Markets tap the combined knowledge of their investors. These investors put money on their confidence in predicting the future. Because they have money in the game, it is fair to suppose that they’re more likely to have studied and thought about what they’re buying than you or me. This is why markets are often described as “pricing in” all existing knowledge that may affect the future value of the investments that are being traded.
The predictive power of regular stock and bond markets, though well understood by classical economists such as Friedrich Hayek, has been popularised in recent books such as Freakonomics by Stephen Dubner and Steven Levitt, and The Wisdom of Crowds by James Surowiecki.
Using markets as prognostication tools underlies the idea of purpose-designed “prediction markets”. The classic example is the Iowa Electronic Markets, where real-money futures contracts on political and economic events are traded. It has become famous for being more accurate at predicting the outcome of US elections than the exit polls that hitherto have been the best available method short of counting ballots.
So, if relying on markets as a predictor of the future is a pretty good idea, then this Bloomberg report is cause for optimism about the future of Iraq:
Holders of Iraqi bonds are giving President George W. Bush a vote of confidence.
The country’s $2.7 billion of 5.8 percent bonds due in 2028 returned 15.2 percent since July… Only Ecuador’s debt gained more, rising 18 percent. Iraq’s securities yield 6.21 percentage points more than Treasuries, the most of any dollar-denominated government debt.
While the war in Iraq has dragged Bush’s approval ratings lower, his policies in Iraq have turned around investor opinion on Iraqi debentures.
Granted, a lot of people, especially outside the US, are heavily invested in the notion that Iraq is a disaster. Their entire worldview is based on the notion that nothing good can possibly come of the foreign policy of Bush the Imperialist Warmonger. Instinctively, they feel what’s good for the US is bad for the world. So if the liberation of Iraq turns out to be a hard-won success, as the markets now appear to predict, don’t expect much more than a grudging silence from the anti-war left. For them, maintaining partisan hypocrisy will prove much less painful than joining the Iraqis in celebrating peace, prosperity and freedom. I’d buy futures on that.
(Hat-tip: Greg Mankiw)