“Assessing Pacification Policy in Iraq: Evidence from Iraqi Financial Markets” by Eric Chaney

1. “Assessing Pacification Policy in Iraq: Evidence from Iraqi Financial Markets” by Eric Chaney Comments by Steven Davis NBER Conference on Economics of National Security July 27, 2007

2. Sensible Ideas • The market price of Iraq bonds reveals information about the survival probability of the current Iraqi regime. • Bond prices respond to news events or nonevents that affect assessments of the prospects for regime survival. • These price responses can be studied to draw inferences about how particular developments affect regime survival prospects.

3. Serious Problems • Information revelation point is oversold • Policy recommendations and conclusions • Oversold • Confused on key issues • Not precise or concrete enough to be useful • Not based on bond market analysis • Rhetoric and language

4. Suggestions for Improvement, 1 • Figure 1 attributes the entire yield spread to a default risk premium. (See footnote 17, page 7.) • Liquidity premium in Iraq bond yield  Figure 1 understates regime survival probability • Alternative: back out default probability using yield spread between Qatar and Iraq bonds. • Does the Iraq bond market get thinner in the wake of bad news about regime survival prospects? • If so, then bond price reactions to news events likely overstate market participants’ assessments of changes in regime survival prospects • Can investigate empirically

5. Suggestions for Improvement, 2 Table 1 • Replace Iraq spread variable with returns on a broad equity index and run regressions over a longer time period Table 2 • Translate results into the shift in default probabilities implied by Milestones Tables 1 and 2 • How much of the variation in the implied default probability is accounted for by key event indicators and the Milestones?

6. On Information Revelation, 1 “Since efficient markets aggregate available information faster and more objectively than any individual or agency could,…” Always? Really? There are at least three issues: • Private information holders who don’t trade • Incomplete revelation of traders’ information • Drawing inferences in real time

7. On Information Revelation, 2 Private Information Holders Who Don’t Trade • Is it feasible and cost effective to take short positions in Iraq bonds? • Can government officials, military officers, Haliburton executives, etc. trade on private information about prospects for regime survival? • Are leaders of Iraqi insurgent groups getting rich (or funding operations) by trading Iraq bonds?

8. On Information Revelation, 3 Incomplete Revelation of Traders’ Information • Rational financial markets do not fully aggregate and reveal private information. • Grossman (1977) “The Existence of Futures Markets, Noisy Rational Expectations and Informational Externalities,” Review of Economics Studies, 44, no. 3. • Grossman and Stiglitz (1980) “On the Impossibility of Informationally Efficient Markets,” American Economic Review, 70, no. 3. • Heifetz and Polemarchakis (1998) “Partial Revelation with Rational Expectations,” Journal of Economic Theory, 80.

9. On Information Revelation, 4 Drawing Inferences in Real Time • Is all relevant information possessed by policy makers (rapidly) reflected in asset prices? • Can we draw precise statistical inferences from partial samples, i.e., samples that exclude future observations as of the assessment date or policy decision date?

10. Yardstick for Policy Evaluation Regime survival ≠ policy success ≠ Iraqi welfare. • Howthe regime survives matters • Shia-Sunni struggle for control of Baghdad • Conditions matter, given survival • Sectarian killings vs. general criminality • Whether economy collapses or thrives

11. Assessing Survival Prospects versus Policy Evaluation • Many news events raise or lower regime survival prospects regardlessof policy response to those events. • E.g., upsurge in sectarian violence • Bond price movements confound multiple effects: • The impact of the event on regime survival prospects • Underlying policy actions and developments that may have caused or precipitated the event • E.g., News of three-party negotiations involving Iraq, Iran and the U.S. • Asset price movements can also confound the effect of an event and the policy response to the event.

12. E.g., “… the market is skeptical of military action against Iran or Syria” (based on yield spread response to outbreak of fighting between Hizb Allah and Israel)

13. Some Policy Conclusions • Make Iraqi factions reconcile • Negotiate with Iran • Don’t kill terrorists or insurgents

14. Example: Negotiate with Iran How to elicit Iranian cooperation? • Promise to work with Europeans to relax sanctions against Iran. • Talk nice and make overtures • Kill, incarcerate Iranian agents in Iraq • Threat to bomb Iranian nuclear facilities or gas pipelines • Threaten to foment internal unrest in Iran

15. “Objective” vs. “Subjective” Analysis Objective Aspects • Iraq bond market participants have a financial stake in the assessments of default risks and, hence, in their assessments of regime survival. • Iraq bond price (imperfectly) aggregates the private information of bond traders. Subjective Aspects • Others have a political or career interest in presenting an overly rosy or overly gloomy assessment of regime survival prospects. • Ideological blinders