Want to know who is most likely to win the presidential race - and why the dollar has plunged on foreign-exchange markets in recent weeks?
Forget trying to make sense of the headlines, the opinion polls, the endless speculation of the pundits and the numbing commentary of television's talking heads. All you have to do is apply a powerful insight developed by Friedrich Hayek.
Hayek argued that markets efficiently collect and register bits and pieces of information from a wide variety of dispersed sources. That vast body of information, which is always well beyond the capacity of one individual or organization -- as Soviet planners finally realized -- is collected and tabulated into objective data that are easy to comprehend and use: market prices.
To use this insight, we must first find a market for the electoral outcome. Such a market exists in London, where betting on elections is legal -- where, in short, people back their opinions with money.
Let's take a look at how the market works: Last Tuesday the odds quoted by bookmakers at Ladbroke's were 4 to 9 for Governor Clinton and 6 to 4 for President Bush. At those odds, each dollar wagered on Mr. Clinton would pay off 44.4 cents if he should win, while a dollar placed on Mr. Bush would pay $1.50 if he should win.
Armed with those odds, we can calculate electoral "prices;" the probability of a Clinton victory is 63.5 percent, that of a Bush victory 36.5 percent. Those market prices (probabilities) are generally consistent with polling data. Indeed, during the course of this presidential race, market prices and polling data about Messrs. Clinton's and Bush's prospects have tended to converge.
If the market and polls tell the same story, why are market prices superior? Recall Hayek's insight: Markets collect and disperse information at a very low cost. Bookmakers and bettors in London don't have to pay expensive pollsters to collect public opinion data, and market prices are free for members of the public to use as they wish.
Cost is only one advantage that the markets have over polls. The other is accuracy.
When market prices and polling data diverge, prices more accurately indicate outcomes. For example, in June, some polls actually had Ross Perot leading the pack. That was not the picture painted by the market, which never gave him a fighting chance. The day before Mr. Perot folded his tent, the market indicated that he had only a 5.8 percent probability of winning.
Other examples show the superior accuracy of the market. In 1980, the final polls indicated that the Reagan-Carter race was too close to call. But the London market gave Mr. Reagan an overwhelming lead, a 77 percent probability of defeating President Carter. In January of 1984, polls gave the incumbent Mr. Reagan only a 1 percent lead over the as-yet unnamed Democratic challenger, but the market gave him a 74 percent probability of re-election. As late as mid-October 1988, the polls favored Mr. Bush over Michael Dukakis by only 6 percent, but the market gave him 2 to 1 odds.
Why is the market more accurate than polls? Although most public opinion polls are "scientific," their interpretation is subject to many assumptions, and in some cases polls can fall victim to manipulation. This is not true of the market, where there is no need for convoluted interpretation and little chance for manipulation.
Indeed, market prices are the objective outcome of the interaction among market participants. Both the bookies and the gamblers have an incentive to collect the best information they can and to "get it right." After all, their capital is at risk. If the bookmakers err in setting betting odds, they won't be able to cover their liabilities and will be forced to eat into their capital or go bankrupt. If gamblers are uninformed or careless, they will be forced to watch their wagers go for naught. As a result of profit-loss incentives, relevant information is drawn into markets like a hound dog attracted to a fresh scent.
Information about the probable outcome of the Bush-Clinton race is also drawn into other markets, such as the international currency markets. All markets are linked. That explains why they can coordinate economic activity so well.
That brings us to the battered U.S. dollar. Its value has been
declining relative to other major currencies since 1985. But since July, it suddenly plunged. In the past week, it hit all-time lows against the mighty Deutsche Mark.
Most observers have concluded that the recent speculative attack against the dollar is the result of U.S. investors scrambling to get out of dollars and into European currencies, where short-term interest rates exceed those that can be obtained on dollar deposits.
That seemingly sensible conclusion is wrong. German rates, for example, have been higher than U.S. rates since mid-1990, so the recent nosedive must be caused by something else. New information has come into the markets and triggered the speculative attack. We don't have to look too far to find the culprit. Capital flight from the U.S. began in earnest at the same time the London betting odds began to show that Mr. Clinton had a good chance in November.
Is there a reason for the linkage between Mr. Clinton's prospects in November and the dollar? There is.
If Mr. Clinton is elected, he promises to impose higher taxes on investors and their capital. Therefore, as his electoral chances improve, capital flight from the U.S. occurs: To avoid the specter of Mr. Clinton's tax increases, American investors sell assets in the U.S. and purchase assets in Europe. That requires the sale of dollars and purchase of marks, for example, which drives the ** dollar's value down relative to the Deutsche Mark.
The moral of this story is clear; politicians can fool the "scientific" pollsters and the voters but they can't fool the markets. When politicians who propose wealth-destroying policies become more electable, a depressant is automatically injected into the relevant markets.
Steve H. Hanke is a professor of applied economics at The Johns Hopkins University and a contributing editor to "Friedberg's Commodity and Currency Comments."