Numerous studies have shown that prediction markets performs remarkably well. For example prediction markets consistently beats opinion polls in predicting the outcome of elections. In general the wisdom of crowds is an extremely powerful tool for forecasting and there no doubt the markets are the best aggregators of information known to man.
Market Monetarists advocate using the power of prediction markets to guide monetary policy. Scott Sumner of course is advocating using NGDP futures in the implementation of monetary policy (as do I). Furthermore, I have advocated that central banks replace their internal macroeconomic forecasts with prediction markets and also that central banks could use Robin Hanson-style prediction markets to choose between different policy instruments in the implementation of monetary policy.
The advantages of using prediction markets are in my view so obvious that one can only wonder why prediction markets are not used more by policy makers – not only in monetary policy, but just think about the endless discussions about “climate change”. Why have policy makers not set-up prediction markets for the outcome of different “climate initiatives”? I think the explanation have to be found in public choice theory.
William Niskanen argues forcefully in his classic book on “Bureaucracy and Representative Government” (1971) that bureaucrats are no different from the rest of us – their actions are determined by what is in their own self-interest. Niskanen claims – and I think he is more or less right (I used to be civil servant) – that that implies that bureaucrats are maximizing budgets.
So how do bureaucrats maximize their department budgets? Well, it’s really simply – they use asymmetrical information. Take what is now called the Department of Homeland Security in the US. The job of the Department of Homeland Security’s is to monitor the risk of terror attacks on the US and implement policies to reduce the threat against “homeland security” (whatever that is…). If the Department of Homeland Security can convince the US taxpayers that the US faces a massive terror threat then the department is more likely to get allocated more funds. So if the Department of Homeland Security bureaucrats want to maximize their budget then it just have to convince the American public that the US faces a very large terror threat.
The average US taxpayer does not really have a large incentive to go out and find out how big the terror threat really is and remember as Bryan Caplan tells us that voters tend to be rationally irrational (they don’t really have an incentive to be rational in terms of political issues) and as a consequence the average US taxpayer would happily accept any assessment made by the Department of Homeland Security about the level of the terror threat. Hence, if the Department of Homeland Security overestimates the terror threat it will be able to increase its budget and as the Department has superior knowledge of the real threat level it can easily to do so. This of course is just an example and I have no clue whether the authorities are overestimating the terror threat (I am sure my US readers will be happy to tell me if this is the case).
Hence, a bureaucrat can according to Niskanen’s theory maximize its budgets by using asymmetrical information. However, there is a way around this and reduce the power of bureaucrats. It is really simple – we just introduce prediction markets.
Lets say that we set up one prediction market asking the following question: “Will more people die in terror attacks than in will die in drowning accidents in the US in 2012?” – Then this “terror/drowning”-prediction could be used to allocate funds to the Department of Homeland Security. My guess is that we would be looking at major budget cuts at the Department of Homeland Security. What do you think?
Anyway, my concern is not really the Department of Homeland Security, but rather monetary policy. If you think that the bureaucrats at the US Department of Homeland Security would use asymmetrical information to increase their budgets what do you think central banks around the world would do? Why would you expect central bank’s to pursue any given economic target in the conduct of monetary policy? And why would you trust the central banks to produce unbiased forecasts etc.?
Why is it for example that the Federal Reserve is so reluctant to formulate a clear nominal target? Could it be that it would not be in the bureaucratic interest of the institution? Could it be that central bank bureaucrats are afraid that they would be held accountable if they miss their target?
I don’t know if it is so, but if not then why not just formulate a clear and measurable nominal target? For example a target to increase nominal GDP by 10% by the end of 2013? And why not then use the opportunity to set up a NGDP futures markets? And why not let prediction markets take care of the Fed’s forecasts?
I am not saying that Ben Bernanke and his colleagues are Niskanen style bureaucrats, but if they want to prove that they are not then I am sure that Scott Sumner or Robin Hanson will be happy to advise them on setting up a NGDP futures market (or any other prediction market).
Of course the US Congress (or whoever is in charge) could also just regulate the FOMC member’s salaries based on their ability to hit a given target…
PS The so-called Policy Analysis Market (PAM) actually was meant to be used to among other thing assess the global terror threat. The project was shot down after political criticism of the project.
PPS our friend Scott Sumner is not all about monetary policy – he has also done research on how to use Prediction Markets to Guide Global Warming Policy.
PPS George Selgin would of course tell us that there is an even better solution to the “central-bankers-as-budget-maximizing-bureaucrats”-problem…