Trading futures on the Web’s ‘prediction markets’

I’ve been making some pretty big Hollywood deals lately.

I’m swimming with the sharks on Wall Street too, and raking it in thanks to my uncanny knowledge of the Fed and currency exchange markets.

So how come I’m not rich?

Alas, it’s all a game. Through the magic of the Internet, I’ve been participating in simulated financial markets that let people wager fake money on the outcome of real events.

Economists have long known that financial markets can forecast events with remarkable accuracy. That’s the whole idea of futures markets -- people trade based on what they think the price of crude oil or winter wheat or pork bellies will be at some future date. Even if most individual traders guess wrong, the market as a whole almost always comes very close to the actual price.

Recently, some economists have suggested that people ought to be able to trade futures in just about anything: the weather; medical and technological advances; the outcome of political contests. These markets could help shape government policies, guide venture capital to the most promising new technologies or help society prepare for natural disasters and other catastrophes.

Internet sites have cropped up that allow the general public to speculate in these “prediction markets.” A site called Hedgestreet lets sub-millionaires speculate in markets normally reserved for the Wall Street elite. The Iowa Electronic Markets, operated by the University of Iowa business school, have let players wager as much as $500 on the outcome of every presidential election since 1988.

There also are play-money markets -- such as the Washington Stock Exchange, which lets political junkies speculate not just on elections but on the appointments, resignations, legislative showdowns and such that make life on the Potomac so thrilling. On the left coast, the Hollywood Stock Exchange lets the moviegoing public predict which new releases will be blockbusters.

Spurred by the profit motive, people bring to markets everything they know and place their bets accordingly. That means markets, with all their chaotic buying and selling and hedging and speculation, are very efficient mechanisms to bring together information.

All that information is revealed in one simple number -- the price.

“The idea here is that prices aggregate information, the oldest idea in economics,” said Justin Wolfers, a professor at the University of Pennsylvania’s Wharton School of Business. “What we’re seeing now is excitement about moving this beyond the standard financial sector.”

Because of state and federal gambling laws, most currently operating prediction markets have to use play money instead of real cash.

The Inkling Markets website uses a currency that is completely worthless. Right now you can use your Inklings -- as the site’s faux currency is called -- to bet on who will win the New Hampshire Democratic primary, what the federal funds rate will be three months from today or which city will host the 2016 Olympics.

But the fact that you can’t buy anything with your winnings doesn’t seem to hurt the performance of Inkling Markets. Top traders in the Inkling Market say they are motivated by competitiveness, the simple desire to see themselves atop the site’s leader board.

“When I log in, the first thing I do now is check the top 10 list and see how No. 2 has been doing,” said Mike Giberson, who was in first place for most of this spring but slipped into second recently.

I, on the other hand, find myself somewhere in the neighborhood of 400th in the Inkling rankings. Whether that’s enough to maintain my interest over the long haul remains to be seen.

That’s one reason some economists dream of the day any American can put real money down on, say, the number of people who will be killed by terrorists in the United States between now and 2010, or whether a hurricane will make landfall in Florida this year.

“Using these markets as forecasting tools could substantially improve decision-making in the private and public sectors,” more than 20 economists said in a letter sent to Congress and federal regulators in May.

The letter urged the government to carve out a “safe harbor” in the nation’s online gambling laws for nonprofit, small-stakes, real-money markets that produce useful information as a byproduct of traders’ efforts to make a buck.

The economists suggested that any “economically meaningful” subject ought to be fair game, but not the kinds of things that would traditionally be considered gambling, such as markets based on sporting events or the outcome of “American Idol.”

The issue of what constitutes gambling looms large over the future of prediction markets. The Pentagon’s Defense Advanced Research Projects Agency learned that the hard way a few years back when it funded a few economists to set up experimental markets that would track America’s national security interests in the Middle East. The markets would have allowed traders to buy futures contracts on measures of military activity, economic growth and Western terrorist casualties in eight Mideast countries.

The hope was that prices in the Mideast security markets might give U.S. intelligence officials a leading indicator of developments in the region. But the project was aborted in 2003 when members of Congress protested that it would allow people to gamble on terrorist attacks the way they would on a football game. Opponents objected to the possibility that people might profit from a terrorist attack, or that terrorists themselves might manipulate the market to their advantage.

Many skeptics argue that surveys work just as well or better than prediction markets in accumulating the knowledge of the masses. A recent study by Columbia University economist Robert S. Erikson compared the accuracy of the Iowa Electronic Market to that of public opinion polls during the 200 days leading up to the last five presidential campaigns.

Though he found the raw market predictions were generally closer to the election vote percentages, Erikson argued that the polls were better if you adjusted for things that they chronically misjudge, such as the incumbent’s early advantage.

In other words, polls -- combined with the knowledge of an experienced pollster -- can outperform the market.

But even though he is skeptical about markets in the context of head-to-head presidential contests, Erikson thinks they have value in other situations, such as the free-for-all that is the early primary campaign season -- i.e., now.