If there were ever a time when the country needed a better way to predict elections, it is now.
For a while, it seemed like economists had the answer: create a futures market for political candidates. A decade ago, the University of Iowa received a special waiver to allow gambling on U.S. elections. And so the Iowa Electronic Markets were born to test an economic theory: the efficient markets hypothesis.
The theory is simple. It states that the current price of any commodity in an exchange market reflects the total amount of information available at the time; in other words, it's the "correct" price or the best possible prediction.
In terms of politics and predicting elections, the implication is that free markets are smarter than polls or pundits. However, it seems that for the time being at least, economists will have to go back to the drawing board with the rest of us, for the futures markets performed as badly, if not worse, than astrology, sports superstitions and every other method for handicapping the presidential race.
There are actually two presidential markets in Iowa. The more popular version is called the winner-take-all market, in which investors buy futures contracts that pay $1 each on Nov. 10 if your chosen candidate wins the popular vote as reported by the New York Times that morning.
The other market is called the vote-share market; it pays out $1 multiplied by the proportion of the popular vote received by that candidate on the same day. So if you bought Bush vote share futures at 40 cents apiece, and then he garnered 48 percent of the popular vote, you'll walk off with 8 cents for each contract you owned.
This year, both methods failed. As Bush and Gore quibble over who will claim the presidency, the Iowa Election Markets seem to mimic the confusion, delivering two contradictory results.
Iowa's winner-take-all market pegged Bush as the clear winner, with confidence in a Bush win soaring in the days before the election. But on Election Day, the market swung wildly and finally flipped to favor Gore. The ambivalence held: Even as late as Nov. 10, the day the market closed, Gore futures were selling for 96.9 cents, not the full dollar they should have cost, given the payout. The vote-share market was more stable, but closed at an anomalous pricing of 49.1 cents for Bush and 48.1 cents for Gore.
At first blush, the efficient markets theory seems a reasonable way to predict elections. Think about it: If a pollster calls you up and asks you who you plan to vote for or who you think will win, you have little incentive to carefully consider your answer. Maybe you say you'll vote for Bush or Gore, but when Election Day comes around, you never make it to the voting booth. Maybe you aren't a very representative voter. These are the intangibles that have driven generations of political scientists crazy.
But if you, the respondent, has to put your money where your mouth is, it's a different story altogether.
Regardless of your political affiliation, you'll make the prudent bet -- placing your money on the candidate you think will actually win. It's a bet based on the belief that the true odds of a particular candidate winning -- according to you -- are greater than the odds determined by the market, that is, that you know something everyone else does not. This is called arbitrage. Of course, as soon as you put in a buy order for Bush, the equilibrium price goes up, reflecting the impact of your "bet."
Hence the notion that the market perfectly reflects the future as suggested by the present.
In a recent paper, professors Steve Kou and Michael Sobel of Columbia University claim that, all else being equal, "when market participants have access to poll results, the market forecast is superior" to preelection polls. Market forecasts should be able to predict elections for the same reason that agricultural futures like pork bellies and cotton do a better job of predicting the climate than the National Weather Service: The numbers reflect the informed judgment of people who have money on the line.
But why were the Iowa Electronic Markets so erratic in predicting this year's election? Perhaps the simplest explanation of why both markets performed poorly and converged to different results is that the they were too small.
Officials who manage the Iowa Electronic Markets report that the total capitalization at the close of the winner-take-all market was about $70,000, with a meager $6,500 for the vote-shares market. The lower the betting pools -- that is, the amounts at stake -- the more room there is for market imperfections. Smaller sample sizes yield less accurate statistics. Prices should converge to their "true" value as the number of traders and the amount capital in the market increases.
It is entirely possible that, had the markets been better publicized and attracted a lot more capital, they would have performed better. But there are a number of reasons to be suspicious of this facile explanation when it comes to politics.
First of all, politics pollutes markets. Perhaps people who are passionate about their candidate bet money on him in order to show support even though all available information spelled failure. In other words, maybe betting in an election market is more like making a political donation: Knowing that others watch the price of the Bush and Gore futures as an indicator, perhaps some investors spend money like a political advertisement to promote the inevitability of their favored candidate. Possibly, Bush supporters are more strategic or more committed in this way. They put their mouth where their money is.
Secondly, inequality matters. On average, Bush supporters are wealthier than Gore supporters. Therefore, they can afford to be less risk-averse than the Gore camp.
Think about it this way: If you support Gore, but only earn $20,000 a year, you might think twice before you bet $100 of your precious cash on Gore. If you're a millionaire Bush supporter, betting $100 or even $1,000 in an election market is no big deal.
This stems from another economic theory: the declining marginal utility of money. If you already have $1 million, one additional dollar means a lot less to you than if you have only $10 to your name, when it makes up 10 percent of your total net worth. So the value of money may be different to Bush and Gore supporters.
Another reason why the Iowa markets failed relates to the use of futures to hedge risk. Stocks, commodity futures, options and even insurance were all once forbidden by anti-gambling laws. Now they're a socially acceptable way to make a living or to protect one's assets from risk.
When viewed as a way to hedge risk, election futures make sense: After all, the elections have enormous impacts on stocks, bonds and the value of other financial instruments both here and abroad. Futures are all about hedging risk, so why shouldn't we hedge our political risk as well? If I'm one of the top 1 percent of American earners who stands to gain enormously from a Bush election, I may want to insure myself against his loss by purchasing Gore futures. This would suggest that investors would bet against their preferences and/or predictions.
Whichever way the election turns out, economists should take note. Markets are not all-knowing or all-powerful. There is a constant battle between the passions and the interests -- and sometimes the passions win. Markets cannot be universally relied on to predict the future any more than religion, astrology or genetics can.