The Legacy of Prediction Markets

This message comes from Avalera. What's it like running a business with Avalera? No thinking about tax and compliance? It's handled calculating, filing, validating, accurately, and audit defensibly Avalera, Aentic tax and compomplliance with Confidence Hey guys, we have an episode for you. We always do, but first we have a question. A lot has happened in the past five or so years and we want to know how you all are holding up Did you make any big decisions that are maybe backfiring now. L did you move to Montana during the pandemic and now your work wants you back in the office in Seattle plan Or is your money in the stock market right now? and you are just like watching it, grow, grow, grow, grow. What are you spending it on We want to check in with our whole planet money community. Does it feel like things cost a lot more these days, groceries, going on dates, doing something fun for your family. Have you found any great life haacks to help you get by or maybe even thrive in this economy? Yeah, we want to hear from you and maybe we'll call you up for a future show about how things feel right now Send us an email about how the economy is affecting you and your life at plananet money at npr. orga and mayaybe we'll call you up to chat St email, plananet Money at MpR. org. All right, Erica, you have a show to start This is Planet Money from NPR Recently, I heard a story that changed how I think about prediction markets. One moment in the story in particular, it was part of the history of where prediction markets came from, which as you may have heard, goes back hundreds of years in some form, but also in another form, prediction markets, as we know them today, were cooked up by economists trying to test some theories on markets. And in this story of the evolution of prediction markets, there's a moment when an economic historian, studying the long ago early roots of prediction markets realizes already a well functioning design of a prediction market. race track Now of course, many of you will say, yeah, obviously gambling is gambling, of course But the part I didn't quite know is that prediction markets for elections were popular and robust until they mysteriously faded away. And one theory is horse racing took over, you know, because instead of an election every year or whatever, you can have a dozen races a week This all comes from this fascinating history of the economic origins of prediction markets. The economists who cooked up the proto prediction markets, the political machines that basically had to financially bet on their candidates hundreds of years ago, and even farther back than that. So today we're going to share an excerert of this story for you comes from our friends at Through Line, NPR's excellent history podcast. They take one big question every episode and bring you the history and context behind it, beautifully sound designed and deeply researched Today we pass it off to host Rund Abdul Futa and throughline for a history of prediction markets Part one Three professors walk into a bar Spring afternoon in nineteen eighty eight Robert Forsythe and two of his colleagues were sitting around a table at a local sports bar called The Airliner in downtown Iowa City And like they often did, the three economics professors got to talking about the news And I would say the conversation was helped because it was a three beer lunch Ams which led to this creativity, I think some days. Three beers each or each of. Okay It was an election year After Super Tuesday, Michael Dukakas was the presumptive frontrunner for the Democratic nomination. That is until a huge surprise upset The Plles had predicted a Dukakus victory, but it didn't happen. It was the day after the Michigan caaucus which as you may recall, Chessea Jackson won. Jesse Jackson He scored a stunning win yesterday in Michigan's Democratic caaucuses, defeating Michael Du Cakus by a margin of nearly two to one in the popular vote. And that was a big surprise. The pooles missed it al togetherether Going in, political polls had shown Jackson and Dukakis running neck and neck But what happened was a blowout Jackson won the Michigan Caucus with fifty three percent of the vote. And Dukakus only got twenty nine percent. And that's where it came from. We said, well, gee, you know as economists, what would we do if we were going to try to predict the outcome or something And what's natural for a bunch of economists is said, well, let's to run a market on it like a stock or commodities market. So Robert and his colleagues got together a couple hundred people, students and faculty at the University of Iowa. They set up an online interface where those people could buy stock in political candidates. And just like on Wall Street, these political stocks could be traded. So for example, when George H. W. Bush and Michael Dukakis ultimately went up against each other in the general election If you didn't like Dukakas' chances, you could sell your shares in him. The overarching idea here, the market might show what people were actually thinking Even better than poles could The wisdom of the crowd And lo and behold, at midnight, the night before election day We ended up predicting the accome of the popular vote within two tenths of one percent That result outperformed major polls, including Gallup, Harris, and CBS New York Times It was so effective that Robert and his colleagues thought We'd like to do this again next selection. This time with a bigger sample size. So we went to the Commodity Futures Trading Commission and asked them whether they would give us permission to operate nationwide. And just so I understand, what was the law that you needed to get around Well, anytime you have people exchanging real money, When the outcome something, the question is is this gambling or not? And even though there's some form of a regulation that's going to oversee you Back then and now, the body that oversees that regulation in the US is called the Commodity Futures Trading Commission, or the CFTC It's been in charge of commodity futures, like markets that set the future price of grain since the nineteen seventies. They've issued us what they called a no action letter. That letter was basically like a permission slip as long as the IOa electronic markets followed a few set rules the CFTC would allow it to do its thing And the roles were we stay small Couldn't accept the conss over five hundred dollars And we didn't engage in paid advertising So they could only run markets on presidential elections. Borts were off the table And the Iowa electronic markets did not make a profit Between nineteen eighty eight and two thousand four, the Iowa electronic markets grew from a one off experiment to one of the most reliable predictors of American presidential elections During that period, its predictions beat traditional polls seventy four percent of the time And as the market continued to grow So did the public's interest in it I'm Bob Bed This is NPR's Morning Edition If you think you know who the next president of the United States will be, there's a place in Iowa where you can back up your convictions with a buck or two. At what point did you realize that Pople outside of the University of Iowa, outside of your orbit, we're starting to pay attention to what you all were doing Well, we started to get a lot of national publicity. This was different enough that before we knew it, the Wall Street Journal and the financial Times of London and NPR NPR in lot of the Television media started picking us up because it was just so different, right? You know I mean, who had ever made a market on an election Oh, so they thought this was the first time something like this was happening. That's right. That's right. It was, of course, N the first election betting market, not by a mile After the break, we go back farther and meet an economic historian trying to find the origins of election betting More through line after the break This message comes from Granger. For the ones who get it done, Granger offers the professional grade products you need to get the job done With fast delivery and access to technical product experts ready to help you meet any challenge. Call, click granger. com or just stop by This message comes from Rosetta Stone Rosetta Stone Sapphire personalizes your language learning. Get unlimited access to all twenty five Rosetta Stone languages and saapphire learning tools. Visit roosettaestone dot com slash npR and receive twenty percent off Support for this podcast and the following message come from e trrade from Morgan Stanley. Discover a wide range of investing choices and banking solutions all in one place. Plus get up to one fif five hundred dollars when you open a brokerage account with a qualifying deposit today. Learn more at erade dot com slash offer. Banking products and services are provided by Morgan Stanley Private Bank National Association, member FDIC. Terms and other fees apply. Investing involves risks, Morgan Stanley Smith Barney LLC, member SIic Okay, let's call this part two the race track. We pick it up with run from through line and Coleman Strump I am an economics professor at Wake Forest University They've been teaching a course on prediction markets for Almost twenty years. Coleman may be an economist, but his driving interest is in human behavior On top of prediction markets, he's written papers about illegal file sharing, tax evasion, and the economics of addiction And he says, if you want to understand where prediction markets came from Just head down to your local horse track My uncleoy used to take me to the race track and haven't me been on horses. I guess I was already a social scientist in training at ten years old because First of all, yes, back many, many years ago, you could be ten years old and go to a raceetrack in bed and I couldn't even reach up to the counter and nobody seemed to care very much. But it was as interesting as much to me to watch what everybody else was doing And a lot of things that I see When I look at markets today, I could sort of first see then Watching people read the odds and make bets taught Coleman something essential about gambling. Winning makes people feel good And the longer the odds better the winners feel I remember when I was younger and I was watching people do it If somebody would bet on a long shot horse and that horse would actually win. The person would not only win a lot of money But they were going around to all their friends saying how smart they were because they managed to figure out this very, very unlikely thing from happening. And I sort of realize that's part of the sort of the psychology of these markets is people like to be smart. People like to use this as a way of sort of showing off their smarts of how they figuure these things out. I should say here, there's been a lot of back and forth over the years about whether or not addiction markets are really just betedting dressed up as something fancier orr if you're looking at legal definitions whether they might count as gambling We're not here to litigate that Coleman's point is as long as people have been putting money on things, whether it's on the stock market, in insurance, or at the rac trrack Social scientists and economists have been able to learn something about us from those bets Fash forward to the two thousand presidential election George W. Bush versus Al Gore one of the closest presidential races in a century Coleman was doing research about election forecasting at the University of North Carolina He was keeping a close eye on the Iowa electronic market I was writing a paper about the Iowa electronic market when my then colleague was at the University of North Carolina at the time, Paul Rody came by my office asked me what I was doing and I said, I'm looking at the first political prediction market we have And Paul, who is an economic historian said, noope, that's totally not correct He was MIT and I'm Stanford. and a lot of times creative frictions happen from people with different perspectives That's Paul Rody He's an economic historian at the University of Michigan But back in the early two thousands, he worked down the hall from Coleman at the University of North Carolina I happen to be reading some film at the library and came across news stories in October, november, nineteen twenty four about election markets. So I go up to Coleman Strump to his office and say, Hey, did you know these happened and he wasn't aware that they happened. So it was an interesting surprise for both of us Paul and Coleman started digging into the archives in earnest And it turns out prettyretty much as long as there have been elections People have been betting on them Back to the sixteenth century. betting on who would become the Pope Elections in city states in Venice and Geneoa. and in the US, you can like find markets going back to George Washington. How long the StAamp Act would be in place before the American Revolution Paul and Coleman say for centuries, these markets stayed relatively small There wasn't a ton of money on the line Sometimes the bets didn't involve money at all. If the candidate I support doesn't win, I'm gonna cut my beard O I'm gonna walk from New York to Boston. or You have to eat a crow if I'm right. You have to push me in a wheelbarrow down mainstreet But around the turn of the twentieth century election markets in the United States really started to gain steam the main place that people would trade on elections was something called the KRb Exchange, which literally, as the name suggests, was the KERb outside the New York stock Exchange they'd be sitting on the curb. And they'd be trading stocks and signaling the people in the offices about them. stocks to be clear in political candidates. People running for office Reporters for the Wall Street Journal, New York Times could go down to this pit and not only tell us what the overall price was, but the names of the people trading. And if you look, the people were trading, these were like the E leadite of the city. These were people from Tammanyany Hall. theseese were bankers, Wall Street, folks, people owned hotels People would be doing this very publicly. So if you were like the head of the Republican Party or you're the head of the New York Timy Hall you'd be expecting to go to the Vting commissioner and be willing to offer money for your candidate.. So it would be part of the publicity about You're standing behind this person you think they have a good shot of winning. Were you expected to bet on your own candidate or could you bet against your candidate if you thought your candidate wasn't going to win So we knew that like William Jennings Bryant, the populist from Nebraska was not popular with the workers in New York The Democratic machine in New York has to light bet for him But then the stories are behind the scenes, they're placing bets the other way so that they cancel out becausecause they don't want to lose money. Like publicly, they'll say, we love him. We endorse him, but they don't want to lose their money in the market Yeah, so they're going to be like hedging or going against their candidate All of this was happening in a sort of legal gray area Making a friendly bet on the outcome of an election wasn't against the law But if he did that You weren't supposed to vote But I don't think anybody ever said we're turning away from the polles because we know that B on election Were these prediction markets from as far as you can tell, good at predicting the outcomes of elections and whatever else was being bet on. So this was like the second thing that I was wrong about. My sense was, okay, the markets will do as well as they can, but there's not much information to be had These markets won't really tell us anything that I was definitely wrong with. And they were always right Basically. They would tell us who would win. they could give you a sense of whether there'd be a landslide. It was really pretty remarkable By the nineteen eighties, the IO electronics market would put that theory into practice Why did it take them so long? That's after the break This message comes from Granger. For the ones who get it done, Granger offers the professional grade products you need to get the job done With fast delivery and access to technical product experts ready to help you meet any challenge. Call, click granger. com or just stop by This message comes from Rosetta Stone and their newest language learning experience, Rosetta Stone Sapphire, personersalized learning so you can focus on what matters most to you ice real life conversations in an interactive setting before you use your skills in the real world takeake your language skills to the next level Get unlimited access to all twenty five Rosetta Stone languages, plus all the new Spphire learning tools. Visit rosettaestone dot com slash npR and receive twenty percent off today Support for this podcast and the following message come from e trrade from Morgan Stanley. Discover a wide range of investing choices and banking solutions, all in one place. Plus, get up to fif thousand five hundred dollars when you open a brokerage account with a qualifying deposit today. Learn more at erade dot com slash author. Banking products and services are provided by Morgan Stanley Private Bank National Association, member FDIC. Terms and other fees apply. Investing involves risks, Morgan Stanley Smith Barney LLC, member CIic And now Three. other golden age of prediction markets. Back to Run from Th line with economist Coleman Strump You kind of pointed out that late nineteenth century to World War II era is this kind of golden age alost of prediction markets, why did they fall off after that for a while It's a combination of factors. One of the things that both drove the popularity of the markets as well as the discussion of the markets was the press coverage. Through this period, all the newspapers covered it, but they were never very comfortable doing this. Then in the nineteen thirties, that's when the scientific polls, Galluop and some other folks came around And so the polls were doing something that was kind of the same thing. And newspapers were much more comfortable writing about polls than they were with markets The other thing in some sense has to do with interest of the people trading. So if you're someomebody who really likes this for whatever reason, you like to be known as a good forecaster, you like to make money, you like the adrenaline rush, any of these factors. The problem with elections or at least I'll just say US elections is we don't have enough of them This is around the time when Thoroughbred racing started to really take off. and so instead of couple of events a year, you could have twelve races a night And I think for people who were interested in that, I think the horse track was more attractive as a thing to do. and I think some of the Interest among traders kind of dissipated at that time As far as Coleman and Paul can tell Presidential election markets went dark sometime in the nineteen forties And then for the next four decades Radio silence I have never found one person who could have been around during that period or even books that talk about elections during that period that mention these markets. This was not some small tiny thing don't know how they've managed to slip through the cracks of you know what's known about that time, but they seemingly did until nineteen eighty eight when three professors in Iowa went for a three beer lunch and the Iowa electronic markets catapulted prediction markets back into the public consciousness as an alternative to political polls Here's Robert Forsyth again, one of the founders of the IO Electronic markarkets Once we went nationally, two things happened. We would get phone calls from traders around the country started realizing we had a five hundred dollars limit that one car They send us a check for several hundred thousand dollars to invest in the market And And we'd have to say, Well, gee, that'd be great, but we only can take five hundred dollars for your money. But we've got to realize that many of these people weren't speculators. These were people that were involved and were trying to hedge some clitical risk that would affect their company or their operations Say you're worried a certain candidate might win and pass laws that will hurt your business You can hedge your bets. Put some money on the person you do not want to win If they win You cover your losses So that was one kind of phone call. and then we would occasionally get a phone call. saying, this is great, but you know, you have to stay small we stay in the United States. Why don't you come with us and come over to the Cayman Islands and we operated there and you can run without restriction. and Maybe we should have done that. I don't know. att the point in time, we were a bunch of academics who were mainly concerned with our teaching and our research. And so we turned those opportunities down lookingoo back on it now Why do you say, Well, maybe we should have done that Well, you know, there are days and I'm sort of jealous of Ki and poly market. I mean, they've really taken the same idea. mean they're running basically the same prediction markets as we did when' on a much bigger scale They basically use the same rules for trading and issuing contracts that we used back in nineteen eighty eight But they certainly have expanded it vastly. until you can just about tril on anything there. The Iowa electronic market established something important. demonstrated to modern economists that prediction markets worked