Can prediction markets replace politics?

Marc Andreessen, the Silicon Valley entrepreneur who co-founded Netscape, points out that markets don’t seem to be adjusting prices to reflect future costs from climate change.

Premium coastal vacation real estate prices are skyrocketing, he says. It's an interesting point that suggests that markets may think the dangers of climate change are overblown, although it’s important to try to compare this to the counterfactual. Maybe they’d be even more expensive if climate change wasn’t happening – or maybe there’s a scramble of demand for them now, so people can enjoy them before they're underwater!

But markets can be good ways of predicting the future. To the extent that they are a form of betting on the future, they can be a ‘tax on bullshit’:

I am for betting because I am against bullshit. Bullshit is polluting our discourse and drowning the facts. A bet costs the bullshitter more than the non-bullshitter so the willingness to bet signals honest belief. A bet is a tax on bullshit; and it is a just tax, tribute paid by the bullshitters to those with genuine knowledge.

As this paper outlines, markets generate good predictions for three reasons: 

First, the market mechanism is essentially an algorithm for aggregating information. Second, as superior information will produce monetary rewards, there is a financial incentive for truthful revelation. Third, and finally, the existence of a market provides longer-term incentives for specialization in discovering novel information and trading on it.

The empirical evidence (outlined in that paper) is that markets generate good predictions for these reasons, and are difficult to manipulate – even if someone is willing to spend a lot of money to bet on a particular outcome, other participants’ judgment about the outcome will not change, and there is a significant profit opportunity for them to bring the price back to the equilibrium level. Of course they’re not infallible – good incentives cannot always overcome sheer ignorance – but at least when people are wrong there, they lose out.

Futures markets are essentially large-scale betting exchanges for predictions about the future, aggregating all the individual bets people are willing to make. So to scrape out the confounding factors in the example Andreessen gives, why not set up a pure futures market on climate? What will the average global temperature be by 2030, 2040, 2050 and so on?

Here there may be a role for government. It would be very socially useful to know what the aggregated best guess about global temperatures in 2050 is, but there isn’t any demand for this so far. There are not enough 'noise traders', who subsidise other futures markets by betting stupidly, for our fantasy climate markets to exist.

So, in order to generate enough volume for the market to be worthwhile, we need to subsidise it: the government pays a premium on top of the standard, market-driven pay-off for winning contracts when the time comes. This may cost several million pounds or even more – a small fraction of the current climate change budget.

We could use this for other purposes as well. Scott Sumner has long advocated an NGDP futures market so that central banks can target the monetary policy variable that really matters, for instance. And we could set up ‘conditional’ markets on policy questions too: “if the government cuts disability benefits this year, how many more people registered as disabled will be below the poverty line next year?” If the government doesn’t do the cuts in the end, all bets are cancelled, so we have a reliable 'what if?' window into the future.

Heck, if we could agree on some end-goal everybody wants, like average wealth levels weighted by the wealth of the bottom decile with red-line rules about freedom of speech and so on, we could replace the legislature with conditional markets. (We could hold regular referendums on what this 'end-goal' should be.) Robin Hanson calls it futarchy. Anyone could propose a policy, and if conditional markets implied that it would raise long-term wealth levels (or whatever we said the end goal was), it would become law.

It’s far-fetched, perhaps, but if it meant we could abolish politics I wouldn’t bet against it. I guess that makes me a noise trader.