Is the Surge Working? Iraqi Bonds Say No.

Gen. David Patreus' testimony this week left the impression that the ramp-up of U.S. troops in Iraq has had mixed results.

And looking at a group of commonly-cited indicators on the war's progress would leave one to conclude much the same, says M.I.T.'s Michael Greenstone.

But an arguably much better indicator for the potential success of the surge is how investors are betting on its outcome. More on that in a bit.

Greenstone examined trends in Iraqi oil production, electricity use, and casualties before and after the "surge" started. He found:

Positives -

• A substantial reduction in civilian deaths
• Possibly an increase in the number of hours of electricity available to Iraqis outside of Baghdad
• Some evidence of a decline in non-fatal casualties suffered by U.S. troops.

Negatives -

• The size of the Iraq Security Force was about 10 percent lower 25 weeks after the surge than would've been predicted by trends before the surge
• Oil production may have decreased

Neutral -

• Little impact on the number of deaths of coalition and Iraqi forces

As for the investors, the data shows that the chance the Iraqi government will default on its debt has increased by 40 percent since the surge. That's hardly a vote of confidence.

In 2006, Iraq issued about $2.66 billion in U.S. dollar-denominated bonds and about 90 percent of these bonds have ended up in the hands of hedge funds and other investors, so Greenstone argues that there's a liquid market for their trading. Since the surge, the yield on Iraqi bonds has increased by 1.15 percent relative to the Lehman Emerging Market Index and 1.70 percent relative to inflation-indexed Treasury bonds. This means that investors wanted a bigger payoff relative to the risk they were taking.

Here's a graphic from Greenstone's working paper. Click for a larger version.

One caveat to Greenstone's conclusion is that the move in bond yields may have been spurred on by credit conditions outside of Iraq. Namely, yields may have been influenced by U.S. domestic policy and the 2008 elections. If investors think a Democrat is going to win (the likely outcome at this point) and that this in turn will darken Iraq's prospects, then they would place bets in a manner that would push Iraqi yields higher. But a large portion of the increase in yields occurred when reports showed the surge was not succeeding, which lends support to the argument that Iraqi bonds are moving on domestic issues.