Is the Bond Market the Best Predictor of the Outcome of a War?--Posner
An article in the business section of the New York Times last Sunday (November 11) by economist Austan Goolsbee, summarized an academic paper by an MIT economist named Michael Greenstone that uses Iraqi government bond prices to estimate the bond market's response to the Bush Administration‚Äôs "surge." Greenstone's paper, available from the Social Science Research Network, is dated September 18, which is two months ago, and perhaps developments since would alter his conclusions. To estimate default risk from the bond's current trading price, and in particular to estimate the effect of the surge on the default risk, is not straightforward. For example, Greenstone adjusts for the probability that a Democrat will be elected President next year (regarded as increasing the likelihood that Iraq will default on the bonds); that probability may have changed since September 18. The worldwide credit crunch has worsened since then, and that might have an effect, independent of the surge, on the price of the Iraqi bonds.
The bonds ($3 billion worth issued in January 2006), which mature in 2028 and until then pay 2.9 percent on their face value twice a year, so almost 6 percent per annum, are trading at a steep discount (currently about a 40 percent discount, which jacks up the yield to almost 10 percent--almost $6 for a bond that costs $60). This means that purchasers of the bonds (which are actively traded) are demanding compensation for bearing a substantial risk of default. The most interesting conclusion in Greenstone's study is that, after correction for other factors, the surge is correlated with a 40 percent increase in the bond market's estimate of default.
It seems unlikely that the surge itself would increase the risk of default, though it might, by enabling both the Sunnis and the Shiites to rest and augment their forces for the eventual showdown, taking advantage of a kind of truce imposed by the additional American troops. More likely, the bond traders see the surge as a desperate last gamble by the United States; as a preclude to U.S. withdrawal and specifically as a sign that the United States will withdraw soon after the next Presidential election, whoever wins the election; as a political gimmick; and as a failure in the aim of the surge of promoting progress toward a political settlement that will enable Iraq to be a functioning nation when we leave. If, as the bond traders fear, Iraq is likely to be divided well before 2028 into three separate nations (Kurdish, Sunni, and Shiite), a default is likely.
There are two general questions that Greenstone's interesting study raises. The first is the relation between default risk and U.S. failure. For comparison, consider another recent study, by Kim Oosterlinck and Marc Weidenmeir, this one of the price of Confederate bonds in the Amsterdam market during the American Civil War. Initially the bond prices traded at a discount that indicated that the Confederacy had a 42 percent chance of winning the war and therefore presumably of repaying the bonds; but with the crushing twin defeats of the Confederacy at Gettysburg and Vicksburg in the summer of 1863, the bond market quickly downgraded the Confederacy's chances of winning the war to only 15 percent, and the estimate kept falling till the end of the war. The difference between that case (and other examples of using bond prices to predict the course of a war) and the Iraq case is that the risk of the Confederacy's defaulting on its bonds depended essentially on just one event, namely whether the Confederacy--the issuer of the bonds--lost the war. In the case of Iraq, the relation of the risk of default to the outcome of the war is obscure. No one thinks that the United States can actually be defeated by Sunni insurgents, al Qaeda in Mesopotamia, Shiite militias, Iranian infiltrators, or any other armed groups in Iraq or the surrounding areas. At the same time, few believe that the United States can win the war in the sense of eliminating widespread violence and coupling withdrawal with handing over control of the country to a functioning government, as the United States was able to do several years after the end of World War II in Germany and Japan. Moreover, if we wanted to avoid a default, we could do so simply by buying up the bonds (at the current discount, they would cost only $1.8 billion, provided they were bought up surreptitiously so as not to force up the price significantly) and then forgiving the debt. And finally, one can imagine a scenario in which American policy is an utter failure, but the utter failure actually reduces default risk. Suppose we pull out of Iraq and Iran takes over. Iran might decide to pay off the bonds in full (the amount of money is small) in order to increase its credit standing.
So really the only (though major) significance of Greenstone's bond market study, so far as our situation in Iraq is concerned, is that it is evidence that the surge, while it has reduced the number of deaths in Iraq, has not increased the viability of the Iraqi state, but instead has revealed (possibly even contributed to the prospect revealed) that the attainment of viability is increasingly unlikely.
The second general question raised by Greenstone's paper is whether financial markets are better predictors of the outcome of wars and other political crises than experts are, including the experts who staff intelligence agencies. One might think that experts would be better predictors because they had specialized knowledge that bond traders would lack and that experts who work for intelligence services would have not only expert knowledge but knowledge that bond traders could not obtain by consulting experts, because it would be classified knowledge. A careful historical study (and access to classified information, at least for recent crises) would be required to answer the question which predictor is better. But it would not be surprising if the financial markets turned out to do better than the experts, including national security personnel. Financial markets aggregate the opinions of a vast number of investors, and those investors who at least think that they have real insight tend to be the ones who determine the prices in those markets.
Friedrich Hayek's great legacy to economics was to show that the price system can aggregate vast amounts of information much more efficiently than a centralized bureaucracy can do. And intelligence agencies are centralized bureaucracies. The innumerable mistakes that the United States has made in Iraq suggest that our government does not have good means of obtaining and evaluating information concerning that country, possibly because of a combination of bureaucratic inefficiency and the vastness of the quantity of relevant data. The people who trade Iraq government bonds do so not because they are told to study Iraq or paid a salary to do so or have an academic or journalistic interest in the country, but because they hope to make money. Presumably therefore they are self-selected for knowing a lot about Iraq‚Äîand for thinking they know enough to put their money where their mouth is. They may be right.