The Wisdom of Crowds?

THE WISDOM OF CROWDS?….Mark Thoma points today to an interesting new paper about Iraq from Michael Greenstone of MIT. (NBER download here.) Quick summary: Greenstone takes a look at all the usual metrics for measuring the success of the surge (civilian casualties, oil production, etc.) and reports that they’re inconclusive. No surprise there. So, being a public finance geek, he takes a look at a different metric: bond prices.

Iraq issued about $2.7 billion in debt settlement bonds (technically Eurobonds) in January 2006, and it turns out that ever since then there’s been a liquid and competitive market for these bonds, which are traded in substantial quantities on world financial markets. The yield of these bonds over time can be converted into a measure of investor belief that the Iraqi government will default on its coupon payments, which in turn is a referendum on the stability of the government itself.

So Greenstone took a look at Iraqi bond prices before and after the surge, and compared them to a set of other bond prices in an effort to control for a variety of non-surge-related factors that might affect the value of Iraqi bonds. In all, he attempted to control for the effect of (a) oil revenues, (b) global subprime woes and their effect on emerging market debt in general [see update below for more], (c) global changes in the yield curve, and (d) domestic U.S. issues. However, even after controlling for all those things, it was clear that investor confidence in the Iraqi government has plummeted since the surge began:

The results are striking. The annual probability of a default…is 5.75% at t = 0 [i.e., on February 14, 2007]. After the Surge begins, it is never this low again implying that even in the early days of the Surge the market didn’t believed that it would improve Iraq’s future prospects. Perhaps even more notable, the expected annual default probability rises to 8.14% by the end of the period. This is an approximately 40% increase in the expected default rate. The clear conclusion is that the world financial markets believe that the probability that Iraq will default on its bond increased after the Surge’s initiation.

Greenstone’s result is noteworthy for two reasons. First, it shows that investor confidence in Iraq’s government has dropped steadily ever since the beginning of the surge. Second, it shows that investor confidence plummeted dramatically beginning in the first week of July.

Why? At this point it’s guesswork. My guess is that despite the happy talk, investors viewed the surge from the start as a last gasp effort that had little chance of success and couldn’t be kept up for long in any case. Then, in July, when the various Sunni blocs left the government and the Iraqi National Assembly went on vacation without having reached agreement on even a single one of its most important measures, investors realized the jig was up. Modest security gains are nice, but they knew all along that political progress was what really mattered. So now they’re voting with their pocketbooks: despite the pictures from the Dora Market and the optimistic reports from the likes of Michael O’Hanlon, they simply don’t believe that the surge is providing the “breathing space” it was designed for. There’s no political reconciliation in sight.

Take this for what it’s worth. Obviously investors don’t have any secret sources of information, and they can be every bit as susceptible to panics and bubbles as the rest of us. Still, since they have large sums of money at stake, they have every incentive in this case to view Iraq dispassionately and analytically, and they obviously don’t like what they see. If markets really are good aggregators of information, the surge isn’t looking good.

UPDATE: Several commenters seem to think that Greenstone is an idiot who doesn’t realize that the price of risky bonds dropped globally when the subprime credit debacle unfolded earlier this summer. Needless to say, that’s not the case.

There are two things to be aware of. First, the price of Iraqi bonds began to plunge before the subprime meltdown. Second, Greenstone compares Iraqi bonds to bonds from other emerging countries, which also suffered from the global flight to quality after the credit markets collapsed. The Iraqi bonds suffered even compared to other risky government bonds. Bottom line: the decline in Iraqi bond prices appears to be genuinely related to events in Iraq, not just events in the global credit markets.

Now, Greenstone might still have missed something. His controls aren’t perfect. But he didn’t just ignore this summer’s problems in the credit markets. Read the full paper for more.