Are bond traders betting against the surge?

An economist argues that the declining worth of Iraqi state bonds means the markets have decided the surge won't work

Published October 10, 2007 9:30PM (EDT)

The latest statistics tell us that since the beginning of the "surge" in Iraq, civilian fatalities have fallen. The rate at which coalition forces have been dying or injured has also dropped. Oil production is down, but electricity generation appears to be up. Some brave souls have begun to suggest that the relative decline in mayhem can be taken as evidence that the surge is "working."

But the bond markets aren't having any of it. Ever since the surge began, the value of Iraqi state bonds, measured in terms of the likelihood of default, has been declining. For Michael Greenstone, an economist at M.I.T., the verdict of bond traders is a clear indication that the surge isn't working, insofar as it is likely to contribute to the future stability of the Iraqi state. (Thanks again to Dani Rodrik, who continues to bolster his terrific track record at spotlighting provocative research, for the link.)

That there even is an market for the buying and selling of Iraqi bonds is a bit of an eyebrow-raiser, given the ongoing chaos in the country. After the first Gulf War, Iraq defaulted on $130 billion dollars worth of debt. But after the "successful" invasion of Iraq, the U.S. brokered a deal in which debt-holders could trade in $1000 worth of old Iraqi bonds for $200 worth of new bonds, issued in January 2006. Not only are those bonds actively traded, but there is also a market for credit swaps tied to those bonds -- a derivatives market in which traders buy and sell the risk associated with whether or not the Iraqi government may default on this second generation of bonds.

Since the surge began, writes Greenstone, the value of Iraqi state bonds has declined, and the credit swaps have become more expensive.

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.... to date, world financial markets have never believed that the surge will increase the prospects for a stable Iraq and may in fact be undermining them.

Greenstone's paper builds on work published earlier this summer by Berkeley economist Eric Chaney, who tracked Iraqi bond prices as a measure of how the markets evaluated the potential success of varying "pacification" strategies engaged in by U.S. troops. In both cases, one has to take as a given that the decisions of bond traders are reliable indicators as to the nature of concrete reality. To anyone who watched the wild swings of the stock and bond markets in August, that might seem a dubious assertion. At present there is a consensus that investors across the world had massively "mispriced" the risk inherent in all kinds of financial instruments. Who is say that the bond traders who are holding their noses at Iraqi paper are not similarly misinformed?

Greenstone suggests that "the appeal of using financial markets is that traders' only concern is to make profitable decisions and this necessarily requires making correct projections. There isn't room for personal biases in this setting." But it seems here that all you can really determine from the downward trend in the value of Iraqi bonds is that bond traders don't think the surge will work, and not that surge has been proven ineffective. How the World Works isn't quite ready to accept the dogma of bond trader infallibility.

And yet, the finding is still interesting, because it raises the obvious question of why, even in the face of some apparent relative staunching of sectarian warfare and daily bloodshed, the bond traders are so unremittingly glum. Greenstone has some theories:

One possibility is that the surge hardened the positions of the combatants in Iraq (e.g., the U.S. military's new alliances with the Sunnis may deepen Shi'a's resentments) and that this has lowered the prospects for a stable Iraq. Another is that the improvements in the security situation have not been followed by meaningful political gains. Thus, the surge may have revealed that the depth of the political problem in Iraq is greater than previously was recognized. Further, the revelation of the magnitude of this problem may have increased the probability that Congress or a new President will remove U.S. troops sooner than was expected.

Are bond trader decisions to buy or sell actually based on such subtle political parsing? Or does their lack of enthusiasm for Iraqi bonds measure a more primal gut feeling, a sense that whether U.S. forces stay, surge, or go, Iraq is just plain screwed?

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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Globalization How The World Works Iraq Iraq War Middle East