Harvard economist Greg Mankiw recently posted this chart depicting an InTrade contract on the probability of a U.S. recession in 2008, with the following commentary:
In online betting, the probability of recession is now about two-thirds, compared to about one-half a few weeks ago.
Evidence pointing toward a recession is certainly present, as Larry Summers and others have noted. Still, experts drawing conclusions about the economy’s future based on a single InTrade contract may be risky, particularly given that, as of Jan. 8, less than $40,000 had been traded since the contract’s inception, a tiny amount even by prediction market standards (compare that to the over $3.8 million that had been traded as of the same date for “Hillary Clinton to be the Democratic Presidential Nominee in 2008″ — you’ll find more analysis of Clinton contracts here and here).
The numbers beg the question: even beyond politics, are we giving too much weight to smaller prediction market contracts? It’s worth acknowledging that in the prediction-market world, an individual betting a few hundred dollars could raise the “likelihood” of an upcoming recession by 20 points.
(Hat tip: John De Palma)
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David,
Speaking as a professional arbitrager, arbitrage does not require any knowledge at all (other than arithmetic). Read up on arbitrage before you start arguing about it, please.
Jeffrey,
Bigger prediction markets are the combined knowledge of people who have a lot of money AND are so confident of their knowledge they are willing to put it at risk. Powerful evidence shows prediction markets have better predictive power than polls. So what does it mean to say they “don’t work”?
These markets have had already had attempts at manipulation in the past. The market reacted exactly as Walter explained.
Some more important questions for me would be:
1. Is this prediction market gambling? If not, how would it differ from sports betting? Conversely, I believe that this is one proof that sports betting is not gambling either in the true sense as the sports bettor is betting into a dynamic market, not a static game such as roulette.
2. Is Intrade prohibited by the UIGEA? They may not be able to accept US credit cards, which would decrease their liquidity and their predictive value.
3. Perfect arbitrage situations can exist with these prediction markets. There are no market makers and the contracts can be very illiquid.
4. Intrade (formerly Tradesports) has had settlement issues in the past, such as with the recent North Korean Missile Contracts. With that contract, they required confirmation from the DoD on the NK missile test. However, the DoD never commented in an official capacity so the contract expired as a “no”. I do not know the final resolution and whether Tradesports simply unwound and repaid everyone.
I went and did some research and it was the Bush election contract in 2004 that had unusual trading activity. Here is the supporting link:
http://www.nationalreview.com/nrof_luskin/luskin200410181132.asp
One interesting point is that the Intrade contract only pays out for 2 quarters of negative real gdp growth, which is the standard definintion. The last “recession” of 2000/2001 as declared by the NBER never had 2 consecutive quarters of negative growth. Thus, the Intrade contract would not have paid out since 1990/1991, which was the last time that the U.S. economy met that measure. The data:
http://www.economagic.com/em-cgi/data.exe/var/rgdp-qtrchg
One thing that must be considered is the transaction costs. Looking at the current NEW.DEM.VP.* contracts, the top fifteen candidates are currently trading at around 150% total. With no transaction fees, this would be a dream to an arbitrageur. However, under Intrade’s rules, selling one of each contract will cost $0.70 in fees, and the profit is reduced from $1.50 to $0.80.
This is still (currently) a good deal for an arbitrageur, but close to half your profits are going directly to intrade. If the top fifteen vice-presidential candidates had added up to only 129%, there would be no arbitrage opportunity.
Transaction costs create enough friction that the prediction markets should not be taken at face-value. IEM is probably different, since it is not-for-profit.
Additionally, I should note that H. Clinton’s chances of winning the Presidency (4.5%) are currently higher than her chances of winning the nomination(3.9%). This is apparently another risk-free arbitrage opportunity. But if you sell 1 contract for 2008.PRES.CLINTON(H) and buy 1 contract for 2008DEM.NOM.CLINTON, the transaction fees force you to sell 2008.PRES.CLINTON(H) at an actual value of 4.2% and buy 2008DEM.NOM.CLINTON at an actual value of also 4.2%. The most likely outcome is that Clinton is not nominated, and is not elected — in which case you break even. This is also your best case.
The transaction and expiry fees on Intrade are high enough that anyone following this market as a spectator must include a 1.5 percentage-point margin of error in any reported prices. Lower, admittedly, that the usual Gallup or Rasmussen poll. But the usual grain-or-three of salt must be taken.