Tomorrow is the most important election in history of the future

Tomorrow millions of Americans will choose between rule guided by wisdom of the crowd embodied in free markets and rule guided by wisdom of elite experts embodied in technocrats' statistical models.

And by that I mean obviously Intrade vs Nate Silver.

What government is all about

Make no mistake - this isn't some obscure issue a few wonky bloggers care about - this is one of the biggest issues the future will face - the problem of predicting itself. Governing is fundamentally about just two things:

• Determining how you value various possible outcomes - how much do you care about low unemployment vs economic growth vs showing off your military power vs not offending God with too much gayness vs other such important outcomes of government policy.
• Predicting how various choices made by the government will affect these outcomes.

Whenever there's full agreement on both, there's really no controversy as for what government should do. You apply Bayes' Theorem and it will tell you precisely which of many possible policies to adopt.

Whenever there is disagreement, it must mean either different values, or different predictions of the future, or both.

Values

Contrary to what you'd expect agreement on values is the easy part. Most things affected by government policy are economic in nature, and people mostly agree on the same things being good - like higher incomes, lower unemployment, cheaper energy, better education, healthier environment, less poverty, and so on - they might disagree on relative weights to be given to these issues, but there's a natural utility metric - one happy voter is one point of utility - so you can just estimate how median voter feels about various issues to get a pretty good starting point for the compromise.

This won't resolve some conflicts, like the one between "people against murdering unborn babies" vs "people against forcing women to carry their rapists' babies", or whatever were the politically correct terms for them these days. Well, too bad, but there's literally no solution that will make everybody happy anyway. Such problems are fortunately fairly rare, and it's not like the government is doing a great job handling them anyway.

Predictions

A much more common and more important source of disagreements about the future is with predicting outcomes of various policies.

If one seriously believes that tax cuts for the rich lead to economic renaissance, and that welfare just makes people lazy, then Romney's policy makes perfect sense.

And if one believes that Obamacare will make healthcare available to everyone at lower cost, and that massive budget deficits saved the world from the Second Great Depression, then Obama's policy makes perfect sense.

There's little difference in values here - both Romney and Obama and most of their supporters want high economic growth, high employment, affordable healthcare, and fewer financial crises - but they have very different ideas on what's the best way to reach such goals.

How to predict the future?

So the problem of governing reduces to problem of predicting the future. And only two serious approaches exist - prediction markets and experts' statistical models.

Prediction markets like Intrade, or for that matter - stock and bond markets - sound a lot like gambling to many, but that couldn't be further from truth. Every transaction on prediction markets is a disagreement about the future - with winner taking loser's money. If you truly believed that Ron Paul was going to win Republican primaries, or that Nokia's N series was going to destroy iPhones, or that deficit spending would result in hyperinflation, you can put your money where your mouth is (on  respectively Intrade, stock market, and bond market) and if you were right then you could be an overnight millionaire. Or if you were wrong, you'd lose your money.

This is a pretty good motivation, and prediction markets tend to be pretty good most of the time. It's really most unfortunate that we don't have any widely traded prediction markets for economic growth, unemployment, and other such macroeconomic indicators, but markets we have tend to perform quite well.

The only second approach is statistical modeling based on reference class forecasting. You accumulate a lot of data about the past, and based on assumption that the future is likely to be broadly similar to the past you can make some really good predictions. This is far from automatic exercise and requires a lot of judgment as to which variables are relevant and how they might be connected, and in the end you often get pretty wide margin of error - but if reference class forecasting tells you we don't know better that's probably because we don't.

I'm completely ignoring all so called "experts" who don't base their predictions on any statistical models and just talk out of their ass, and all claims of "markets" that are not backed by actual money on the claim. These have track record more dismal than asking my cat's opinion.

So how do we decide between prediction markets and experts' statistical models?

Intrade vs Nate Silver

Unfortunately we have very few serious statistical models, and very few serious prediction markets, and even less overlap. Pretty much the only area where we can compare them against each other is predicting outcomes of American elections. And unfortunately for us, in the past they've been mostly in very good agreement with each other.

However, something really interesting happened. As of today, prediction markets and statistical models disagree more than at any time in history. Here's quick summary of Obama's vs Romney's chances of victory (normalized to 100%):

• Intrade (popular vote by at least 0.5%) - 58.1% to 39.1% (1.48 to 1)
• Intrade (electoral college) - 67.3% to 32.7% (2.06 to 1)
• Intrade (Ohio) - 68.7% to 31.3% (2.20 to 1) 
• Iowa Electronic Markets (popular vote) - 74.0% to 26.0% (2.85 to 1)
• betfair (electoral college) - 79.3% to 20.7% (3.83 to 1)
• 538 (popular vote) -  80.2% to 19.8% (4.05 to 1)
• 538 (electoral college) - 86.3% to 13.7% (6.30 to 1)
• 538 (Ohio) - 87% to 13% (6.70 to 1)

Don't be misled by the fact that they both predict Obama's lead - they differ so drastically in predicting how big is the lead it's as if they were seeing different elections. 538 offers odds more than three times Intrade's. Difference is very similar for popular vote and for Ohio winner.

If Romney wins after all, this will be a stunning victory of prediction markets over experts' models, and Nate Silver will most likely go back to baseball statistics.

If Obama wins, especially if he wins by a big margin, it will be a major defeat of prediction markets, especially Intrade.

Now you may not think a single such outcome matters much, but I have a bunch of completely unscientific anecdotes regarding their past performance.

Intrade and Obamacare Supreme Court Judgment

Intrade was really bad at predicting Supreme Court judgment, it peaked at about 80%. And Intrade turned out to be completely wrong.

The worst thing about is was not so much wrong prediction - it was how it went up from 65% (2:1) to 80% (4:1), doubling the odds, with zero new information becoming available. It was just Intrade bubble - people were estimating odds higher because they were going higher, unless someone had insider information to Supreme Court justices, which in this case at least we can safely say didn't happen.

It completely baffled Nate Silver as well, who responded with much more reasonable 1:1 odds based on statistical analysis of past information, and turned out to be much closer to being right.

Intrade and Gadaffi

Here's even more baffling one - market that Muamar Gaddafi will no longer be leader of Libya by 31 December 2011.

Not only it didn't go up to 100% after fall of Tripoli, when Gaddafi was reduced to being a mayor of Sirte at most, it actually fell down, because it turned out into market for "what the hell Intrade admins meant by leader of Libya", and it stayed there for days.

It wouldn't be the weirdest thing to ever happen if some rebels with big Intrade investment made sure the market was judged correctly by putting a few bullets in Gaddafi's head.

This shows how difficult it is to run prediction markets for anything will less defined outcomes than winners of Oscars or elections. Uncertainty over interpretation of market rules might be greater than uncertainty over interpretation of outcomes. And unfortunately most important things in life are less clear than election winners, so if prediction markets can't handle them, they're of not that much use.

Republican Primaries

Here's a very interesting case. Intrade was always far more pro-Romney than polls during primaries.

Polls disagreed widely on who was leading Republican primaries - with just about everyone including Herman Cain having their time as the top candidate - except Romney who was always number two. Meanwhile Intrade didn't doubt Romney for a moment, and Intrade was right.

Nate Silver even wrote a post why on we shouldn't underestimate Herman Cain's chances, which looks really silly in retrospect.

Tomorrow

Regardless of tomorrow's winner - be it Nate Silver/Obama or Intrade/Romney - we will learn something important about which way of predicting the future is more reliable - and I'm sure the future will care far more about this than about pretty minimal differences between Obama and Romney.

Post Scriptum

To make things even more clear, as of Tuesday morning UK time, 538 updated its predictions to 92.0% to 8.0% (11.5 : 1).

Intrade and Betfair are completely unmoved. (I don't actually know how often Betfair updates its odds, but Intrade is live).