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Political markets settle up

IEM

A chart shows share prices on the Iowa Electronic Markets for the projected outcome of the 2010 congressional elections. The blue line is the trend for Democratic control of House and Senate. Green stands for GOP control of House, and Democratic control of Senate. Red represents a Republican sweep, and the black line shows the prospects for a Democratic-led House and a GOP-led Senate.

The conventional wisdom about today's midterm election has been consistent for weeks, based on trading patterns in political prediction markets as well as more traditional polling data. Barring surprises, the Republicans will gain control of the House, and the Democrats will hold onto a slim majority in the Senate.

But for economists, figuring out the factors behind those voting trends will be as interesting as the final results.

In the past, prediction markets have done as well if not better than traditional political polls when it comes to forecasting the outcome of campaigns. But they go about it using a completely different method that has more in common with Las Vegas gambling than election-place canvassing.


Traders can make "investments" in shares whose value varies with the fortunes of a political candidate. Suppose that on Monday, you bought into the proposition that the GOP would win the House but not the Senate. You would have paid 85 cents a share at the Iowa Electronic Markets, with the expectation that you'd win $1 a share if you were right, but lose your investment if you were wrong.

Share prices have been floating up and down for months, but the general trend has favored the split decision for congressional control. "This year, the markets are not predicting anything different from what most of the pundits are saying," said Thomas Rietz, a finance professor at the University of Iowa's Tippie College of Business who is on the IEM's steering committee.

The University of Iowa has special dispensation from the Securities and Exchange Commission to run the IEM as an experiment in market behavior. And although the market's verdict isn't much of a shocker, Rietz said this year's election provides a prime opportunity to look at one of the key questions in politico-economic science: Are elections primarily decided by economic factors such as unemployment statistics and gross domestic product?

"If you talk to a structural political economist, they would say that the election is largely determined by those factors well in advance," Rietz told me. "On the other hand, if you talk to the news media, they would say the situation changes every time somebody coughs."

After experiencing a coughing fit and getting a drink of water, Rietz continued: "We think the truth is in between."

A prime practitioner of the economic-modeling method is Douglas Hibbs, a U.S.-born economist affiliated with Goteborg University in Sweden. Back in September, he issued an analysis predicting that the Democrats would lose 45 seats in the House, thus giving up their majority.

Another modeler, Yale economist Ray Fair, agrees that House Democrats will be in the minority -- but he's looking at a closer margin. His algorithm, based on economic growth rates and inflation indexes, suggests that the Democrats would get 49.2 percent of the aggregated national vote in this year's congressional races.

Tonight you'll see which model comes closest to the mark.

Rietz said Iowa researchers "aren't very far into the process" of figuring out what factors influenced the IEM's ups and downs this time around, "but we can say things are definitely tied to the economy."

IEM director Joyce Berg, another professor at the University of Iowa, said researchers would look at economic statistics as well as what was going on in the news during particular turning points in the campaign.

"For this election, it seems as if something certainly was happening there in August," she told me. "We think it's economic reports -- the continuous [stream of] not-that-promising economic reports that went against what people were looking for."

Even as the professors do their postmortem, they'll be ramping up the Iowa Electronic Markets for the 2012 presidential campaign. "We're going to try to get them open pretty fast here," Berg said.

The Intrade Prediction Markets, which can take real-money bets because they're based in Ireland, is already handicapping the 2012 race as well as the 2010 elections. Intrade's figures suggest that the Republicans have a 95 percent probability of taking over the House for the next session, while Democratic control of the Senate is nearly a 50-50 proposition. As for 2012, Intrade's clients favor the Democrats to hold onto the White House -- but it's still early in the game.

How would you bet? Do you think the prediction markets have gotten this election right? Feel free to weigh in with your comments below, keep track of tonight's results by checking in with our "Decision 2010" coverage, and check back here on Wednesday for a recap on the political prediction markets.

Update for 10 p.m. ET: NBC News projects that the Democrats will hold 199 seats in the new House, compared with 236 seats for the GOP. That would be a significantly poorer showing for the Democrats than the 211 seats that Hibbs projected in September -- but the margin of error for NBC's current projection is plus or minus 13 seats. 


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