Risk Markets And Politics

Tuesday, May 22, 2007

Policy Event Derivatives

The essential purpose here is to advance the ideas of public policy markets and tax futures. To this end, we can once again show that such markets help to address well-known problems that arise in government.

Consider the typical "special interest" problem as described in public choice economics. A concentrated group stands to profit from a legislative decision. Say, for example, there are one hundred people in an industry, and that each one would make one million dollars from a proposed government subsidy. They will lobby heavily for this subsidy, and indeed spend money in the process. On the other hand, if there are 100 million other taxpayers, they will each have an additional implied tax burden of one dollar (or likewise a tiny reduction in real purchasing power) and thus individually they will not care to oppose the subsidy and likely will not even know about it. And so the bill goes through, irrespective of its true merits.

Yes, there is more at work among voters than rational ignorance. Voters do have irrational biases on certain issues, but this fact is not a challenge here. If anything, it underlines the desirability of being able to hedge against bad legislation and policy.

Now, when markets that predict the outcomes of legislation and future tax rates are in place:

  • The dispersed interests, by betting on outcomes otherwise negative for them, will have a recourse specifically against involuntary transfer payments, and generally against government overspending and other bad policies.
  • Risk-averse concentrated interests will have the option of hedging legislation, by betting against their natural desirable outcomes.
  • The demand for congressional "favors" and lobbying itself might be reduced. Instead of embarking on costly and uncertain lobbying campaigns, special interests can quickly reduce risk in the market.
  • The legislators may find compromises to be easier, since private individuals would be able to voluntarily "meet each other half way", with price being the arbitrator. This could ease political log-jams, making law-making itself more flexible and efficient. Sensible yet otherwise politically infeasible measures such as unwinding entrenched subsidies could be made viable.
  • All interests will be able to make decisions with less uncertainty about the future.
All of the above advantages stem from the risk-sharing capacity of these markets, but the informational value of their prices could ultimately be even more valuable.

  • Such markets should improve the quantity and quality of public debate on relevant issues, since it will be more likely for large wealthy concerns to have a stake in what would otherwise be a dispersed interest.
  • Consider a pair of markets predicting some macroeconomic variable such as unemployment, conditional on whether or not a certain policy is adopted. The market prices will give a clear signal as to which policy is more desirable according to the pooled knowledge and expertise of the participants. In this case, market rewards would be established for policy expertise.
Much of the literature on policy markets has in fact focused on such informational aspects. Only a few to date have considered the benefits arising from the risk-sharing itself, but what research there is suggests yet another positive result:

  • The existence of hedging markets could improve the efficiency of outcomes of elections in which candidates promise redistributive policies. That is, if total wealth will be greater in a certain outcome, the existence of hedging markets will make that outcome more likely.
This is the argument of Ole Jakob Bergfjord, and, in an under-appreciated paper, David Musto and Bilge Yilmaz. (Note that we are now talking about a contract on an election with redistributive implications, though this is essentially the same as a contract on a piece of tax or subsidy legislation.) Like all models, the one developed by Musto and Yilmaz carries assumptions that may not hold in the real world. Specifically, they ignore transaction costs, which can be crucial when one of the interests is heavily dispersed. (Musto and Yilmaz also predict that elections will be determined by ideological positions to a greater extent when risk-sharing markets are in place. Let us call this a neutral effect of these markets, for now.)

Turning to the likely development of policy event derivatives, although the special and dispersed interests are natural counter-hedgers, which is an oft-cited condition for a successful market, it is likely that speculators will stand in for the dispersed interests at first. Commonly, the speculators will try to capture a premium by providing insurance to the special interests, and the first speculator to join the market should capture the largest premium.

Though we often use the term "futures", and enthusiasts of new markets are biased towards exchange-traded contracts, it is likely that such markets will begin in an over-the-counter environment. The news suggests markets with regularity: the estate tax, energy windfall taxes, the ethanol subsidy, etc. In fact it is surprising that we have not heard of such deals yet. In addition to all of the positive effects listed above, this could be the biggest untapped business on earth. People in finance are usually not reluctant to interject themselves into trillion dollar flows.

Leo Melamed, while developing the now $2 trillion/day foreign exchange markets in the early 1970s wondered, "if offering 'dollar futures' [...] was so logical, why hadn't anyone else thought of it? I wasn't sure if there was an obvious reason why it wouldn't work." With policy event derivatives, there are clearly many legal and regulatory obstacles in the way. At the same time, the idea of betting on government strikes many as unnatural and suspicious, a rough beast slouching towards Washington, so to speak. This anti-market bias has helped to keep people from thinking about such markets, and of course, businesses already having success in conventional areas are reluctant to raise the eyebrows of Washington.

There are other potential issues with these markets that we've addressed before, but none of them seem to be insurmountable. Even if these markets come to be explicitly outlawed in a given country, one can be confident that they will be given their fair try somewhere in the next ten years. As the old Nymex slogan goes, "evolution is inevitable".

Previous:
Tax futures and the libertarian paradox
Tax Futures
Some benefits of legislation-linked derivatives
Why we don't have tax futures

2 Comments:

  • The dispersed interests, by betting on outcomes otherwise negative for them, will have a recourse specifically against involuntary transfer payments, and generally against government overspending and other bad policies.

    The existence of hedging markets could improve the efficiency of outcomes of elections in which candidates promise redistributive policies. That is, if total wealth will be greater in a certain outcome, the existence of hedging markets will make that outcome more likely.


    Note that this is a Coasean solution(?) to the public good problem, which may be applicable in other contexts (see Mike Linksvayer's list of related concepts). Transaction costs are clearly relevant.

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