Policy Analysis Market

Introduction

The Defense Advanced Research Projects Agency (DARPA) was born in the uncertain days after the Soviets launched Sputnik in 1958. Its mission was to become an engine of technological change that would bridge the gap between fundamental discoveries and their military use (Bray, 2003). Over the last five decades, the Agency has efficiently gone about its business in relative obscurity, in many cases not getting as much credit as it deserved. The Agency first developed the model for the internet as well as stealth technology. More recently, DARPA innovations have spanned a wide array of technologies. To name a couple: computers that correct a user's mistakes or fix themselves when they malfunction and new stimulants to keep soldiers awake and alert for seven consecutive days.

Because DARPA is mandated to take on risky projects, failures have occurred. For the most part, however, the agency's low profile has protected it from inaccurate scare stories cropping up in the popular press. However, in 2003 DARPA has managed to make the front pages twice, both times with disastrous results. Earlier in the year Congress moved to scale back the agency's Terrorism Information Awareness Program (TIA). In an effort to spot patterns of terrorist activity, this program proposed the development of advanced computer systems capable of scanning commercial databases containing information on millions of Americans.

Then, in late July, the Agency backed off a plan to set up a kind of futures market (Policy Analysis Market or PAM) that would allow investors to earn profits by betting on the likelihood of such events as regime changes in the Middle East. Critics, mainly politicians and op-ed writers, attacked the futures project on the grounds that it was unethical and in bad taste to accept wagers on the fate of foreign leaders and the likelihood of terrorist attacks. The project was canceled a day after it was announced. Its head, retired Admiral John Poindexter, has resigned.

The debate over the Policy Analysis Market has been quite contentious, but there have been few answers to several critical questions: How were the markets supposed to work? What were PAM's underlying theoretical and empirical assumptions? What was PAM supposed to produce in the way of intelligence? As the title of this essay asks, was the project an innovate way of thinking outside the box or just an off-the-wall idea?

How the Policy Analysis Market (PAM) Would Have Worked?

With the development during the last several decades of well functioning futures markets for many commodities, private sector analysts often use the prices from these markets as indictors of potential events. The use of petroleum futures contract prices (Looney, Schrady, Brown, 2001) is an example of the manner in which traders gauged the likely outcome of events such as the U.S. Naval response to Iraq's invasion of Kuwait in 1990. In a like manner, the movement of petroleum futures prices in late March 2003, after the recent Iraq war began, reflected the implications traders drew concerning the outcome of the conflict--falling rapidly in the first few days of the conflict, but rising again after it became apparent the Iraqi regime would not fall in a matter of days. Before the Iraq war began, oil prices, incorporating a war premium, suggested there was a very high probability of a conflict (Leigh, Wolfers and Zitzewitz, 2003).

In a similar fashion, the proposed Policy Analysis Market would have provided the U.S. Intelligence Agencies access to a wide variety of markets in various events. Trading in these events, as in the case of petroleum futures, would produce price movements that could be easily translated into the likely occurrence of future incidents, such as the likelihood of a coup in Yemen.

Fig.1 DARPA's Vision of the Contribution of Markets to Intelligence

The presumption was that in many cases, intelligence derived in this manner would be more accurate than that obtained through traditional means (Fig. 1) Initially the site was to be confined to political economic, civil and military futures of the key Middle Eastern countries of Egypt, Jordan, Iran, Iraq, Israel, Saudi Arabia, Syria, and Turkey, and the impact of U.S. involvement with each. A typical bet would involve issues such as whether the United States would pull its troops out of Saudi Arabia (Coy 2003), or whether the Egyptian currency was likely to fall by 20% by the end of the year. Assassinations, the most controversial feature of PAM and the most publicized, were not officially listed as a likely market.

Operationally, PAM planned to offer three types of futures contracts:

* Quarterly contracts based on data indices that track economic health, civil stability, military disposition, and U.S. economic and military involvement in Egypt, Iran, Iraq, Israel, Jordan, Saudi Arabia, Syria, and Turkey

* Quarterly contracts that track global economic and conflict indicators such as the likely occurrence of a regime change in Syria

* Specific possible events (e.g., U.S. recognition of Palestine in the first quarter of 2005)

At the expected start of trading (October 1, 2003), there were to be contracts of the first two types. These were scheduled to mature at the end of the 4th quarter 2003, 1st quarter 2004, 2nd quarter 2004, and 3rd quarter 2004. On January 1, 2004, contracts were to be issued that matured at the end of the 4th quarter 2004. In this way, the forward view of PAM was to be maintained at one year. The plan was to add contracts of the third type as relevant situations presented themselves.

Another design innovation permitted traders to take positions based on interrelated issues. For example, the economic health of a country may affect civil stability in the country, and the disposition of one country's military may affect the disposition of another country's military. The trading process at the heart of PAM allowed traders to structure combinations of futures contracts (Fig. 2). Such combinations were to be structured to represent predictions about interrelated issues of critical interest to the intelligence community. The idea here was to create chains of events leading up to the activity of main concern. It was anticipated that trading in event structured derivatives of this type should result

Fig. 2 Structure combinations of futures contracts

in a substantial refinement in predictive power. In effect this process would be similar