All Bets Are Off The so-called terrorism futures market sounded like a hoax: investors would have been able to make money from attacks and strife. Now that the red-faced Pentagon has closed down the project, it's appropriate to ask, "What were they thinking?" The Department of Defense argued that markets "are extremely efficient, effective and timely aggregators of dispersed and even hidden information . . . often better than expert opinions." That's true. The University of Iowa has a neat system allowing bettors to establish the odds for candidates in races in America and overseas. The Iowa markets have generally done a better job than pollsters at predicting the outcomes of elections. Markets also do a great job at more traditional tasks, like matching buyers and sellers and setting prices for everything from chickens to semiconductor chips. Still, the Pentagon's concept is flawed. Markets are not very good at setting prices for rare events. Those who trade in the Iowa political exchange have the benefit of historical election results and daily polls; property insurance companies know full well when the Florida hurricane season starts. But could markets have given us a price for the odds of a shooting in the balcony of City Hall in New York? Sure, markets learn from experience. It's been a long time, though, since Aaron Burr shot Alexander Hamilton � and that was across the river in New Jersey. Before Saddam Hussein invaded Kuwait in 1990, I directed a White House study on the Strategic Petroleum Reserve. Should we add to the reserve? What were the chances of a war in the gulf or an OPEC boycott like the one in 1973? These events take place intermittently and are hard to predict. But we had to make some estimates. Likewise, in order to allocate our domestic defense resources, we have to estimate the odds of terrorist events on the ground, in the sky or at sea. Here again, markets work better when they are deep and liquid � that is, with many participants and lots of transactions. This raises reliability and reduces the risk of manipulation. How deep and liquid could the market for terrorism futures be? This was the problem faced by the Pentagon. To attract "investors," the Pentagon needed to offer a significant payoff. But with big payoffs, the incentive for market manipulation rises. And in the case of terrorism futures, market manipulation can show up not as a forged buy order but as a bullet. http://www.nytimes.com/2003/07/31/opinion/31BUCH.html