Assessing pacification policy in iraq evidence from iraqi financial markets by eric chaney
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“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. Sensible Ideas.

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

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“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

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.

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

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

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?

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

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?

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.

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?

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

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.

  • 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)

Some Policy Conclusions

  • Make Iraqi factions reconcile

  • Negotiate with Iran

  • Don’t kill terrorists or insurgents

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

“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

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