The Wisdom of Crowds and the Federal Reserve

At 11:38 am on January 28, 1986, the space shuttle Challenger lifted off from its launch pad at Cape Canaveral. Seventy-four seconds later, it was ten miles high and rising. Then it blew up. The launch was televised, so news of the accident spread quickly. Eight minutes after the explosion, the first story hit the Dow Jones News Wire.

The stock market did not pause to mourn. Within minutes, investors started dumping the stocks of the four major contractors who had participated in the Challenger launch: Rockwell International, which built the shuttle and its main engines; Lockheed, which managed ground support; Martin Marietta, which manufactured the ship's external fuel tank; and Morton Thiokol, which built the solid-fuel booster rocket. Twenty-one minutes after the explosion, Lockheed's stock was down 5 percent, Martin Marietta's was down 3 percent, and Rockwell was down 6 percent.

Morton Thiokol's stock was hit hardest of all. As the finance professors Michael T. Maloney and J. Harold Mulherin report in their fascinating study of the market's reaction to the Challenger disaster, so many investors were trying to sell Thiokol stock and so few people were interested in buying it that a trading halt was called almost immediately. When the stock started trading again, almost an hour after the explosion, it was down 6 percent. By the end of the day, its decline had almost doubled, so that at market close, Thiokol's stock was down nearly 12 percent. By contrast, the stocks of the three other firms started to creep back up, and by the end of the day their value had fallen only around 3 percent.

What this means is that the stock market had, almost immediately, labeled Morton Thiokol as the company that was responsible for the Challenger disaster. Six months after the explosion, the Presidential Commission on the Challenger revealed that the O-ring seals on the booster rockets made by Thiokol--seals that were supposed to prevent hot exhaust gases from escaping--became less resilient in cold weather, creating gaps that allowed the gases to leak out. Thiokol was held liable for the accident. The other companies were exonerated.

In other words, within a half hour of the shuttle blowing up, the stock market knew what company was responsible. How did they get it right? Said Cornell economist Maureen O'Hara, "While markets appear to work in practice, we are not sure how they work in theory." From The Wisdom of Crowds by James Surowiecki

The theory of the "wisdom of crowds" is based on the idea that a large enough group of people acting as separate individuals will come up with a conclusion, once their differing opinions are aggregated, that is better than the opinion of those same people meeting as an expert committee (You can read more here: http://experimentgarden.blogspot.com/2009/12/critical-analysis-wisdom-of-crowds-by.html or in the book). Researchers at the University of Iowa have actually developed a futures marketplace that allows individuals to place "bets" of up to $500 on future events. It is most heavily used for political elections, and its "crowd-based" predictions outperform the "experts" (www.intrade.com)

This brings us to Fed Chairman Bernanke and his belief that "printing" $600 billion will help our economy. Where can we find signals to evaluate his bet against the wisdom of crowds? Remember, the individuals in the crowd must act independently and must have real money at stake. Here are some described by Alan Reynolds in the WSJ today (http://online.wsj.com/article/SB10001424052702303467004575574610003111250.html?mod=WSJ_hp_LEFTTopStories#articleTabs%3Dcomments):
1. Gap between regular Treasury bonds and inflation-protected bonds (TIPS): widened by 60 basis points since August (bet is against bernanke)
2. US dollar: dropping against non-Western currencies (bet is against)
3. ETF ProShares: This fund bets against long term interest rates falling. If Bernanke's gambit was to work (ie by decreasing interest rates), the Proshares should drop. So far, it has not (bet is against).

The point here is not so much that Bernanke is "clueless", because he is not. The point is how one best makes a difficult judgement: by trusting experts and committees or by trusting Hayek's marketplace. Free markets out perform top-down marketplaces over time, because they rely on the latter. If you think you can identify an undiscovered predictor from the crowd, you could also make a lot of money.