The Party's Over...

...and here’s the bill. So now we know more clearly the cost of this bust (in which GDP is now forecast to fall some 3.5% this year) and it is shocking. Public sector net debt was 36.5% of GDP in the fiscal year 2007/8 and today the Chancellor has projected public debt to rise to just a shade under 80% of GDP by 2013/14. Public debt was previously as large as 80% of GDP in 1968 when the trajectory was still gradually adjusting downwards after WWII. This government’s self-imposed Golden Rule, or threshold, for public debt of 40% of GDP has been shattered with some £790Bn of borrowing planned over years from 2008/9 to 2013/14.

Admittedly, accompanying this debt projection are some plans for taxes to rise and for the growth in government spending to fall somewhat more than earlier plans. But these new plans represent second order modifications around a potentially explosive path. The risks to the path for debt to GDP seem to lie on the upside should the economy continue to remain longer in the doldrums and, which may follow, should there be further calls on the public purse to bail out financial institutions.

The big picture is that a large quantity of debt, created during the long 1990s expansion which ended in 2008, has now been transferred from the private sector to the public sector. And the trick that the public sector is trying to pull off is to smooth the increase in taxes that need to be levied on the private sector to pay-off these debts. But the danger is that financial markets will see through this trick and start to treat the public sector as more risky, like the hapless private sector, and that is why the initial reaction has been for bond yields to rise some 8-10bp. Now where’s that aspirin?

Are we in another Great Depression?

Too early to tell. The chart below shows data from the Angus Maddison’s well known dataset on long run growth in world economies (the data can be downloaded from http://www.ggdc.net/maddison/), which compiles national data sources into a comprehensive annual dataset. The data was mostly constructed postwar by various academics and research institutes in the countries concerned, that is after the fact, and is probably subject to some huge measurement errors but I found the chart highly instructive when thinking about the scale of the recessionary problems we might face in comparison to the so-called Great Depression.

Before discussing the chart, let me point to an old debate that seems to have been re-ignited between those who judge business cycle phenomena such as a possible Depression to be the result of shifts in productive potential or whether such phenomena are always the result of demand deficiency. Peter Temin (MIT, JEL, September 2008) recently reviewed work by Tim Kehoe and Ed Prescott (Minnesota School, Response FRB Minneapolis, December 2008) on the causes of Great Depressions and severely questioned the basic hypothesis that it was possible to think of the Great Depression as resulting from the former rather than the latter. In recent work, Kehoe and Prescott point to a sharp fall in US productivity in 1929-33, which was associated with a sharp fall in labour hours which did not recover even when productivity recovered later in the 1930s. Temin argues that: “(a)ny description of sort run macro events needs to pay attention to the effects of monetary and fiscal policy”. I am very sympathetic to the Minnesota School but when I start to think about the current debate and possible causes of this downturn, in a world of immense and prolonged analysis, I have seen little or no reference to a productivity slowdown as a cause of the financial crisis. Maybe it will come.

Turning to the data. The data gives us 1990 US$ price GDP in a variety of countries and I simply normalise the GDP at 100 for 1929 and see when output returned back to its previous level for a few countries. The results surprised me. The UK seemed to have a relatively mild output recession following its exit from the Gold Standard in 1931. Following my previous blog, it is remarkable how often the exchange rate helps adjustment in the UK. The US did not return to its previous output level until 1936/7 but that masks positive growth from as early as 1933.

In some senses the US path is probably the worst we might expect given an absence of effective countercyclical monetary (Friedman and Schwartz, 1963) and fiscal policy and the adoption of protectionism, which exacerbated negative trade multipliers. The stylised fact for the Great Depression is that world trade (exports plus imports) in 1913 US$ constant prices was around US$36bn in 1929 and fell to $25bn in 1938 i.e. around 33% and world output over the same period moved from US$241bn to US$270bn, which meant that the fraction of trade to GDP fell from around 15% in 1929 to 9% by 1938 (Estevadeordal, et al, QJE, 2003).

For obvious reason, we may not want to dwell on the militaristic solutions in Japan and Germany but, at a stretch, these might be analogous to making some kind of point that with the right kind of demand management, economic growth might return quickly and rapidly. So the question then is whether extreme monetary and fiscal policy stimuli currently being developed are sufficient to drive demand in the absence of much global demand (recent market inflation expectations data suggests this might be the case)? And under what circumstances will the saving nations (e.g. China) shift their investment functions outwards – as this will probably require some reform of their financial institutions it will probably not happen anytime soon? A financial crisis is difficult as it impacts on demand, as agents’ wealth and ability to smooth consumption evaporates, and it impacts on supply, with capital and labour shedding resulting. So we know that output will fall and demand management can have, at best, a temporary impact. So in the end the authorities simply do what they can, given tremendous uncertainties, and hope that confidence returns.

Whither Sterling?

Much ink has recently been split on the causes and consequences of the sharp decline in UK exchange rate. The bare facts look to be a concern, since mid-September 2008 sterling has fallen by 14% against the Euro and some 25% against the US dollar. In combination with the confirmation of a deep recession, it seems that the world is shunning the UK. The speed and extent of the decline is remarkable and is not dissimilar to that which occurred in the days and weeks following ERM exit in September 1992. It is even argued that if Sterling is to lose its role as an international store of value then far better to consider joining a large currency zone where the external unit of value cannot be so easily buffeted around by gales blowing though the world of international finance.

So just how much of a problem is the depreciation of Sterling and does the scale of the decline provide a potential cure or kill for the UK economy? The Chart (below) shows a weighted average of the UK exchange rate versus the US$ and the Euro on a daily basis since 1985, with down signalling a depreciation in Sterling. The red-line shows the ratio of share prices in banks relative to those of the FT All-Share Index and is a measure of the news on banking profits relative to the whole economy. We can see that ERM exit was broadly a good thing for bank shares, most probably signalling that UK policy rates were more likely in future to reflect domestic growth prospects – implying that the bank profitability would benefit from such a re-direction. Furthermore, in the mid-1990s, once growth had been re-established Sterling did recover its previous level. On the other hand, we can see that the more recent fall in the exchange rate after the start of the Credit Crunch in 2007 (vertical line), seems to have been driven (at least in part) by the relative downgrading of bank profitability compared to the rest of the economy. In other words rather than being an exogenous cause of bank profitability and recovery, the widespread perception that this crisis will continue to constrain financial intermediation for some time to come may have led to a fundamental re-assessment of the Sterling’s fair value.



So where is the gain from the fall in the currency? Those involved in international trade will not be pleased, importers of goods and services will face higher bills and yet because of weak UK demand may find that it is not possible to pass on these higher costs and their profits will be directly reduced. Exporters may superficially benefit but much of UK exports are simply added value to imported raw materials or component manufacture and so the direct gain will be somewhat militated. It also seems likely that international corporations may dislike to notion of being sited in an economy where the exchange rate fluctuates widely as this will tend to disrupt profit forecasts and the lead to volatile remittances priced in foreign currencies.

But even if the exchange rate channel offers a rather weak form of direct support, it might be that every little bit helps. And so to the extent that the fall in sterling simply reflects an anticipated reduction in interest rates in the UK relative to those overseas, then exchange rate adjustment may help the economy adjust to its new equilibrium following a constellation of shocks. For the UK economy a list of these shocks might include: (i) a persistent downward shock to the value of financial intermediation; (ii) a downward shock to asset prices and hence net wealth; (iii) a realisation that the household balance sheet was becoming too heavily indebted and (iv) a global reduction in overall demand for UK goods and services.

As well as the possible impetus to net exports there are two further ways that the exchange rate depreciation may help the UK economy. First in the midst of mounting deflation pressures, a large exchange rate depreciation offers a one-off increase in the UK price level that will hold those pressures in abeyance for some time. The depreciation will increase the price of traded goods and lead to a temporary inflation as the increased costs of imported goods feeds though the economic pipeline as typically it is still the case that there is a large pass through from a nominal exchange rate change into the domestic price level. By keeping inflation temporarily higher than it would otherwise be, the economy may avoid some of the problems brought about by too rapid a disinflation. Secondly, the reduction in the foreign currency price of UK assets means that they may now offer a good prospective return in foreign currency terms and lead to some support for both the domestic housing market and equities from foreign capital, which may be looking for a place to park itself.

The danger really is that the depreciation in Sterling hinders in some way the government’s ongoing ability to deal with the financial crisis. By which I mean that we can characterise the policy response to the crisis as a transfer of risk from the private to the public sector, as we are using public debt to hoover up private debt contracts. If the decline in the exchange rate becomes widely thought of as a reflecting risk in the UK, rather than an adjustment associated with economic fundamentals, then the upper bound on the government’s ability to sell its debt will bite somewhat earlier than would otherwise be the case. And that in the end is the real risk from a Sterling sell-off – that it somehow signals looming fiscal insolvency.

Orthodox and Heterodox Monetary Policies

The financial crisis has shaken some core beliefs of central bankers as they find themselves running increasingly heterodox policies. Having spent much of the last two decades developing simple rules about the operational conduct of monetary policy, they now find that this new rule book has to be torn up. Although initially controversial, the adoption of the interest rate as the main operational instrument in pursuit of a clearly defined policy objective had become a near universal article of faith.

But with interest rates heading towards zero and having little impact on lending behaviour, because a freeze in financial intermediation, central bankers have had to think of new policy measures. Attention is moving from the price of money to ensuring that a sufficient quantity of money is held by the private sector in order to effect transactions. In this blog I outline the crossing of the central bank Rubicon.

The nice, linear story central banks liked to tell about monetary policy was illustrated in my blog: Deflation: A Real Problem and a Possible Cure and also in a recent working paper. The policy rate sets the base level for the funding costs of the banking sector and acts as the floor to financing in a given currency. Central banks ensure that the policy rate remains at or near the floor by draining the overall banking system of reserves and selling these back at the policy rate via open market operations, which have no monetary consequences. The hidden assumption in this framework is that the constellation of all other market interest rates, from interbank to long term corporate bond rates and beyond, will respond proportionately to any impetus from the central bank’s policy rate. The set of market interest rates are thus thought to be akin to a sequence of mark-ups over costs, related to the costs of monitoring credit and market risk. And so much of the transmission of monetary policy operates through its impact on other market interest rates.

When setting the policy rate, the central bank commits to supplying central bank money perfectly elastically at that interest rate to commercial banks. At lower interest rates, the demand for narrow money should increase, as the opportunity cost of its holding has fallen, and this extra demand is satisfied by central bank provision of base money. The expansion in narrow (central bank) money is multiplied through the economy by the money multiplier, which is the extent to which commercial banks increase their balance sheets by more than the amount of narrow money alone by extending bank credit to the private sector. And it is arguably this money multiplier that has collapsed in the current banking crisis.

In the stylised balance sheet of a fractional reserve commercial banking sector, commercial banks hold central bank money as liquid assets and loans as illiquid assets. Loans to the private sector will ultimately correspond to deposits by the private sector in the banks, which are liabilities. The ratio of broad to narrow (base) money is the money multiplier and so we can observe that when the market for central bank money clears at a higher quantity and if the money multiplier remains constant, then broad money will expand by the change in the central bank money times the money multiplier. To the extent that broad money is required to fund private sector transactions, a change in broad money will correspond to a given level of nominal transactions. If the banking system is unable to convert base money into a sufficient quantity of broad money activity may suffer in the short run and over the longer run a deflationary impetus will be established.

Clearly when and if interest rates arrive at zero, central banks can no longer control the policy interest rate via open market operations and so monetary policy is driven by the need to set the quantity of base money in circulation directly. Furthermore if financial intermediation is severely impaired, policy may also have to provide a direct impetus for the creation of broad money liabilities and this is our working definition of quantitative easing.

The central bank balance sheet typically comprises assets of foreign exchange reserves, loans to the government, bonds, claims on banks and on the private sector. Liabilities comprise currency, commercial banks’ reserves deposited with the central bank, central bank securities, government deposits and any capital reserves. Central bank balance sheets are typically dominated by the main liabilities of base money (notes, and in some cases coin, on issue) and foreign assets and claims on financial institutions.

When the central bank effects a purchase of government bonds, the following changes to the balance sheet occur. Central bank assets will rise and liabilities will expand by the exact amount of currency issued to pay for the bonds. The currency is remitted to the commercial bank, government or insurance company from whom the central bank has bought the asset and this will be measured as a commercial bank deposit. And so the purchase of government bonds will show up as both an expansion of the central bank balance sheet, an increase in base money and an increase in broad money.

At some point in the future, the central bank can close out its position in government bonds by selling back to the private sector the bonds it holds on the asset side of the balance sheet, soak up the currency created and deflate its balance sheet. This begs the question of what is the initial purpose of buying government bonds? The hope is that by creating more short-term deposits in the commercial bank sector, this will generate commercial bank lending, given a reasonably stable money multiplier. The problem is that when commercial banks are uncertain about both the availability of future liquidity, losses from past lending and the riskiness of new lending in a recession, the new monetary liabilities may not translate very easily into new lending.

And so central banks have already gone further. The purchase of commercial bank assets and mortgage backed securities at discount provide both succour to commercial banks’ balance sheets by providing liquidity against possibly undervalued long term assets, as well as expanding broad money, and the possibility that central banks may profit from the resale of these assets. The open questions here are then at what price are these assets bought – not so high as to endanger the sustainability of the central bank balance sheet but not so low as to question the sustainability of the commercial banks and to discourage their future lending.

With such a large expansion of the central bank balance sheet, central banks increase the relative supply of short term debt (including central bank debt) to long term debt, which should lead to a change in the relative price of short to long term debt, with the latter becoming relatively expensive. And if long term interest rates do indeed fall during a quantitative easing then the private sector will have an incentive to invest as the user costs of capital falls, household balance sheets should be ameliorated with lower interest and debt burdens and asset prices should be stabilised, underpinned by lower long term rates. The question then is when all this activity starts to take off when will inflationary pressures start to re-emerge?

Deflation - a real problem and a possible cure

I ended my previous post with the question: so what’s the problem? And I suppose it is Deflation. A persistent deflation poses particular problems for monetary policymakers because with nominal policy rates facing a lower bound of zero, central banks can, in principle, lose control of real rates that will continue to rise if inflation expectations follow inflation down. Deflation is, of course, not a new phenomenon and prior to WWII year on year deflation was over the long run as likely as inflation but as long as inflation expectations remained in line with notions of long run price stability real rates would perhaps not destabilise the economy. The real worry for policymakers as we head into a deep recession is that inflation expectations fall markedly in line with deflation. Wide-ranging monetary and fiscal policy responses will then be designed to try and prevent a significant and persistent fall in inflation expectations.

Over the past decade or so we had become used to the following story about monetary policy. Short-term policy rates are nudged, with some reluctance, in one direction or another in order to limit the deviation of short-term inflation forecasts from an explicit (or implicit target). These short-term inflation forecasts are projections of the output gap and so the basic story says that by stabilising inflation, output is kept as close to potential as possible at the same time. The parable finishes by soothing us with the observation that providing the economic shocks are not too large and monetary policy continues to have traction on the economy via its influence on financial prices, then the economy should tend towards stable outcomes.

This nice, linear story is illustrated in Chart 1 (see http://econpapers.repec.org/paper/ukcukcedp/0815.htm for more details). Here we show a Fisher equation, which relates short-term nominal rates equiproportionally to inflation (or inflation expectations). The intercept corresponds to the economy’s natural real rate, which is essentially exogenous to monetary policy and is closely related to the expected growth of per capita consumption. The inflation target determines the long-run expected level of nominal rates, which are equal to the natural real rate and the inflation target. The central bank’s policy reaction function is to respond actively to any expected deviations in inflation from target and so is drawn steeper than the Fisher equation line so as to suggest policy induced real rates that are lower or higher than the natural rate, when inflation is correspondingly lower or higher than target, which acts to boost or bear down on demand as required.

But things can change quite radically once we move out of this comfortable little space. Specifically, if inflation starts to decelerate quickly, the central bank can find itself bumping near to its zero bound on nominal rates and might, in principle, lose control of its ability to set real interest rates. At this point short-term debt instruments and money yield near-identical nominal returns, and given that bonds bear a default risk, there will be a strong preference to hold liquidity in the form of cash. This means that even though the central bank will continue to supply private agents with escalating levels of narrow money to meet this increased demand, it will not be spent and demand will not emerge to chomp up the large output gap.

Chart 2 shows the limits to the standard mode of interest rate control. Once nominal rates hit zero at Point A, if inflation continues to fall real rates will then start to rise. And so there is a possibility that the output gap will get even higher as rising real rates bear down even further on demand, leading to a loop of lower inflation, higher real rates, lower demand and even lower inflation. The classic answer to the deflation trap is that at some point money demand will be sated and the decrease in the price level will mean that money holders will feel wealthier and start to spend. But in a world of debt that may not be sufficient because if those money holders are also indebted, the fall in the price level will increase the real value of their debt and so ultimately the existence of a deflationary trap will depend on whether the increasing indebtedness of debtors outweighs the increasing wealth of money holders.

So will a deflation lead to a complete economic collapse? Not necessarily. Chart 3 shows two annual inflation distributions in the UK from 1800 to 1947 and again from 1948-2007. The first distribution seems reasonably symmetric around zero and suggests that deflationary years approximately matched inflationary years in the nineteenth century and the first half of the twentieth century. Subsequently, we have hardly any evidence of deflation to draw upon, with inflation mostly moderately positive (with occasional lapses in good behaviour). It is not at all clear that we can make a simple comparison between a financially complex economy and one that was still in the midst of industrialisation. But one clear distinction can be made as there seems to have been long-run price stability in Britain in the earlier period: which implied offsetting years of positive and negative inflation, but these did not necessarily bring about sustained economic crises. Why?

One reason might be that the maintenance of long-run price stability means that a temporary deflation, which lowers the price level, was also accompanied by expectations of an inflation, which would return the price level back to its long-run average. The advantage of a positive inflation expectation during a deflation is clear because even though current inflation falls, expected inflation rises and this means that the expected real return on stable nominal rates falls. And so the likelihood of a deflation taking hold in a persistent manner may be significantly mitigated.

Unfortunately, in the current deflation scare, in the UK inflation expectations have moved very much in line with current inflation, which is rather unfortunate and suggests that credibility, the belief in the inflation target, may be less than complete. The rise in CPI inflation from 2004 to 2008 was accompanied by an increase in both breakeven inflation and NOP inflation expectations and as CPI inflation has started to decelerate in the second half of this year we have almost immediately noticed a decline in inflation expectations. The nominal anchor seems to be being dragged around by contemporaneous developments and hence the monetary constitution may ultimately be in need of some reform.

An important part of the answer in dealing with a deflation is to conduct monetary and fiscal policy in such a manner that inflation expectations do not fall along with prices: that, in fact, as far as possible they remain at or near the inflation target. Convince agents that inflation will be higher in the future than it is now, so enabling real rates to fall as nominal rates fall to zero. And so if the risk of deflation is real, and in the most recent Inflation Report the Bank of England placed the probability at around 20%, we can expect a highly accommodative monetary and fiscal policy stance to be maintained.

The Portfolio Approach to...Monetary Policy

Let me start with a poser. You have the chance to allocate your income across two assets A and B, which currently trade at the same price. The eventual payoff from holding these assets depends on one of two states. You do not know which will occur but are given the probabilities of each state at 0.5. Which asset do you hold?

Your choice on relative assets holdings will, of course, depend on the payoff in the various states. In the example below, the expected payoff from Asset A is 5 (10*0.5+0*0.5), as is the payoff from Asset B (2*0.5+8*0.5). So should you be indifferent between holding asset A or B? Not necessarily. Let imagine you decide to hold A, then you will receive either 10 or 0, when the state is revealed. Similarly if you decide only to hold B, then you receive 2 or 8, when the state is revealed. But if you hold 50% in A and 50% in B, then you will receive 6 or 4 when the state is revealed, which may be preferable to the outcome from holding only A or B. Note that your expected return across the states is the same and is independent of your allocation in this case but the variability of your payoff across the states can be reduced by choosing a combination of assets in inverse proportion to their variability. So if we choose 3/8 in Asset A and 5/8 in Asset B, we will have an income of 5 whatever the state turns out to be and this may be preferable to the alternatives.

The observation that an investor is likely to have mean and variance in his or her utility function won Harry Markowitz a Nobel prize in 1990. And there are a number of areas to which we may be able to apply these insights. Let us, for example, use this framework to think about the recent monetary policy problems facing the UK. It is becoming fashionable to argue that the Bank of England’s Monetary Policy Committee (MPC) should have responded in a forward-looking manner to offset the strong possibility of recession and so cut policy rates much earlier and decisively this year. Using our previous analysis would such a policy have been especially wise?

Imagine that Asset A is inflation and Asset B is output and payoffs are negative rather than positive. So the policy maker’s problem is to minimise losses by choosing an appropriate path for Bank Rate. So under X1 there is an inflation problem and something of a downturn and under X2 there is no inflation problem but a severe downturn. Should the MPC have kept interest rates mostly on hold, because of offsetting risks, until it was clear which state would obtain or taken a gamble and judged that X1 was simply not going to happen? In other words should the MPC have behaved like a speculator with his or her own strong prior beliefs and plumped for one outcome or the other? Or more like a portfolio manager and adopted a policy that delivers some stability in either possible state?

Some MPC members and one in particular seem to have adopted the speculator’s stance to go overweight on one asset rather than manage the possible portfolio of risks. Some might consider this to be a dangerous way to set policy because even though you may get lucky, and the inflation threat may dissipate, you may also get very unlucky and exacerbate the inflation threat. The MPC as a whole plumped for the portfolio approach. In the August 2008 Inflation Report (http://www.bankofengland.co.uk/publications/inflationreport/irspnote130808.pdf), the collective judgement of the MPC was that there were upside risks to inflation and downside risks to output and so like our portfolio manager they played it safe and did not move interest rates radically until it had become clear on which side the risks emerged.

The financial markets were perhaps more circumspect (!) than some MPC members. The chart below shows the five year inflation forwards calculated from the difference between the yield on nominal and index-linked (real) government bonds, which are linked to the retail price index (RPI). It is not a simple matter to interpret the inflation forwards as necessarily measuring inflation expectations as they may encompass either or both of inflation and liquidity premia. But if we hold those concerns to one side temporarily (and perhaps heroically), we can see a drift up in the expected inflation rate five years ahead from mid-2002, possibly reflecting concerns about the house price boom and second round effects from oil and commodity price rises. And throughout this year these inflation expectations also continued to drift upwards and it seems that only after end-August did these start to fall, and then somewhat precipitously. (Some of this fall seems relate to a flight to liquid assets as the financial crisis once again took a turn for the worse.) And that was the time interest rates should have started to fall as we found out that we were likely to have arrived in State X2. Since that August Report, Bank Rate has come down in three large steps from 5% to 2%, so what’s the problem?

The US Presidential Election Results – what did the markets predict?

It is a truism often stated that what seems obvious with hindsight looked less obvious before the fact and this is no less so in the realm of finance than politics. And so as we all start to debate the inevitability of President-elect Obama’s victory it is worth reminding ourselves to what extent this result was in doubt as we approached the election date. Prediction markets are a useful device to check the extent to which we dabble in ex post rationalisation. They allow agents to trade the likely outcome of economic and political events in real-time in advance of and all the way up to the event itself.



The charts here show one well known prediction market run by Iowa University (http://www.biz.uiowa.edu/iem/). There were two US Presidential markets: the first for the respective share of Democratic and Republican votes and the second a winner-take-all market for the Party that would secure the greater number of votes. The vote share market represents the purchase or sale of futures on the Democratic or Republican share of the popular vote. On expiry, after the election, the future will be worth the fraction of US$1 equivalent to this percentage share. So, for example, early indications suggest that the Democratic share of the popular vote was 52% yesterday and so the price of the Democratic contract on expiry will be likely to be around 52 cents - meaning that anyone who bought at less than 52 cents or sold at more than 52 cents, prior to expiry, will make money. The official source for the liquidation price will be this Friday’s New York Times.

The first chart shows the prices of Republican and Democratic contracts since the contract started trading in June 2006 and we can see that apart from some glitches in May this year, there seems to have been a consistent lead for the Democrats, with some evidence of an increasing divergence since mid-September, after the collapse of Lehman Brothers. I do not have data on previous elections to hand but the consistency in the lead for the Democrats is interesting but so perhaps is the relatively small difference projected in the share of the popular vote. The spread of prices on the close Monday 3rd November data was 53.4-54.1 cents for the Democrats and 46.1-47.0 cents for the Republicans, which seems to have turned out to be reasonably accurate.

The second market is a simple horse race bet on which party will win the greater share of the popular vote with the all the pot distributed to those betting on the winner. In this case, the winner-take-all future is bought on either of the two parties at a discount to $1 with the sum of the prices equal to one dollar. The payoff on the contract, to those holding a future on the winning party, is paid for by the losses of those holding contracts in the losing party. Again the liquidation prices will be set by the report of the election in this Friday’s New York Times. So let us suppose that there was a 50:50 chance ex ante of either party winning the major share of the vote, this would be reflected in an equal amount of money being placed on either possibility and the prices of the two futures would trade at 50 cents. If this market felt that the Democrats became more likely to win, the price of the Democrat future would rise and that of the Republican future would fall. And in this case, as the Democrats have received the majority share of the vote anyone holding a contract for the Democrats, for which the price on Monday 3rd November close was 90.3 cents, will be paid $1 and anyone holding a Republican contract for which the price on Monday was just under 10c will get nothing and lose their stake.



The second chart shows a similar picture to the first, in terms of a consistent lead for the Democrats but also suggests that after the re-emergence of financial turmoil in September betting on the blue corner took a hold. With prices of the futures going from 53c on September 12th to over 90 cents by Monday morning, representing a 70% return in under seven weeks. Clearly Democratic Party Futures were the hedge against stock market turmoil. The prediction markets do seem to tell us that the Democrats were the most likely winners all along but it was perhaps only after the further bout of financial turmoil in September that this became very likely.

There are, of course, many reasons why we should not trust the signal from prediction markets completely. The financial stake may not be meaningful (in Iowa prediction markets investments are limited to between $5 to $500 per investor). Relatedly, liquidity may be low and prices thus too sensitive to lumpy trading. And the markets may simply reflect other evidence from opinion polls rather than promote a process of information discovery. But as a device for aggregating information across diverse individuals and for allowing a hedge against unwanted outcomes, these types of markets may well be able to help all markets become more complete. If you happen to be a Republican supporter my commiserations, but if you had also bought those Democratic futures at 53 cents in September you may not have felt quite so miserable this morning!