It turns out that there's a liquid and competitive market for Iraqi government bonds, which have been traded in substantial quantities on world financial markets since the start of 2006. The yield of these bonds 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, (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 realistically 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, 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.