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Tilting at Windmills

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September 15, 2007
By: Kevin Drum

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.

Kevin Drum 7:57 PM Permalink | Trackbacks | Comments (77)

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Comments

http://engram-backtalk.blogspot.com/ debunks this bs.

Posted by: egbert on September 15, 2007 at 8:09 PM | PERMALINK

Engram hasn't even mentioned this on his blog, as near as I can tell. He's certainly a fan of the surge, though.

Posted by: Kevin Drum on September 15, 2007 at 8:13 PM | PERMALINK

Hello, do you even read the business section of your local paper? Did you possibly hear that 150 days after February 15 (i.e., mid-July) the credit markets went crazy? You would get the exact same chart if you plotted any BBB credit spread to Treasuries over the same period.

P.S. If you don't know what the BBB spread to Treasuries is, you shouldn't claim that the bond market is supporting your political views.

Posted by: y81 on September 15, 2007 at 8:15 PM | PERMALINK

I am no fan of the surge, but the mid-July onward part of the graph is meaningless for the reason mentioned by y81. It is hard to believe a professor of economics, after kind of cleverly thinking that bond yields might provide an independent view of the Iraqi government's prospects, would then fail to realize that most if not all of the effect he was seeing was exogenous.

Posted by: matt wilbert on September 15, 2007 at 8:32 PM | PERMALINK

The paper is available for download and I just skimmed it--it looks like he compared three alternative bond types and the Iraqi bonds, which should partially control for the general issues in the credit market. However, it looks to me (and he appears to acknowledge in the paper) as if the alternative bonds are all higher quality than the the Iraqi bonds to start with, so under the credit conditions extant from July on, it isn't obvious that these are an appropriate control group.

It will be interesting to see if he is willing and able to defend his results as meaningful. But I am positive the graph is not illustrative of anything interesting.

Posted by: matt wilbert on September 15, 2007 at 8:46 PM | PERMALINK

Here's why this guy is a statistician and not a maqrket man:

"...approximately 27,662 US soldiers have been wounded...." So is the actual number 27,662.25 or 27,661.55? I think 27,600 or 27,700 would do, don't you, considering there were probaly a number of soldiers who have been grazed, cut or even wounded who never reported and self-treated same?

More importantly it's not who's selling the bonds but who is buying them. Where is the smart money? Anybody remember the junk bond collapse? Sort of similar to the dot-com bubble -- but it's those who judge the risk-reward correctly and buy for pennies and sell for dollars, or those who buy after the turn has been made, or those who buy cheap and are left holding the poop.

My personal read would be that the politics is now in free-fall until someone (Iraqi) comes along and takes a grip. I'm not sure that's possible when a significant minority is side-lined (Sunnis) and the other two major entities are in a tug of war.

We don't hear much of the Kurds -- wonder why -- but they think they have their own entity. That's why they've been at war with the Turks since god knows when. They have oil and a stable form of regional government constructed by themselves; and it works for them! The Shias and Sunnis do not.

The US has never allowed the Iraqis to find their own way so I can't see an Ataturk or S. Hussein or a Churchill or Reagan rising to help and/or unite the country.

So I will now drag my arse through this paper almost knowing what I will read in a non-market man's analysis of a market. Hope it's more interesting than I expect.

Posted by: notthere on September 15, 2007 at 9:00 PM | PERMALINK

i'm not quite sure why y81 believes the credit markets were in free fall on july 15. they were not.

Posted by: howard on September 15, 2007 at 9:02 PM | PERMALINK

What's a "maqrket man"?

Posted by: notthere on September 15, 2007 at 9:03 PM | PERMALINK

No particular view on this piece, and I haven't read the article. But, would the perceived risk of US withdrawal affect the expected annual default probability? Whatever other problems there may be with this paper, beyond any fundamental difficulties in the wisdom of the market arguments, I'm wondering whether this measure of "how the surge is going" is influenced at least partly by estimations of how the US political system will view the surge and how it will respond.

Posted by: christor on September 15, 2007 at 9:15 PM | PERMALINK

If you need psuedo marketplace stats,
To tell you that Bush's Iraq mess,
Is fucked up beyond all repair,
You've got cognitive problems.

Shit folks...
Even Cheney knew Bush's Iraq war was an idiot proposition back in '94.

Come on:

NO EXCUSES.
NO PSUEDO FACTS.
NO GENERAL BETRAYUS BULLSHIT...

Just the truth ma'am:

IT IS A DUMB ASS WAR RUN BY DUMB ASS PEOPLE.

End of fucking story.

Posted by: ROTFLMLiberalAO on September 15, 2007 at 9:18 PM | PERMALINK

howard, I didn't say "free fall" and I didn't say July 15 as a particularly significant date. The credit markets experienced significant difficulties and credit spreads widened significantly during July, as every finance professional will tell you. If you plot the price of any BBB credit relative to Treasuries for the year, they will all look like Iraqi bond prices, so I doubt that the bond market is making some particularly significant statement about the Surge.

Posted by: y81 on September 15, 2007 at 9:19 PM | PERMALINK

I heartily encourage Egbert and y81 to stock up on all the Iraqi bonds they can find. I suspect sellers would be easy to locate.

Posted by: Brandon Claycomb on September 15, 2007 at 9:19 PM | PERMALINK

No offense, folks, but if you're going to claim that Greenstone is full of shit, at least read the paper first. He compares Iraqi bonds to other emerging market bonds as a control against the general meltdown of the credit market caused by the subprime debacle. It's not perfect, but it's a decent measure, and Iraqi bonds are clearly doing way worse than others.

Also, the Iraqi bonds started going south in the first week of July, before the general weakening of the credit market. And they were declining for months before that.

The subprime meltdown might account for some of the problems with Iraqi bonds, but clearly not for all of them. The investment community is pretty obviously bearish on the surge.

Posted by: Kevin Drum on September 15, 2007 at 9:21 PM | PERMALINK

Brandon Claycomb, I make no claim that credit spreads will narrow in the near future.

Posted by: y81 on September 15, 2007 at 9:22 PM | PERMALINK

Kevin thinks this is a pessimistic study, Actually, it's fairly optimistic.

It says that the bond investors decisions as of July were consistent with an expected annual default probability of 8.14%. In other words, the investors believe there's a 92% probability that the bond won't default within a year. So, they are substantially optimistic that the Iraqi government will continue to function for some considerable period of time.

Whether or not the change in interest rate accurately reflects the effect of the surge, the overall level of interest rates shows that bond investors have been fairly confident and remain fairly confident of the ongoing continuence of the Iraqi government.

Posted by: ex-liberal on September 15, 2007 at 9:25 PM | PERMALINK

Hello, do you even read the business section of your local paper? Did you possibly hear that 150 days after February 15 (i.e., mid-July) the credit markets went crazy?

Can you read English, y81?

If you don't know what "controls for"* means in statistical jargon, it's better if you keep your inane opinions to yourself on this manner, and let the grown-ups talk.

And I say that in the nicest way I can.

* This sentence makes your statement 100% foolish: "effort to control for a variety of non-surge-related factors". You're in over your head in this discussion.

Posted by: teece on September 15, 2007 at 9:42 PM | PERMALINK

"Kevin thinks this is a pessimistic study, Actually, it's fairly optimistic."

ROFL.... No, dear, it's pessimistic. You really should learn to read since you quite clearly don't understand Greenstone's argument or Kevin's point.

Posted by: PaulB on September 15, 2007 at 9:52 PM | PERMALINK

Kevin Drum, I did read the whole paper (well, the whole part about bond markets, that being what I do for a living). The author doesn't discuss intertemporal changes in credit spreads at all, which makes the analysis laughable.

teece, the phrase "controls for" normally relates to regression analysis. This is a different sort of analysis. If the author had computed a correlation coefficient between Iraqi bond yields and, say, BBB corporates, the concept of "controls for" would be relevant, but that isn't what he did. (Incidentally, I don't know what such a regression analysis would show, or if it would be meaningful, but it isn't what is being run here.)

Posted by: y81 on September 15, 2007 at 9:52 PM | PERMALINK

It's difficult to believe that someone would criticize the article or mis-state what the article is contending without even taking a cursory look at it!

It's clearly a working paper and there clearly are rough edges. However, the author carefully notes what can be said: "Overall, the bond market findings fail to support the view that the Surge is helping to pave the way for a stable Iraq to emerge and may in fact be undermining it."

If the surge was working to create a stable Iraq, the spreads should be heading down. They're not. If financial markets believed that the surge had some non-trivial probability of success, the spreads should have headed down almost immediately upon announcement of the surge. They did not. The strongest cast that you can make is that there may not be a statistically significant increase.

And on the notion that 8% implied annual default rate is good news, in particular, a 92% probability that it won't default within a year, there are two cautionary points. (1) What is the probability that the U.S. de facto guarantees the bonds or props up the otherwise unstable government? That gets counted in the 92%. (2) You might just want to go back and look at a wide range of other bonds and see who else is or has been at 92%. It's particularly depressing and is not an argument in favor of a strong market view of the stability of the Iraqi government.

Posted by: rich on September 15, 2007 at 10:03 PM | PERMALINK

Kevin, I read your update. You don't seem to realize that credit spreads widened across the board. (E.g., the spread between BB and BBB widened.) To find a meaningful result relating to Iraqi bonds, you have to find an index that is flat to Iraqi bonds six months ago. Not only does Greenstone not do this, he doesn't even discuss the issue.

Posted by: y81 on September 15, 2007 at 10:05 PM | PERMALINK

Rich, as long as people confine themselves to the modest statement that "bond market findings fail to support the view that the surge is [working]," that's fine. But Kevin calls the results "striking" and draws a graph which implies that the situation in Iraq deteriorated substantially in July, whereas what deteriorated substantially in July was the overall level of credit spreads.

Posted by: y81 on September 15, 2007 at 10:11 PM | PERMALINK

You're going to have to do better than that, y81. You may have a point but you sure aren't sounding like it. You're just making assertions without bothering to back them up. And you're completely ignoring the substance of Kevin's update. If comparison to bonds from other emerging countries is not an adequate basis for comparison, why isn't it?

Posted by: PaulB on September 15, 2007 at 10:13 PM | PERMALINK

"But Kevin calls the results 'striking' and draws a graph which implies that the situation in Iraq deteriorated substantially in July, whereas what deteriorated substantially in July was the overall level of credit spreads"

If Iraq's deterioration was and is greater than those of other comparable markets, Kevin's point still stands.

Posted by: PaulB on September 15, 2007 at 10:15 PM | PERMALINK

In the market, "perceptions" rule.

Casualties don't count.

In WWI or the US Civil War, thousands died in a day and were perfectly acceptable if you felt you could win and the cause was important enough.

The Iraqi war worth any US lives?

The "Surge", "mixed results." Really? Where we put more troops, fewer casualties, more peace. Migration of violence, change of insurgent tactics. More troops on the street, higher casualties. Predictable?

Worth any US lives?

"Functioning of Iraq" = daily deaths, security forces, oil production, hours of electricity. Really? Where does government -- local or national -- come into this? Again, people will put up with a lot for believed outcome. London or Berlin in WWII!

Worth any US lives? Maybe.

I just love this Credit Default Swap. It's another name for an option. You buy and can redeem your money for a premium. The inventiveness of the criminals has no bounds. Give it a new name and the punters will come. Where is the Fed and other fiduciary protectors.

I want to issue all US citizens with a Surplus Monetary Condom.

Snake Oil is out there.

Refinance, anyone? At 3%?

Posted by: notthere on September 15, 2007 at 10:20 PM | PERMALINK

PaulB, if you look at the Greenstone paper, you will see that the Iraqi bonds carried a higher coupon than the emerging markets index generally back on February 15. As I said, to control for changes in credit spreads, you have to start with a set of bonds that traded flat to the Iraqi bonds in the early months of the year.

Posted by: y81 on September 15, 2007 at 10:26 PM | PERMALINK

The article isn't exactly what I would like but y81's criticism appears far from the mark. I would like to see the implied default spread calculated from the initial debut of the bonds. And I would like to see alternate controls beyond what's already included.

However, the author appears to understand the limits of the analysis. He also does not attempt to overstate the analysis, e.g. noting that "governments have defaulted on sovereign debt before without complete state failure" so that the default rate is not the same as the government failing.

The author clearly considers intertemporal changes in yield spreads - it's what the last couple of charts are based on. And in terms of relative comparisons and "flight to quality," Figure 12 touches on the issue comparing Iraqi bonds and an index of emerging markets. If the spike for Iraqi bonds was simply a flight to quality, other emerging markets should have been similarly afflicted. In fact, it's not clear that the flight primarily out of sub-prime U.S. mortgages should have any impact on either of these markets. To the extent that you want out of sub-primes, you can argue that some will head to alternate non-U.S. vehicles like emerging markets and the net result would be those bond prices heading up. (I wouldn't argue that they would head up, but I will argue that they need to head down.)

Posted by: rich on September 15, 2007 at 10:26 PM | PERMALINK

If the point is to show that investors in Iraqi bonds aren't confident in those investments, and this is the best way to show that, then I don't see what the problem is.

Posted by: Swan on September 15, 2007 at 10:29 PM | PERMALINK

Here's the scoop from The London Sunday Times:

QUOTE

AMERICA’s elder statesman of finance, Alan Greenspan, has shaken the White House by declaring that the prime motive for the war in Iraq was oil.

In his long-awaited memoir, to be published tomorrow, Greenspan, a Republican whose 18-year tenure as head of the US Federal Reserve was widely admired, will also deliver a stinging critique of President George W Bush’s economic policies.

However, it is his view on the motive for the 2003 Iraq invasion that is likely to provoke the most controversy. “I am saddened that it is politically inconvenient to acknowledge what everyone knows: the Iraq war is largely about oil,” he says.

UNQUOTE

Greenspan, an elder statesman of the Republican Party is now saying what many of you folks have been saying all along -- and been ridiculed for saying it.

I hope Kevin gets into this and that all faithful bloggers have a go at it.

I'm especially interested in what the right-wingers who sometimes post on this list have to say, since they are the ones who derided the information that Bush, Cheney and Rumsfeld were after Iraq's oil. And, of course, I'd like to hear what all have to say about sacrificing American lives and limbs for oil and for the personal profit of the oil barons, to say nothing of the horrible destruction of Iraq itself.

If there are any Republicans left standing after this, I'll be mightily surprised. GREENSPAN, of all people.

Posted by: scoop on September 15, 2007 at 10:29 PM | PERMALINK

I think I'm a bit more willing to give the benefit of the doubt to the tenured professor of economics at MIT than to a bunch of anonymous yahoos on the intarweb who seem to think their understanding of the world credit markets is unparalleled in its depth and sophistication. Particularly given the likelihood that most (if not all) of those yahoos don't seem like they've actually read the paper in question.

Posted by: phleabo on September 15, 2007 at 10:30 PM | PERMALINK

"PaulB, if you look at the Greenstone paper, you will see that the Iraqi bonds carried a higher coupon than the emerging markets index generally back on February 15."

That doesn't deal with the substance of Kevin's update or of Greenstone's paper. You're going to have to do better than that. I repeat: If Iraq's deterioration was and is greater than those of other comparable markets, Kevin's point still stands.

Posted by: PaulB on September 15, 2007 at 10:30 PM | PERMALINK

To make it clear what I'm objecting to, y81, if you're saying that Kevin is overstating the case, then yeah, I'd say you have a point. If you're saying that comparison between Iraqi bonds and those of other comparable markets is just a single data point and isn't a definitive argument, then yeah, I'd agree with that, as well. So what, precisely, is your argument?

Posted by: PaulB on September 15, 2007 at 10:36 PM | PERMALINK

y81, if you say that the credit markets "went crazy" in july as a justification for ignoring the fall in value, then perforce you mean they went into "free fall," so don't play little hair-splitting games.

and when you say that credit markets "went crazy" in july, it's irrelevant unless they went crazy on july 15, the date that the market in these bonds turn. needless to say, that's simply not true, and i don't care what pap you're telling us about your massive bond savvy.

and if iraqi bonds performed worse than other emerging market bonds since february, i have no idea whatsoever (and i'm not clear that you do either) what your reference to finding a set of bonds that traded "flat" to iraqi bonds earlier in the year is supposed to mean.

other than that, your critique is spot on. or something.

Posted by: howard on September 15, 2007 at 10:39 PM | PERMALINK

All I'd remind people is that Greenspan was not, NOT, an unmistakable reader of tealeaves or intentions.

Other than that I'd say that there are are a number of reasons the US invaded Iraq. In my opinion all bad but not more than the disregard of tribal, regional and national politics. No plan. No direction. No ideas. Not Even NOW!

The country, Iraq, is lost at this time. Where to go?

Posted by: notthere on September 15, 2007 at 10:50 PM | PERMALINK

PaulB, I understand Greenstone's argument just fine. He may well be correct that investor confidence in the Iraqi government declined substantially between Feb. and July of 2007. (I would quibble with characterizing the change in interest rate as "bearish on the surge." Rather, if the study is correct, it's bearish on the combination of circumstances between February and July, 2007.)

My point is that these bond investors are pretty bullish on the continuation of the Iraqi government. Certainly, they are more bullish than those who are hopeless -- who say there's nothing the US can do to preserve this government.

I must admit that the bond investors are not a random sample. Only those with confidence in the Iraq government would buy its bonds. Still, in analyzing data, before one looks at a relative change, one ought to look at the absolute magnitude.

Incidentally, one disturbing aspect of the study is that it's not intuitive. Most observers think the surge did no good or that it did some good. Few think it made things worse. So, it would be surprising if bond investors became dramatically more pessimistic during this periom.

Posted by: ex-liberal on September 15, 2007 at 11:19 PM | PERMALINK

"PaulB, I understand Greenstone's argument just fine."

Ah, then you were just being dishonest with your post above? If that's the way you want it, I'm fine with that, dear.

"Rather, if the study is correct, it's bearish on the combination of circumstances between February and July, 2007.)"

ROFLMAO..... No comment necessary. Don't you just love it when dear little faux says something so self-evidently stupid that you don't even have to bother coming up with a response?

"My point is that these bond investors are pretty bullish on the continuation of the Iraqi government."

Dear heart, not only can you not back up this statement, since the data don't support it, it has nothing to do with Kevin's point.

"Certainly, they are more bullish than those who are hopeless -- who say there's nothing the US can do to preserve this government."

ROFL.... You mean like the conservatives who want Maliki out?

"So, it would be surprising if bond investors became dramatically more pessimistic during this periom.[sic]"

Not even remotely, dear. "The surge" [tm] was the last-ditch effort, remember? If it failed, and the available data indicate that it did, then pessimism is clearly indicated.

Posted by: PaulB on September 15, 2007 at 11:27 PM | PERMALINK

never-ever-liberal, if bonds could go into backwardation it would be a no brainer. You could make money. In reality it just depends what odds you think are a gamble or an investment. Unless you are realy rich there is a significant separation.

As I pointed out, the surge has had benefits where it was targeted and deficits where it was not, and it is reasonable to assume that these benefits will recede/depreciate with fewer troops. At the same time social/governmental stability is continuing to degrade and it has never been on the US "need-to-do" list -- not even April 2003 when it needed to be. This is supreme idiocy.

This is the mark of this presidency. Why? Because this "president" IS an IDIOT.

Get with the agenda.

Posted by: notthere on September 15, 2007 at 11:54 PM | PERMALINK

"Obviously investors don't have any secret sources of information..."

Without a doubt these guys have a lot better information than most. Maybe secret, maybe not secret, but certainly not available to me. I bet a fund manager on Wall St. who was persuaded/told/pressured to invest in Iraqi bonds can call lots of people in various governments or contractors and get the scoop. I think that is part of the strength of this approach. These guys do know more than we do.

Its clear to me the trend is what's important. The trick is obviously separating signal from noise. And you can bet that the wingnut links would bloom across the intertubes if the trend was the other way.

Posted by: Nat on September 16, 2007 at 12:02 AM | PERMALINK

If the question is trend in Iraqi security and stability in recent months, why in the world would you NOT look at the numbers of refugees leaving Iraq (or becoming internally displaced)?

That's as close to the ground/source/critical info as you can possibly get.

People are voting with their lives, to save their lives. It's not a paper game. The numbers indicate the real personal risk to themselves and families, where the risk of relocating (with much certain loss) is evaluated as less than the risk of staying.

Now if that isn't a meaningful metric of safety and stability measured countrywide, what *is*?

The trend, BTW, is bad, and has been getting worse, with 4M displaced. If that trend were reversed, with thousands pouring back into Iraq, you could conclude the surge (or something anyway) was working. But that's not the way it is.

I guess the bond deal is okay too, but really, WTF? Isn't the refugee count many many times more reliable as an indicator???

Posted by: tubino on September 16, 2007 at 12:27 AM | PERMALINK

Just a futile plea not to use "metric" in this way, because a metric is a symmetric bilinear mapping. The correct term is "measure". Why did everyone forget about this perfectly good word?

Posted by: matt on September 16, 2007 at 12:42 AM | PERMALINK

Thanks Matt. I always wonder, do they mean Euclidean or non-Euclidean, or what?

Posted by: Dave Howard on September 16, 2007 at 1:04 AM | PERMALINK

Yeah Dave, and then they'll start computing Cristoffel symbols and Nijenhuis tensors . . .

It wouldn't be such a bad thing if they really did need the word, but, because there is already a perfectly good one, with the correct technical meaning too, clearly they're only appropriating the word for whatever authority it affords. Same deal with "optics".

Posted by: matt on September 16, 2007 at 1:28 AM | PERMALINK

I want to address the narrow point of why the comparison bonds chosen by Greenstone are questionable in the July-August context, and hence the spread graph shown earlier is not good evidence about the surge. Y81 already tried to explain this, but perhaps a little more detail would help.

The relevant information in on page 53 of the Greenstone paper. If you look at his data, you will see that the emerging index he uses starts off paying about 3.4% less than the Iraqi bonds, and the Qatar bond pays about 3.9% less, which is quite a large differential. This difference existed because both Qatar and the average emerging country in the index is a substantially better credit risk than Iraq--what idiot would loan money to Iraq at the same rate as Qatar? In other words, the Iraqi bonds are junk, or near junk. Certainly they are a lot junkier than the Qatar and EM index bonds and I would expect them to behave more like a junk bond than the others.

Now if you look at a chart of the high-yield spread during 2007

http://bespokeinvest.typepad.com/.shared/image.html?/photos/uncategorized/2007/08/23/high_yield_spreads_through_0823.png

you can see how spreads spiked upward from June onward in the junk market. This spike is just as dramatic as the spike in the paper and it appears to me as if until June or so the Iraqi bond spreads were deteriorating a bit relative to junk spreads, but after that the spreads didn't expand any more than the junk spreads. If anything it looks as if the Iraqi spreads actually grew a bit less. But the point is that they didn't behave wildly differently.

Since there is no reason to think that the junk spreads expanded because of anything happening in Iraq, it seems to me that it would be hard to show that the Iraqi spreads grew because of events in Iraq, given the similarity in magnitude. It is pretty clear from the paper (page 19) that the author, referencing the issues in the subprime market, still believed the bonds he used for comparison purposes are appropriate. Given that the salient issue during this period was quality, and the bad quality match involved here, I find that surprising and unpersuasive.

Posted by: matt wilbert on September 16, 2007 at 1:28 AM | PERMALINK

Thank you Matt Wlbert and Y81. You have made the issue clear as glass.

An interesting question is why the issue you explained wasn't equally clear to those who accepted the paper for publication.

Posted by: ex-liberal on September 16, 2007 at 1:37 AM | PERMALINK

Nice job. This is the sort of thing that makes me keep coming back to your site.

How about the flow of construction money into Iraqi Kurdistan? Is that continuing?

Posted by: MatthewRmarler on September 16, 2007 at 1:46 AM | PERMALINK

I am no fan of the surge, but the mid-July onward part of the graph is meaningless for the reason mentioned by y81.

True enough, but like every fact, it has interest of its own.

Posted by: MatthewRmarler on September 16, 2007 at 1:48 AM | PERMALINK

The real question is, how many of these bonds does Bush own?

Oh right, almost all of his money is in (U.S.) Treasuries.

Posted by: Nancy Irving on September 16, 2007 at 1:52 AM | PERMALINK

Mark Thoma from comments there: I didn't dig into all the details of the paper - so it may be there to some extent - but I also wished some of the data had been qualified (and doubted) more. He says he spent hundreds of hours on the data, and that large investment could, I suppose, lead him to give the data more credibility than someone looking in from outside.

KD may have missed this, but Thoma finds the paper's premise interesting not conclusive.

The paper notes who buys the Iraqi bonds but I wonder what an Iraqi credit swap would cost? If it's roughly in the range of the probability of default (8.14%) or 814 bps, an anecdotal comparison is that Countrywide credit default swaps carried a 620 bps price in recent weeks which is huge.

Also, the bond market prices issued paper but also could reflect the conversion rate of future Paris Accord swaps. The Iraqi government will pay more for debt forgiveness than previously. This despite oil prices in the $80 range which at 2 million bpd translates into almost $60 billion a year. Total external reissued debt, then, is only about 5% of annual gov't revenue.

Posted by: TJM on September 16, 2007 at 7:00 AM | PERMALINK

Thanks TJM. I found a source that discusses the issue you raised, namely Iraq's enormous existing foreign debt. The article says that in July, the Paris Club of government creditors met to add up what it is owed, a large figure that had not been previously known.

This re-evaluation of Iraq's total debt would naturally have an impact on the rate paid on new lending. It was naive of Professor Greenstone to attribute changes in this rate solely to the surge.

Posted by: ex-liberal on September 16, 2007 at 7:34 AM | PERMALINK

After reading a good part of the paper, I looked at most of the comments to see if the paper addressed any of the concerns. One set of comments highly critical of the paper is from y81. It says the paper didn't account for:

intertemporal changes in credit spreads at all.

Well, actually, if you look at pp 19ff, the author speaks to this issue at some length, so I take the comment to anticipate an error that doesn't look to be an error.

As for the paper's conclusion about the financial markets view of the surge, the author looked at other variables and says:

The ultimate purpose of the Surge is to create the conditions that will allow for a stable Iraq to emerge. Thus far, the paper has documented that the Surge has been effective at improving the security situation in Iraq without an appreciable increase in casualties among coalition and Iraqi troops.

As to whether the paper deals with the subprime crazy market, I note this from p19:

The Qatari and Lehman Index are also appealing, because the Surge period partially coincides with the subprime mortgage lending crisis that caused a “flight to quality” for US treasuries

So it seems as if both y81 and matt wilbert' comments about missing the sub prime effect to have a junk bond quality themselves.

Oh, and everything ex-liberal says is just palin wrong. But you all knew that.

Posted by: TJM on September 16, 2007 at 7:50 AM | PERMALINK

"palin" wrong, as in Michael as in "Monty Python" as in I came here for an argument.....

Posted by: TJM on September 16, 2007 at 7:59 AM | PERMALINK

The bond market is best left to bond traders. Some, like Mike Milken, the ex-junk bond king, are brilliant enough to be placed on the "inside", so to speak, becaue they can see valid opportunities where the rest of the traders see only disaster. We, by definition, are on the outside of the rest of bond traders. So it is almost impossible for us to get the picture of the bond market. Probably on the outside of us are most economists, given that they don't trade and have incomplete theories to gum up their vision. :-)

I traded T-bond futures and options on those futures for years in the eighties. I had one real insight in all those years, and it lasted about a week. As a result, I feel real happy that my head is still attached to my body.

I would love to hear Milken's opinion on Iraqi bonds. He was shafted by the legal system, by the way.

Posted by: Bob M on September 16, 2007 at 8:03 AM | PERMALINK

Kevin said 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.

I appreciate the novel approach of looking at bonds, but I ask again, if you want a measure of Iraqi stability, why not look at the trend in numbers of people fleeing the country in desperation each day? Why is that NOT one of the "usual metrics"? NOT looking at that allows the author to make this claim:

The ultimate purpose of the Surge is to create the conditions that will allow for a stable Iraq to emerge. Thus far, the paper has documented that the Surge has been effective at improving the security situation in Iraq without an appreciable increase in casualties among coalition and Iraqi troops.

If something has been effective at improving the security situation in Iraq, then why are the numbers of internally and externally displaced Iraqis rising rather than dropping?

Put it another way: if the anticipated or real bond default rate decreased (got better), but the number of refugees leaving per day was steady or increased (got worse), which measure would give you a better insight into stability conditions throughout Iraq?

The bond analysis is interesting, certainly, and give the stats pros a chance to show off, but isn't there a much more direct measure of stability, with pretty good data available, right under our noses?

Posted by: tubino on September 16, 2007 at 8:13 AM | PERMALINK

I took only a quick look at the paper so chances are I missed something. But the one criticism I find valid is about the comparison bonds. I agree they should have compared with other similarly rated governments. AFAIK Iraq is not rated by anyone but I can't believe it would be rated higher than the 'B' category (although I wonder if the implicit ratings in the bond spreads when the 2006 came out were higher).

Posted by: Gabriel on September 16, 2007 at 8:38 AM | PERMALINK

I'd like to suggest that Greenstone's analysis is not a measure of the market's perception of the success of the surge per se, but a measure of the anticipated outcome of the tactics employed (specifically, US efforts to "fight al Qaeda" through support and reorganize the Sunni-based Baathist insurgency) by Petraeus.

Its not like investors were unaware of the potential for civil war/chaos in Iraq prior to the announcement of the surge. And most smart money realized in advance that the surge wasn't going to work -- that it was simply an effort by Bush to buy time.

In other words, while investors saw a risk that Iraq would default prior to the surge, they now think that a "failed state" -- one which is no longer capable of collecting revenue and paying its bills -- in Iraq is far more likely.

Posted by: p_lukasiak on September 16, 2007 at 9:26 AM | PERMALINK

Let me repeat something I said earlier and that appears to have been lost in much of the discussion.

"It's clearly a working paper and there clearly are rough edges. However, the author carefully notes what can be said: 'Overall, the bond market findings fail to support the view that the Surge is helping to pave the way for a stable Iraq to emerge and may in fact be undermining it.'"

There are some that are willing to discount Greenstone's analysis because it doesn't fit with their desired results. I have yet to read anyone's comments who addresses the paper's point head-on or who makes valid criticisms of the paper.

Ex-liberal notes "An interesting question is why the issue you explained wasn't equally clear to those who accepted the paper for publication." Let me note again that it's a working paper. (Working Paper No. 07-24.) It hasn't been published yet; it's a draft and will undoubtedly be revised. There are issues as I suspect Greenstone is well aware.

The issues raised here are largely off-point. Matt Wilbert's complaint that the comparisons Greenstone makes with spreads initially of 3.4% and 3.9% indicate the weakness of Greenstone's argument. There's a kernel of truth there. However, Wilbert never addresses the question of what would be the most accurate comparison - and the chart provided of high-yield is useless for reasons I'll get to in a moment.

Suppose that emerging market debt isn't a good comparison with Iraqi debt even at the outset because of the spread. That should be a great concern to anyone who supports the U.S. presence in Iraq. It's saying that Iraq even at the outset of the surge is a much more risky investment than one of the most risky investments around - emerging markets. If there's a flight to quality, e.g. as a result of concerns over contagion based on the sub-prime difficulties, it should show up in the returns in emerging markets.

Let me return to finance 101 for a moment. When you're looking at spreads - or intertemporal changes in spreads - you can have changes either in real returns, in inflation premiums, or in risk premiums. There is debate among finance professionals - or finance academics - on whether there's intertemporal variation in real rates. However, even if there were, a six month window or even a four year window wouldn't be sufficient to capture it anyway. Thus, this factor can be safely ignored.

Changes in inflation premiums could certainly cause substantial changes in spreads and you don't need to go far to see evidence of that. (Look at Russian or Argentinian bonds, for example.) I suspect that there hasn't been an appreciable change in the Iraqi inflation rate over this short window, but that's something that Greenstone doesn't appear to address. It's a real problem with the paper, but I would guess that he will address it in a revision. If that doesn't make a difference, then we're left with differences in risk premiums as the cause for the movement.

There clearly is a question of what is the appropriate benchmark for which to compute the spread. No evidence has been presented that there's a better measure than what Greenstone uses, e.g. emerging markets. A weakness of the paper is that it's not clear that the results are robust with respect to other methods of calculating the spread. (Again, I suspect that in any revision that point will be addressed.) If someone wants to criticize Greenstone on this point, I'm willing to listen -- as long as they repeat his calculations using the available data and show the results just as he has. Until then, count me as a skeptic of those criticisms.

Greenstone's discussion makes clear that he understands that his calculated default rates are the overall default probabilities and that those default probabilities need not reflect that the Iraqi government falls. The July increase may well reflect an increase in the recognition of total Iraqi debt and thus a revision of default probabilities. Nevertheless, we're still in a position where there is no evidence that the surge improved matters - exactly the conclusion the Greenstone emphasizes.

Finally let me note that presenting another chart on another spread that looks somewhat similar to Greenstone's key charts and arguing that therefore his analysis doesn't hold may make supporters of the surge feel better but doesn't shed any light on the issue of whether the surge improved matters.

Posted by: rich on September 16, 2007 at 9:35 AM | PERMALINK

Is it too much to suggest that it's just a little crazy to begin with to use bond markets of all things as some kind of "objective" metric for the success of the surge? So bond buyers and sellers aren't buying into the notion that the surge is working. So goddamn what? What do they know, even in aggregate, that the rest of us don't know, or can't know?

I realize that the author of the paper is an economics professor, and it's very convenient for him to try to reduce a non-economic question to an economic one. But why should his limitations drive us to accept an argument that comes at the basic issue from such a large degree of separation?

Posted by: frankly0 on September 16, 2007 at 9:37 AM | PERMALINK

Do the bond yields measure the human suffering in Iraq as well??

Posted by: The Conservative Deflator on September 16, 2007 at 10:01 AM | PERMALINK

appreciate the novel approach of looking at bonds, but I ask again, if you want a measure of Iraqi stability, why not look at the trend in numbers of people fleeing the country in desperation each day?

Because, the number of people capable of fleeing with a better prospect of setting back up wherever they land may be dwindling.

And, just because the people who are left over think that they can't afford the dangerous, long trip to the border and beyond (or are too scared to go), and then the risk of setting up anew, doesn't mean that Iraq is going to be more stable with only those left-overs there.

If people are leaving less, it doesn't mean it's because they're less scared, or that they observe less signs of trouble where they are.

Posted by: Swan on September 16, 2007 at 11:16 AM | PERMALINK

appreciate the novel approach of looking at bonds, but I ask again, if you want a measure of Iraqi stability, why not look at the trend in numbers of people fleeing the country in desperation each day?

Maybe (wink, nod) someone will spread a rumor that it is too dangerous to leave and domestically this will make the surge look better when people stop leaving.

Posted by: Swan on September 16, 2007 at 11:43 AM | PERMALINK

Rich, citing Greenstone: "governments have defaulted on sovereign debt before without complete state failure". Actually this point does not help Ms Rosy Scenario and her friends on this thread. It applies to tough governments like Zimbabwe's presiding over economic failure, or socialist radicals like Chavez. But Iraq isn't bankrupt or facing a communist insurrection. If there's a government at all, it will have a large oil export income, and any remotely likely government, including an Iranian proxy, will pay the interest on the bonds. All the risk is of political collapse.
Do Afghanistan and Somalia, the closest analogies, have sovereign debt outstanding?

Posted by: James Wimberley on September 16, 2007 at 12:10 PM | PERMALINK

**

Posted by: mhr on September 16, 2007 at 12:12 PM | PERMALINK

I'd like to suggest that Greenstone's analysis is not a measure of the market's perception of the success of the surge per se, but a measure of the anticipated outcome of the tactics employed (specifically, US efforts to "fight al Qaeda" through support and reorganize the Sunni-based Baathist insurgency) by Petraeus.

Its not like investors were unaware of the potential for civil war/chaos in Iraq prior to the announcement of the surge. And most smart money realized in advance that the surge wasn't going to work -- that it was simply an effort by Bush to buy time.

In other words, while investors saw a risk that Iraq would default prior to the surge, they now think that a "failed state" -- one which is no longer capable of collecting revenue and paying its bills -- in Iraq is far more likely.
Posted by: p_lukasiak on September 16, 2007 at 9:26 AM
-------

Yes. Investors eventually came to view the surge simply as a tactic to delay the inevitable collapse of the government until Bush can leave office. The stated objective of the surge was to foster political progress in Iraq. But, there hasn't been any progress, so the surge has failed even by the administration's initial criteria for success. They've just changed the *criteria* for success-now it is "Peace in Anbar", "AQI is being demolished", "We're doing it from the ground-up instead". The real question now is can Bush actually succeed in running out the clock? I'm a little doubtful about this-events are unravelling pretty fast.

Posted by: Doc at the Radar Station on September 16, 2007 at 12:24 PM | PERMALINK

"Is it too much to suggest that it's just a little crazy to begin with to use bond markets of all things as some kind of "objective" metric for the success of the surge?" No argument that there are lots of possible metrics and using implied default probabilities wouldn't be my first choice. However, you have a situation in Washington where many have an incentive to "mis-state the truth." To ask someone to evaluate whether his plan worked is silly on its face. The bond market has the advantage of having real participants betting heavily for or against a particular outcome. Perfect? Far from it. Better than listening to someone effectively evaluate himself? Certainly in my judgment. (One other similar application is an analysis of implied default probabilities for U.S. and Confederate bonds during the U.S. Civil War.)

Afghanistan has had near complete debt relief; Somalia has a large debt for a country of their size, about $2.6B I believe. However, they've made no pretense of even paying interest on it and most likely will be either forgiven or will default. One could construct a scenario where a tough-minded Iraqi government does default. Suppose Iraq follows Iran into a virulently anti-American and anti-West orbit and suppose that most of the bonds are held by westerners. It would be very simple for them to invoke Sharia Law and say the bonds are null and void. I'm not predicting that outcome, but if I'm buying Iraqi bonds it's something I need to factor into the price.

Posted by: rich on September 16, 2007 at 12:32 PM | PERMALINK

Swan responded to my question about refugee trends with this: Because, the number of people capable of fleeing with a better prospect of setting back up wherever they land may be dwindling.

Okay, and it seems true that the wealthy left a long time ago, the middle class and poor are leaving now ... but many have pointed out the same problem with counting casualty numbers to measure success in stabilizing Iraq. To wit, an "ethnically-cleansed" neighborhood of Baghdad may become relatively calm and non-violent, because likely victims (minority) are dead or have left.

The thing is, though, that in a truly stable Iraq, one would expect to see not only dwindling numbers for those leaving, but to be outnumbered by those RETURNING (some of those FOUR MILLION plus). So net gain/loss would have some validity, no? Not perfect, but nothing is.

Posted by: tubino on September 16, 2007 at 12:54 PM | PERMALINK

Surely one of the corollaries of this discussion is that those who believe that the surge is working and that Iraq is returning to stability have a wonderful opportunity before them: they should invest in Iraqi bonds, which are selling at a discount.

Posted by: buckets on September 16, 2007 at 1:09 PM | PERMALINK

buckets: Surely one of the corollaries of this discussion is that those who believe that the surge is working and that Iraq is returning to stability have a wonderful opportunity before them: they should invest in Iraqi bonds, which are selling at a discount.

I just spoke to my broker, Charles Schwab. The representative on the phone put me on hold and asked a colleague about Iraq bonds. He said the colleague laughed. "Must be a Democrat," he said.

The telephone representative had no information on the price of the bonds or how to buy them. He said I would have to talk their fixed income division, which is not open on Sunday. I'll give them a call next week.

I will be traveling Monday and Tuesday, so may not make a decision in time to describe it on this thread. My inclination is to invest a bit if the discount is big enough.

Posted by: ex-liberal on September 16, 2007 at 1:48 PM | PERMALINK

ex-lib: My inclination is to invest a bit if the discount is big enough.


spoken like a trailblazer for freedom...

Posted by: mr. irony on September 16, 2007 at 2:01 PM | PERMALINK

One of the data points you'd want to consider, ex-liberal, is that the CEO of Hunt, who also happens to be on Bush's Foreign Intelligence Advisory Board, went with an oil deal with the Kurds, and this appears to have ended any national reconciliation on oil revenue distribution.

The point is that an administration insider is betting on -- even pushing for -- regional secession/autonomy over central management of the key revenue source of the country.

But hey, it's your money.

Posted by: tubino on September 16, 2007 at 2:22 PM | PERMALINK

tubino:The thing is, though, that in a truly stable Iraq, one would expect to see not only dwindling numbers for those leaving, but to be outnumbered by those RETURNING (some of those FOUR MILLION plus). So net gain/loss would have some validity, no? Not perfect, but nothing is

Let's assume the Shiite strategy were to drive out the Sunni and that the strategy was working. As the # of Sunni declined due to death or flight, the trend in both casualties and refugees would be down. At the point where there were no, or few, Sunni, and none returning, the state would be stable (barring, say, Saudi assistance to the Sunni). Good for the Shiite, bad for the Sunni, but stable which would be great for bond prices.

Posted by: TJM on September 16, 2007 at 2:30 PM | PERMALINK

"It was naive of Professor Greenstone to attribute changes in this rate solely to the surge."

LOL... Still haven't read the paper, have you? Since that is not, in fact, what Greenstone did, you are, as usual, completely wrong.

Posted by: PaulB on September 16, 2007 at 2:40 PM | PERMALINK

I would love to hear Milken's opinion on Iraqi bonds. He was shafted by the legal system, by the way.

LMAO.

Posted by: Disputo on September 16, 2007 at 3:47 PM | PERMALINK
….My inclination is to invest a bit ex-lax at 1:48 PM
While you're at it, real American patriots always sell Euros short.

[Chrsst, you couldn't invent this clown on a toot.]

Posted by: Mike on September 16, 2007 at 10:40 PM | PERMALINK

Beyond all the other arguments against using the valuation of bonds as a metric for success of the surge, how about this: even if the probability that bonds will default is relatively quite high, the claim is that the expected annual default probability is now 8.14%.

Well, as I understand what that might mean, that would more or less imply that over roughly the next four or five years, we would expect about a 50% probability of survival of the government.

Well, why is that number so bad? In principle, Bush and friends might argue that a probability of success of only, say, 30% or 40% might well be worth fighting for, given the disaster that would otherwise ensue.

Personally, I place the probability of a stable government in Iraq 5 years out at well below 10%, perhaps well below 5%. I don't see the US as sticking around past 2009, because any Democratic President will pull out the vast majority of American forces, and that will lead almost certainly to a quick collapse of the government (and I regard it as very highly likely that a Democrat will win in 2008).

Again, why entertain the fiction that bond sellers and buyers are on to something the rest of us aren't?

Posted by: frankly0 on September 16, 2007 at 10:55 PM | PERMALINK

Rich: Why should an Iranian-controlled government in Iraq want to default on its sovereign debt? Iran issued Eurobonds in 2002, though Americans aren't allowed to hold them - so default would not hurt the the USA, only more sympathetic Europe and Japan. Fitch rates Iran's sovereign debt B+, higher than Brazil's, with "outlook stable". Islam is the only majot religion founded by a buseinessman!

Posted by: James Wimberley on September 17, 2007 at 5:38 AM | PERMALINK

Actually, working through the numbers, if the expected annual default probability is 8.14%, the probability that the bonds would not default even 10 years out appears to be about 47%.

Again, why is this such a terrible number for staying the course in Iraq?

Posted by: frankly0 on September 17, 2007 at 10:42 AM | PERMALINK

spoken like a war profiteer

Fixed it for you.

Posted by: Gregory on September 17, 2007 at 2:37 PM | PERMALINK

The probability assessment has little to do with the Maliki government. If the bonds continue to make timely interest and principal payments, the market is indifferent to who is running the government. There is a risk, reflected in the price, that a new government, which could be the next or the one after that etc., would refuse to pay.
The price spike could reflect that if the US needs a "surge" to keep the present gov'tin place, there is added uncertainty as to what the next government might do. Once that uncertainty is resolved, one way or the other, the price should stabilize.

Posted by: TJM on September 17, 2007 at 6:38 PM | PERMALINK




 

 

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