PRESIDENT BUSH’S surge of troops in Iraq has done little to resolve the political debate over the Iraq war. But global financial markets have been monitoring the war for months, and with remarkable consistency, they have concluded that the long-term prospects for a stable Iraq are very bleak.
That is the picture that emerges from a study by Michael Greenstone, an economics professor at the Massachusetts Institute of Technology, titled, “Is the ‘Surge’ Working? Some New Facts,” which has been circulating as a working paper in academic circles.
Professor Greenstone started by reviewing basic statistics on the Iraqi economy and on the battle for security within Iraq since February. This data provided a murky view, at best.
He found that civilian deaths in Iraq had fallen substantially in recent months. At the same time, though, he found little change in the rate of American and Iraqi military fatalities, while the recruitment of members of the new Iraqi security forces declined sharply. On the industrial side, crude oil production fell as much as 20 percent, but there was evidence of a slight improvement in the availability of electricity.
Sifting through these facts was time-consuming, but it provided little real guidance on the state of affairs in Iraq.
It wasn’t until Professor Greenstone began examining the financial markets’ pricing of Iraqi government debt that he had his eureka moment. It was immediately clear that the bond market — which, historically, has often been an early indicator of the demise of a political system — was pessimistic about the Iraqi government’s chances for survival.
First, some background on the Iraqi bonds. After the United States helped Iraq renegotiate its leftover debt from the Saddam Hussein era, the Iraqi government issued about $3 billion of new bonds in January 2006. These dollar-denominated bonds pay 2.9 percent twice a year and mature in 2028, paying the face value of $100.
To say the least, the market for these bonds is not robust: as of last week, a bond with a face value of $100 was trading at around $60. Professor Greenstone calculated that, from the markets’ standpoint, the implied default risk over the life of the bond was about 80 percent.
The important point is that anyone who owns one of these Iraqi bonds has to decide each day whether the Iraqi government is likely to be functional enough to make its debt payments, or will default along the way. All else being equal, if the surge policy is effective, it ought to be raising the market price of these bonds.
Bondholders “aren’t politically motivated,” Professor Greenstone said. “They don’t have to rationalize their previous statements or justify their votes from years past. All they care about is whether there will be a functioning Iraq in the future such that they will receive their payments.” At a certain price, most securities will find a buyer, and there are still buyers for Iraqi bonds. But the price they are willing to pay is very low.
Of course, it’s worth asking whether bond traders know anything more about Iraq than the pundits do. It’s impossible to say with certainty, but the collective wisdom of financial markets has proved remarkably adept at evaluating events and predicting the future, even the turning points of war.
During the American Civil War, for example, when Confederate forces lost at Gettysburg, Confederate cotton bonds traded in England dropped by about 14 percent. During World War II, German government bonds fell 7 percent when the Russians started their counterattack at Stalingrad in 1942, and French government bonds rose 16 percent after the Allied invasion at Normandy in 1944. Many such examples of the prescience of financial markets have been documented by economic historians.
Comparing the yields on Iraqi bonds from the start of the surge in February to late August, Professor Greenstone calculated that the bondholders implicitly raised the chances of an Iraqi bond default by 40 percent. Over that period, Iraqi bond prices fell about 14 percent — as much as the Confederate cotton bonds fell after the battle of Gettysburg.
Professor Greenstone is quick to acknowledge that the bond evidence does not necessarily imply anything about the surge as a military tactic. The American troop buildup might be giving the Iraqi government a reprieve, but over the long term, most bondholders seem to have concluded, it’s a lost cause.
In an interview, Professor Greenstone used a medical analogy to describe the possibility that the surge might be defined as successful, but would still result in the demise of the Iraqi government. “It might be a heart surgery that failed so the patient is dying,” he said, “or a heart surgery that succeeded but during the operation they found a deadly liver cancer so the patient is dying. Either way, though, the guy is dying.”
HE also knows that the late-summer turmoil in global bond markets because of the subprime housing problems and the ensuing credit crisis could complicate his analysis. But he points to two important pieces of evidence suggesting that the overall problems in the credit markets did not cause the Iraqi bond meltdown.
First, the Iraqi bonds were already falling before the subprime crisis began, and at no point did they ever rise above their pre-surge levels. So even if you do not attribute the entire 40 percent increase in the chance of default to the surge, there is certainly no evidence that it reduced the odds.
Second, and more important, while the bond-market turmoil affected all kinds of debt, the plunge in the value of Iraqi bonds has been much worse. Professor Greenstone’s data shows that Iraqi bonds have fallen not just in comparison with safe United States Treasuries but also when compared with those of nearby Qatar, and with a broad range of risky emerging-market bonds.
In the market, people vote with their money, and the vote is not going well for the new Iraq. Politicians in the United States may be divided over whether the surge has raised the chances of political reconciliation in Iraq. But the bond market has already made its message clear: don’t bet on it.
-In the Bond Market, a Bleak Prognosis for Iraq
Related: Programs and Data Used to Produce the paper