On Michał Kalecki

Brad DeLong posted the following earlier today, referring to Michal (not Michel) Kalecki:

Back in the 1930s there was a Polish Marxist economist, Michel Kalecki, who argued that recessions were functional for the ruling class and for capitalism because they created excess supply of labor, forced workers to work harder to keep their jobs, and so produced a rise in the rate of relative surplus-value.

For thirty years, ever since I got into this business, I have been mocking Michel Kalecki. I have been pointing out that recessions see a much sharper fall in profits than in wages. I have been saying that the pace of work slows in recessions--that employers are more concerned with keeping valuable employees in their value chains than using a temporary high level of unemployment to squeeze greater work effort out of their workers.

I don't think that I can mock Michel Kalecki any more, ever again.

Few economists have been more unjustly neglected by the profession over the past century than Kalecki, so I was happy to see him mentioned on DeLong's widely read blog. But I feel obliged to point out that Kalecki was well aware that "recessions see a much sharper fall in profits than in wages". His two-sector model predicts precisely this. Kalecki assumes that all wages (and no profits) are spent on consumption goods, which implies that total sales in the consumption good sector are equal to the sum of wages in both (consumption and investment good) sectors. Hence total investment expenditures equal total profits in the economy. Since total investment expenditure is determined by the aggregate (uncoordinated) decisions of firms, Kalecki concluded that while workers spend what they get, capitalists get what they spend. When private investment investment collapses (the hallmark of a recession) then so do profits.

Kalecki's work anticipated significant parts of Keynes' General Theory, and it's a pity he doesn't get more credit for this.

The 2008.DEM.VP.GORE Contract

There have been some very strange price movements in the 2008.DEM.VP.GORE contract on intrade since late May:

This contract pays $10 if Gore is the democratic vice-presidential candidate in 2008. The probability of this event has got to be approximately zero. I can't imagine why someone is sinking thousands of dollars into this contract.

This has to be either a crazy hunch by a very rich individual, or an attempt to profit from some astonishing inside information.

For more on this see:

http://the-ts-maven.blogspot.com/2007/07/demvpgore-knife-fight.html

Information and Prices

How exactly does new information get transmitted into the prices of financial assets once it becomes publicly available? To me this is one of the most interesting questions in the economics of finance. Sometimes the information has rather obvious price implications. For example, once Mark Warner announced that he would not be seeking the Democratic presidential nomination, the price of the contract 2008DEM.NOM.WARNER (which pays $10 if he is the eventual nominee) dropped rapidly from about $1.50 to practically zero, and has remained there since. It's perfectly obvious to everyone that this contract is very unlikely to pay anything at all.

Most of the time, however, new information is much harder to interpret. Today, for example, a new Mason-Dixon poll was released showing Lincoln Chafee up a point in the Rhode Island Senate race, the first time he has led in any poll since August. In fact, the two previous polls in the RCP list had him down by double digits. Clearly, the race there is tightening, and one would expect to see this reflected in the prices of the RI.SENATE06.DEM and RI.SENATE06.GOP contracts. But by how much should the prices change? In other words, to what extent should the new poll cause us to revise our beliefs concerning the likelihood of a Chafee victory?

Well, here's what actually happened to the price of RI.SENATE06.DEM (which pays $10 in the event of a Chafee loss to Whitehouse). The last trade before the new poll became public was at $9.39. Soon after the poll became public on the morning of November 5, the price dropped to $8.73. This was at 8:17 AM. By 9:38 the price was down to $8.00, by 10:08 to $7.50, by 10:22 to $6.70, and by 10:30 to $4.50. By 11:11 it was back up to $7.97, and has remained between $7.00 and $8:00 ever since:

The point is that nobody really knows what the "true" likelihood of a Chafee victory really is, and how exactly to adjust one's beliefs in the face of new information. The market aggregates the opinions of all participants, but does so in a noisy way that can sometimes involve a lot of volatility and overshooting. More interestingly, the process may be path-dependent, since trading alters the distribution of assets and cash holdings among participants, and hence the extent to which their individual beliefs are reflected in the eventual price.

Bayh

Writing recently in Slate, John Dickerson argues:

"The most likely beneficiary of Warner's departure may be Bayh, who was competing for a similar sphere of donors and activists as a representative of the centrist wing of the Democratic Party. As a former governor of Indiana, Bayh can claim executive experience, just as Warner could, and offer the same hope that as a favorite son he could turn a red state into one the Democrats could count on."

As I noted yesterday, the initial market response to the Warner withdrawal was that Edwards would be the main beneficiary. But there's also some support for Dickerson's view. At around the same time as the price of the Warner contract was collapsing, the price of the Bayh contract jumped upwards:



Still, the rise in price here is small compared to the rise in the Edwards contract, and even the Clinton contract has gone up by more. It'll be interesting to see what happens over the next few days.

Warner

At some point this morning it became clear the Mark Warner would not be seeking the Democratic presidential nomination for 2008. I'm not sure exactly when the first public announcement appeared, but here's a Reuters post stamped 9:55 AM.

As you might expect, the price of the Warner contract on Intrade (which would have paid $10.00 if he had been the nominee) collapsed rapidly from $1.50 to practically zero:

The price at 9:40 was $1.50; by 10:41 it was 11 cents. What's interesting about this is that the decline in price should have been matched by comparable increases in the prices of other contracts. Specifically, if the market believed that there was a 15% chance of a Warner nomination prior to the withdrawal, this probability should have been reallocated to other contenders once the announcement became public. This did not begin to happen for quite some time, and the process is still incomplete. The only contract to have risen significantly at this point is that for Edwards:

A sharp increase in price, from $0.81 to $1.28, took place during a ten minute interval starting at 11:33, about an hour after the collapse of the Warner contract. A couple of other contracts (Clinton, Bayh and Obama) have also seen modest increases but the main beneficiary of Warner's withdrawal seems to be Edwards.

Price Inconsistencies

In my last post I provided an example of price inconsistencies across contracts in the Iowa Electronic Markets. These discrepancies are usually pretty minor. But price inconsistencies across different exchanges can be quite large, which makes you wonder about the rationality of traders.

Here's a recent example. The IEM House06 market has two contracts (RH.hold06 and RH.gain06) which, taken together, are equivalent to the HOUSE.GOP.2006 contract on Intrade. In fact, IEM's RH.hold06 contract is dominated by Intrade's HOUSE.GOP.2006 contract, since the former expires at zero if the Republicans gain seats. So the price of RH.hold06 should never exceed that of HOUSE.GOP.2006.

But take a look at the prices of HOUSE.GOP.2006 on Intrade between 10/3 and 10/6:

At no point did it cost more that $4.90 for a contract that pays $10 if the Republicans keep the House. The average price was $4.52 on the 4th and $4.38 on the 5th, with almost $120,000 worth of contracts traded over those two days combined. Now take a look at the IEM prices on October 4 and 5:

Date	Contract	Units	$Volume	AvgPrice
10/04/06	RH.gain06	128	3.348	0.026
10/04/06	RH.hold06	275	140.369	0.510
10/05/06	RH.gain06	249	5.812	0.023
10/05/06	RH.hold06	673	336.133	0.499

To buy a set of contracts that are equivalent to HOUSE.GOP.2006 cost $5.36 on average on the 4th and $5.22 on the 5th. That's a price difference of more than 18%.

Why did traders on IEM pay so much more for contracts that they could have purchased on Intrade? I'm not really sure about this, but it's clear that the traders on these two markets are receiving different information, or processing it in different ways. Meanwhile, the stakes on IEM are too small to make it worthwhile for someone to engage in arbitrage across the two exchanges.

Arbitrage in Prediction Markets

One of the interesting things about the IEM Congessional Control Markets is that there are lots of different ways in which to take a position on an event. So, for example, if you want to bet on the event that Democrats take control of the House, there are four ways to do it: (i) buy RH.lose06 in the House06 market, (ii) buy a fixed price bundle and then sell both RH.gain06 and RH.hold06 in the House06 market, (iii) buy both NH_RS06 and NH_NS06 in the Congress06 market, or (iv) buy a fixed price bundle and then sell both RH_RS06 and RH_NS06 in the Congress06 market. In a thick market with heavy trading and optimal behavior on the part of traders, these four different ways of entering the same position should cost the same. But these are thin markets with varying degrees of sophistication among participants, so prices across contracts and markets are sometimes not mutually consistent.

In fact, sometimes prices get so misaligned that there appears an opportunity for aribrtage: one can take a combination of positions that yields a sure profit (regardless of what happens in the election). Consider for instance the prices as of 7:30 CST this morning:

07:30:00 CST, Thursday, October 05, 2006.

Symbol	Bid	Ask	Last
RH_RS06	0.445	0.460	0.430
RH_NS06	0.031	0.045	0.031
NH_RS06	0.300	0.315	0.320
NH_NS06	0.208	0.235	0.207

Symbol	Bid	Ask	Last
RH.gain06	0.022	0.039	0.022
RH.hold06	0.516	0.534	0.520
RH.lose06	0.455	0.515	0.462

At these prices, a trader could bet on Republican loss of the house in the House06 market and simultaneously bet on Republicans maintaining control of the house in Congress06 for a sure profit. Selling RH.gain06 and RH.hold06 in the House06 market, and selling NH_RS06 and NH_NS06 in the Congress market has a total net cost of $0.954 per contract. Whathever happens on November 7, the positions in one market will expire at $1 while positions in the other will expire worthless. So you're buying $1 for a $0.954 on each set of contracts traded in this way.

Nobody is going to get rich looking for opportunities such as this, which is why it's so easy to find them. But this example is a nice way to see the logic underlying arbitrage based pricing relationships such as the put-call parity theorem.