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Sometimes economists are just flat-out wrong. According to economic theory, annuities and reverse mortgages should be very popular for managing risk and liquidity — yet both products struggle for mainstream acceptance. Another favorite of economists is prediction markets: contracts with payoffs contingent on some real-world event. Their future is also highly uncertain.
In essence, prediction markets let people “bet†on some feature of the economy, thereby creating a new financial derivative. A prediction market in gross domestic product, or perhaps in local rates of unemployment, could be a useful means of hedging risk. If you are afraid that GDP will fall, you could “short†GDP in a prediction market and thus protect your overall economic position, because your bet would pay out if GDP came in lower than expected.
Prediction markets are also a useful means of discovering information about what is likely to happen next. If you want to know who is likely to win the Super Bowl, is there any better place to look than the published betting odds? By the same reasoning, various interest rate futures markets offer clues about what the Federal Reserve might be planning. The value of having more and better public information is another reason to encourage prediction markets.
The big puzzle is why prediction markets haven’t taken off, at least not since the earlier 19th-century history of “bucket shops.†Part of the reason is regulatory constraints, but prediction markets have not succeeded in some other parts of the world without such constraints. Intrade.com, now defunct, was based in Ireland and created active and successful markets in sporting events and presidential elections. But most of their prediction markets remained fairly illiquid, due to lack of customer interest.
Now enter Kalshi, a San Francisco-based startup that aims to create prediction markets. Fortunately, the company already has won approval from the Commodities Futures Trading Commission to run a derivatives exchange. Will the demand for the product be strong this time around?
A skeptic might say that demand is limited because there are already so many good and highly informative markets in other assets. In 2009, for instance, was a market necessary to predict how well the iPhone was going to do? The share price of Apple might have served to perform a broadly similar function.
The question, then, is which prediction markets might prove most useful. Nobel Laureate economist Robert J Shiller has promoted the idea of prediction markets in GDP, but most people face major risks at a more local, less aggregated level. One of the risks I face, for example, concerns the revenue of the university where I teach. This year enrollments rose slightly even though US GDP fell sharply. So a GDP-based hedge probably is not very useful to me.
—Bloomberg