own money at risk, will tend to be people with some expertise or inside information that is expected to generate profits.  Furthermore, over time, the competitive process of the market tends to weed out those traders whose vision and knowledge are found lacking.  Thus, a spontaneously self-organized and sufficiently dynamic market might well produce consensus assessments of potential future events that are different and even better than the assessments of expert analysts studying multiple and contradictory intelligence reports.  In theory, by allowing such a market to self-organize, the government could mine a great deal of patterned information on a diversity of security issues, including potentially significant intelligence on the nature, location, and timing of specific risks and crises.

It was a rather creative idea and it certainly referenced legitimate market theory to support its positive validity claims.  However, there are some good reasons to suspect that this futures market might have failed on purely positive grounds, though not if we adhere strictly to the idealistic tenets of neoclassical market theory (which, incidentally, is the theory base for the valuation models of futures, options, and other derivative securities).  For one example, consider the fact that this futures market would not be a spontaneously self-organizing process, but rather a state-organized system in which participants would almost certainly be profiled and monitored while trading state-created property rights of questionable legitimacy.  The positive validity claims of market theory that were employed in support of the Policy Analysis Market presuppose a spontaneously self-organizing process of exchange involving property rights legitimized, first and foremost, by the parties to each exchange.  Absent these conditions, we have reason to doubt the positive claims made in support of what appears to have been conceived as a state-managed market bearing only superficial resemblance to the decentralized market of market theory.

For another example, consider that if terrorists wanted to fool intelligence analysts they could manipulate the market by deliberately trading against their own knowledge of future terrorist activities.  They could sell contracts on a particular type of terrorist attack even though they were intending to carry out such an attack.  They could buy contracts on a completely different type of attack even though they had no plans to ever conduct such an attack.  In this way they would subtly undermine the quality of the patterned information reflected in the spatio-temporal price structure of the market by deliberately ignoring the objectivist profit motive they are presumed (according to neoclassical theory) to be exercising in the market.  And because there are no property rights and no markets for actual terrorist attacks, the implied underlying securities of which the futures are merely derivatives, there is no way to measure the profit, loss, risk and return for terrorists when they ultimately carry out (or fail to carry out) an attack they were secretly planning.  Therefore, the incompleteness of this particular futures market would contribute to its potential manipulation by the very people the Department of Defense would like to discover and control.

Considerations such as these might have constituted a sufficient disconfirmation of the positive validity claims of this otherwise creative initiative.  But the economic dialogue in Congress was not primarily concerned with positive validity claims.  Whatever its positive merits and demerits might have been, the initiative was ultimately blind-sided by its own normative implications.  When politicians discovered this program, they denounced it as “morally repugnant” and even illustrated this claim by asking their colleagues to imagine how it would feel to learn of a foreign government-sponsored futures market that allowed people to bet on the potential assassination of an American politician (Hulse, 2003).  While watching excerpts of the dialogue on television, I heard one politician exclaim that he didn’t care whether or not the market could work, because it was so morally offensive that we shouldn’t even consider it.  Therefore, the normative inappropriateness of the state’s economic proposal was so pronounced as to silence any further discussion of its positive merits or demerits.  Needless to say, the program was hastily scrapped and its public webpage immediately removed from the DARPA website.

© 2003 by Daniel J. O'Connor.  All Rights Reserved.