This is a partial transcript of Special Report with Brit Hume, July 31, that has been edited for clarity. Click here to order the complete transcript.

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(BEGIN VIDEO CLIP)

DONALD RUMSFELD, SECRETARY OF DEFENSE: I canceled it because it's clear that even if it happened to have been a brilliant idea, which I doubt, it would not have been able to function in the environment that it was created.

(END VIDEO CLIP)

HUME: Defense Secretary Rumsfeld (search) was talking about a modest Defense Department plan to set up an Internet futures market in possible terrorist incidents to take advantage…there you see what it would have looked like. At least the web page describing it, take advantage of the sometimes uncanny way markets have of sensing things that experts can't or don't foresee. The idea, though, was immediately denounced as what one politician called it a, quote, "federal betting parlor on atrocities in terrorism." No one defended it and it didn't even last one news cycle.

But there are some who think that was regrettable. One who feels that way is Eric Zitzewitz, an economic professor at Stanford who says the idea behind the scuttled plan was legitimate.

Mr. Zitzewitz, thank you very much. Nice to have you.

ERIC ZITZEWITZ, ECONOMIC PROFESSOR, STANFORD UNIVERSITY: Yes. Thanks for having me.

HUME: What is your feeling about this program? First of all, how basically would it have, worked, really?

ZITZEWITZ: Well, sir, I think the basic idea was to do for Middle Eastern (search) politics what markets like the Iowa electronics markets and some private sector versions of that have done for U.S. politics. On Iowa, you can buy a security that's worth a dollar if George Bush is re-elected in 2004. Right now that securities is trading at 66 cents. So, you can look at that price and you can say, the market thinks there's a two-thirds probability that Bush will be re-elected.

The idea was to with this project, to do that for a bunch of different events that could happen in Middle Eastern politics, I think a subset of which were terrorist events. But you know, I think the ones that were actually more interesting were the non-terrorist events.

HUME: Such as?

ZITZEWITZ: Well, such as, is Yasser Arafat (search) going to continue to be the leader of the Palestinians or is he going to loose influence over time? I mean that strikes me as a kind of event that a lot of people on the ground are going to have a little bit of information about. But nobody is going to see the whole picture. By letting those people participate in the markets or maybe the journalists who are talking to them participate in these markets, you have got the potential of aggregating that information, learning things we couldn't otherwise learn. That potential was pretty exciting.

HUME: What is it about markets that makes them predictive?

ZITZEWITZ: Well, what is great about a market is that it averages everybody's opinion, but only to the extent you're willing to put your money where your mouth is. So with normal opinion surveys, you know, you get some strong opinions. You get some weak opinions. You have no way to tell how to weight them. Markets kind of provide an automatic weighting.

HUME: So, in other words, if you…strong opinion will lead to money being placed and that gives you the idea of the weight of opinion?

ZITZEWITZ: That's right. And if the market price ever gets too far out of whack, there is smart money that's ready to jump in and push it back towards the correct level.

HUME: And this…what about the information? I mean presumably, governments would have with classified information and intelligence and all that, a better idea of what may be coming in the area of terrorism or some even in some other areas of Middle Eastern politics than would independent citizens who simply have money in their hands.

ZITZEWITZ: That might be true, but you know, there may be instances in which it's not true. And you know, this market would generate a set of market prices. And then you could at the end of the day, look at each market price and decide well, do I trust the market or do I trust this inside intelligence that I may have?

I mean all this...

HUME: What is the track record on…not on terrorism, but on these kinds of things? Have markets been better predictors than government agencies?

ZITZEWITZ: Well, sir, there are lots of example where they have worked quite well. The Iowa markets out perform opinion polls in predicting elections; similar markets do that in Australia. The orange juice futures, this was shown 20 years ago, out predict the National Weather Service (search) at predicting Florida weather.

We've studied this market on Saddam. Would Saddam still be president of Iraq in June? And you know, that was essentially tracking the probability of the U.S. going to war. And we found that to be a pretty, good market indicator.

So when these markets succeed and they attract a lot of investors, when they're deep, liquid markets, they work extremely well.

HUME: Could something this small done on the Internet by the U.S. government have been effective on anticipating terrorism in your judgment?

ZITZEWITZ: Sir, I think it might have been more effective, as I mentioned, in anticipating other sorts of political events. But you know, that's a hard question to answer. But I would have liked to see them get the chance to try. I think there is a decent chance it could have worked. And had it worked, it could have been pretty valuable.

HUME: Did…do you…does it seem to you then, that the reaction was unreasonable or can the U.S. government really be in the business of accepting bets on terrorism?

ZITZEWITZ: Well, you know, from a political standpoint, it may have made more sense to figure out some way of encouraging a private sector organization to do this. And in fact, the private sector organizations that are already running markets in U.S. politics may step up to the plate and start to add more of these securities, particularly given all attention that this issue's now gotten.

I mean I think one of the big barriers to them doing that...

HUME: Quickly.

ZITZEWITZ: ... is right now, that would be considered gambling.

HUME: Got you.

ZITZEWITZ: You know, Internet gambling. And so there are some legal issues to be sorted out.

HUME: Mr. Zitzewitz, thank you very much for doing this. Nice to have you, sir.

ZITZEWITZ: Well, thanks for having me.

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