One common worry about NGDP futures markets is that no one would be interested in trading the contracts. After all, if there was interest then why wouldn’t someone already have created such a market?
In fact, the lack of interest in NGDP futures would actually improve the efficiency of an NGDP targeting regime. If lots of people wanted to hedge against NGDP risk, then a futures price might be biased, it might not reflect the expected future level of NGDP. In other words, it might include a risk premium.
But the bigger problem with these critics is that they haven’t bothered to even read the proposals. The plan is to have the Fed subsidize futures trading, at a level high enough to create a relatively efficient market.
Robin Hanson makes a similar point (when criticizing Casey Mulligan):
No, a market can single-task, with no other function than prediction, and no other trader motive than selfish financial profit, if someone who wants the info will pay to subsidize the market. It is only when you want people to answer your question for free that you’ll have to piggyback on their having some other reason to trade.
Of course there’s no guarantee that your willingness to pay for some info exceeds other folks’ cost to supply that info. Supply and demand curves need not intersect at a positive quantity. But that’s hardly a failure of an info exchange mechanism.
Later Robin criticizes Snowberg, Wolfers, and Zitzewitz on much the same grounds:
Noise traders are traders who subsidize your market for free, for reasons of their own, such as risk-hedging, idiocy, etc. If you fail to attract noise traders, you fail to get their free subsidy. But you can still offer to directly pay for your info, by subsidizing the market, as the Microsoft sentence in the quote indicates. Similarly, if employees find executive questions uninteresting, that just means they won’t answer such questions as freely in their spare time. But that hardly means firms can’t pay employees to address key firm questions. Here we are only talking about a “failure” of prediction markets to mooch stuff for free!
Given the cost of business cycles can run into the trillions of dollars, I don’t see any problem with the Fed spending a few millions, or even tens of millions, to insure interest in an NGDP futures market.
Michael Sankowski says the following:
Economically useful contracts apply to every possible futures contract design. If the contracts aren’t economically useful, nobody trades them. This means the Central Bank does not get private sector forecasts from NGDP level futures.
Michael still doesn’t seem willing to actually read the proposals; otherwise he would have known that the market would be subsidized, so there is zero risk of no one trading the contracts. If no one else trades, I will, and I’ll gladly walk away pocketing the entire multi-million dollar subsidy.
Later he repeats the claim that Goldman Sachs would walk off with $500 billion despite the fact that the Fed could easily set up the market in such a way that it never took a net long or short position. I think people might find it more useful to think of this as a “prediction market” rather than a “futures market.” The point is to have the public predict the monetary policy instrument setting that is most likely to result in on target NGDP growth. There are many ways of doing this, some allow the Fed to take a position (if it sees market inefficiency) and others work more automatically, setting the instrument at the point where the public’s net long and short positions exactly balance out. It’s entirely up to the Fed how much risk it wants to take. I could easily visualize a small prediction market, in the millions of dollars, not billions. Studies suggest that even smaller prediction markets (in the thousands of dollars) can be highly efficient.
Here’s another common misconception about prediction markets, this time from Free Exchange:
FOR over a year, the prediction market site Intrade offered a contract on whether the Supreme Court would rule the Obamacare’s individual mandate unconstitutional by the end of 2012. For most of its life, the contract traded below $5; the collective wisdom of the market suggested the mandate would stand. In late March, however, a surge of public scepticism about the Court’s tolerance for the mandate led to an impressive jump in the price. By the eve of the Court’s ruling, the market put the odds that it would be struck down at nearly 80%. Then the fateful day arrived—and on word that Chief Justice Roberts voted to uphold the mandate as a tax the contract instantly plummeted to near zero. So much for the wisdom of the markets, right?
Not quite, says a new NBER working paper by Erik Snowberg, Justin Wolfers, and Eric Zitzewitz. Their research sets out to show how prediction markets can provide the best available estimates of future events and figures. Yet while the paper argues strongly for the utility of markets, it also offers plenty of reason to treat their conclusions cautiously.
. . .
In what ways do prediction markets fail? The paper provides some discouraging answers. First, they struggle when there is a high degree of insider information. On the question, “Will the mandate be struck down”, for instance, only the Chief Justice himself could say for sure, and so the market was likely to be wrong. There must be information to aggregate.
The market didn’t “fail” at all, the 80% forecast was probably the optimal forecast. And it’s not true that the traders had no information—the questions asked by the conservatives made many people think they were leaning toward rejecting the individual mandate. And they were leaning that way! Kennedy was almost universally viewed as the swing vote, and even he ruled against Obamacare. What few people expected was a last minute change of heart by Roberts. Sure, there was always some uncertainty, that’s what 80% means. That’s why the market didn’t price in a 100% chance of the law being overturned. (Robin Hanson makes a similar argument.)
Consider the following analogy: Two prediction markets are set up to predict the toss of the coin before the next Super Bowl. One says 50% odds of heads and the other says 58% odds of heads. Then the coin is tossed, and it’s heads. Which market “failed?” I’d say the market with the 58% forecast. They made a bad forecast and simply got lucky. I find people are way too mesmerized by predictive success. The important issue is whether a market delivers an optimal forecast, not whether it turns out to be correct in any single case.