When a Pentagon agency proposed a futures market to help forecast political events in the Middle East, it quickly died amid criticism that the program would allow bettors to capitalize from predicted terrorist attacks.
Largely lost amid the criticism of the Defense Advanced Research Projects Agency (DARPA) were dispassionate voices of economists, statisticians and others who contend that free markets are actually pretty good predictors of future events.
That theory has long been applied to politics at the University of Iowa's College of Business. Its Iowa Electronics Market (IEM) allows students and others to place bets on upcoming elections.
The hottest commodity now is the presidential race. Bettors can wager on whether President Bush will be re-elected, who the Democratic nominee will be and what percentage of the vote the candidates will receive.
The higher the price, the theory goes, the higher the likelihood of the event happening.
The market-based program's creators say it is a better predictor of voter behavior than conventional polling techniques. Polls are only snapshots of public opinion during a static period of time, said Thomas Rietz, a University of Iowa finance professor and a director of the IEM.
"They don't take into account the fact that people may change their mind," he said.
In addition, voters surveyed in polls do not always give accurate answers, particularly on volatile issues like affirmative action and abortion. They instead tell pollsters what they think sounds politically correct or popular, and then pull their lever differently when behind the curtain of the voting booth, Rietz said.
The IEM allows students to invest real money ($5-$500) and trade in a variety of contracts. In the political section, students can trade "shares" of political candidates. Other subjects for betting include a company's quarterly earnings, a corporation's stock price returns or a movie's box office receipts, among others.
The amount paid for each candidate share depends on the seller's confidence that the candidate will win. When the candidate is doing well in the race, investors are confident that their stock will pay off, so they charge more for it when they sell. When the candidate is doing poorly, investors charge less.
If participants buy shares when the stock is low, they don't have to wait for Election Day to cash in. They can sell the shares at a profit as soon as the stock improves.
The IEM has been in the business of predicting political outcomes since 1988. During the past four U.S. presidential elections, the future market's forecasts, on the same days as nearly 600 polls, were closer to the election results 75 percent of the time, according to IEM officials.
Its election eve predictions were off by an average of 1.37 percent compared with an average of between 2 percent and 2.5 percent for polls, Rietz said.
The Iowa market has not been perfect in its predictions; it forecast a Democrat-controlled Senate in the , when Republicans regained control of the chamber.
Interest in the IEM prompted the online prediction market to participate in betting on the California gubernatorial recall election. High-profile races like that one and presidential contests are likely to bring in the most accurate predictions, because the highest amount of people will be participating, said Dr. David M. Pennock, senior research scientist at Overture Services Inc., a Web search advertising company in Pasadena, Calif., where he focuses on prediction markets.
The free market is often the best predictor of election results, just as bets on the price of orange juice futures are often able to forecast Florida weather better than meteorologists, Pennock said. In these situations traders often accurately predicted rain and drought periods.
The fact that traders can bet real money increases the odds of accuracy, though the $500 maximum is relatively low compared to other futures markets.
"Traders are not going to randomly pick things, but it's not the same as some of the bigger stakes commodities," he said.
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