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Tuesday, September 18, 2007

Jim Hamilton: Economic Indicators of Success in Iraq

Jim Hamilton discusses a recent evidence on the prospects for Iraq gleaned from financial markets:

Economic indicators of success in Iraq, By James Hamilton: Some economists have been interpreting economic developments as shedding light on the success of the military surge in Iraq. I think one needs to use a bit of caution in drawing conclusions from such evidence.

Paul Krugman's analysis generated some interesting discussion at Economist's View, Daily Kos, and Brian Beutler, among many others. Krugman writes:

To understand what's really happening in Iraq, follow the oil money, which already knows that the surge has failed....

.... Last month, the provincial government in Kurdistan, defying the central government, passed its own oil law; last week, a Kurdish Web site announced that the provincial government had signed a production-sharing deal with Hunt Oil of Dallas, and that seems to have been the last straw.

Now here's the thing: Ray L. Hunt, the chief executive and president of Hunt Oil, is a close political ally of Bush. More than that, Hunt is a member of the President's Foreign Intelligence Advisory Board, a key oversight body.

....what's interesting about this deal is the fact that Hunt, thanks to his policy position, is presumably as well-informed about the actual state of affairs in Iraq as anyone in the business world can be. By putting his money into a deal with the Kurds, despite Baghdad's disapproval, he's essentially betting that the Iraqi government-- which hasn't met a single one of the major benchmarks Bush laid out in January-- won't get its act together. Indeed, he's effectively betting against the survival of Iraq as a nation in any meaningful sense of the term.

The smart money, then, knows that the surge has failed, that the war is lost, and that Iraq is going the way of Yugoslavia. And I suspect that most people in the Bush administration-- maybe even Bush himself-- know this, too.

Mr. Hunt's plan is apparently not a distant potential, but something for implementation here and now. Dallas Morning News reports:

Hunt said it would begin its geological survey and seismic work by the end of this year and planned to begin drilling in 2008.

Here's the question for Professor Krugman-- would you invest many millions of your own dollars in a region that you were convinced is slipping irrevocably into chaos and instability? I found the Kurds' spin on this story (as reported again by Dallas Morning News) a much more natural interpretation than Krugman's:

"Kurdistan is looking more and more like an island of stability" in Iraq, said Qubad Talabani, the son of Iraq's president and the representative of the Kurdistan Regional Government to the United States. "This should get the attention of other companies."

Now, I'll grant Krugman that the deal does suggest that the future of Iraq may develop along different lines than embodied by the current central government and its oil plan. But that does not mean that the future is necessarily a bleak one for the Iraqi people or U.S. interests.

I have a similar concern about the thoughtful new research paper by MIT Professor Michael Greenstone, which has been favorably described by Freakonomics, Marginal Revolution, and Economist's View, among others. Greenstone looks at a number of indicators, one of which is the price of the Iraqi government debt. Here's Greenstone's description of the background:

Prior to Iraq's invasion of Kuwait in 1990, Iraq issued about $130 billion in debt. After the Gulf war, they defaulted on this debt. When the US led coalition invaded Iraq in 2003, the holders of this debt were spread around the world.... After the end of combat operations in May 2003, the US government brokered a deal to exchange $1000 in the existing bonds for $200 worth of new bonds for those creditors who held at least $35 million in Iraqi bond so that the new Iraqi government would not be hamstrung by this debt. As a result of this debt relief agreement, the Iraqi government issued roughly $2.66 billion in US dollar denominated notes in January 2006.

Greenstone then notes that the interest rate on this debt has increased in recent months. One of his most interesting graphs was the following, which calculates that the implicit probability of default on these bonds has risen from less than a 6% annual risk to more than an 8% annual risk:

The Implied annual default Rate of Iraqi state bonds. Source: Greenstone (2007).


Greenstone described this as a 40% increase in the expected default rate. I suspect that fewer people would be misled if we had instead reported these same numbers as a 2% increase in the probability of default. And while I agree that it is most natural to interpret this as market concern over increased instability, that is far from the only possible explanation. I would think, for example, that exactly the same kind of conditions under which Hunt Oil would profit from its deal with the Kurds would also mean a reduced likelihood of the central government repaying the debt. I could also well imagine that further debt forgiveness could be an integral part of negotiations for what comes next. So while I agree with Krugman and Greenstone that the oil deal and interest rate changes may signal less confidence in the continuation of the current regime in its present form, I do not see the basis for assuming that any changes in that regime necessarily equate with less stability.

Notwithstanding, I can certainly recommend Greenstone's paper for its careful and thorough analysis, which has a number of interesting results besides the observation on interest rates. For example, Greenstone concludes that the surge has successfully reversed the trend in civilian fatalities:

Daily fatalities of Iraqi civilians from 1 year before the surge began through 153 days after the surge began, with regression lines allowing for a break in trend. Source: Greenstone (2007).


If one were asking the question, as I wish more people were, of which course among the currently feasible options would be in the best interests of the Iraqi people, I think exploration for new oil and a decrease in the number of Iraqis who are being killed would be viewed as unambiguously hopeful developments.

I appreciate the point that we should think about what's best for the Iraqi people. Sometimes, that seems to be given little weight or forgotten in these discussions. A few points in response:

First, I thought one of the points of the paper is that the standard indicators give mixed messages about the success of the surge. The unreliability of the data combined with the ability for those in charge to manipulate the data make it difficult to reach firm conclusions. As the author says, "Evaluating such conflicting indicators is challenging," and hence the use of financial market data instead which, though not perfect, may give a better indication of the chance of success. And what the financial market data say is not encouraging.

Second, of all the data used in the paper, the author took special note of the data on civilian deaths, saying that "even among the available data, there are legitimate questions about quality and reliability. This is especially the case with the civilian casualty data." For that reason, the confidence intervals are large and the break shown in the graph is unlikely to be statistically significant when all sources on uncertainty are accounted for.

Third, beyond the measurement problems with civilian deaths, and there are serious questions about how these data are gathered, much like the fall in interest rates can be a sign of god or bad developments in the economy depending upon the source of the change, a drop in civilian deaths must be interpreted in terms of the underlying cause. There is evidence that the fall in civilian deaths is due to ethnic cleansing in many neighborhoods. Once a neighborhood is "cleansed," violence drops, but it's hard to interpret that as a success for the Iraqi people.

Fourth, is Balkanization good or bad for the Iraqi people overall? It probably depends upon which group you belong to and how it plays out. I can't disagree that Balkanization "does not mean that the future is necessarily a bleak one for the Iraqi people or U.S. interests," but there's certainly no guarantee that will be the case and it's hard to imagine getting to that outcome without a substantial amount of violence. Since the Hunt deal relies upon the dissolution of the current government and involves who gets the property rights to Iraqi oil, the potential for instability and negative consequences for the Iraqi people seems quite real.

    Posted by on Tuesday, September 18, 2007 at 09:36 AM in Economics, Iraq and Afghanistan | Permalink  TrackBack (1)  Comments (21)


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    Economist Michael Greenstone has done an admirable, even handed and statistically rigorous analysis of available data on the trends in Iraq since the beginning of the surge. His most important conclusions: Civilian casualties have declined. The decli... [Read More]

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