Austan Goolsbee, writing in the New York Times, discusses Michael Greenstone&#8217-s paper (discussed here at Midas Oracle in September) that examines the market for Iraq&#8217-s bonds for an assessment of the long-term future of the Iraq government. Goolsbee&#8217-s quick conclusion: &#8220-But global financial markets have been monitoring the war for months, and with remarkable consistency, they have concluded that the long-term prospects for a stable Iraq are very bleak.&#8221-

It wasn’t until Professor Greenstone began examining the financial markets’ pricing of Iraqi government debt that he had his eureka moment. It was immediately clear that the bond market — which, historically, has often been an early indicator of the demise of a political system — was pessimistic about the Iraqi government’s chances for survival.

First, some background &#8230- the Iraqi government issued about $3 billion of new bonds in January 2006. These dollar-denominated bonds pay 2.9 percent twice a year and mature in 2028, paying the face value of $100.

To say the least, the market for these bonds is not robust: as of last week, a bond with a face value of $100 was trading at around $60. Professor Greenstone calculated that, from the markets’ standpoint, the implied default risk over the life of the bond was about 80 percent.

The important point is that anyone who owns one of these Iraqi bonds has to decide each day whether the Iraqi government is likely to be functional enough to make its debt payments, or will default along the way. All else being equal, if the surge policy is effective, it ought to be raising the market price of these bonds.

Bondholders “aren’t politically motivated,” Professor Greenstone said. “They don’t have to rationalize their previous statements or justify their votes from years past. All they care about is whether there will be a functioning Iraq in the future such that they will receive their payments.” At a certain price, most securities will find a buyer, and there are still buyers for Iraqi bonds. But the price they are willing to pay is very low.

Goolsbee tosses in a few examples which show, in his words, &#8221- the collective wisdom of financial markets has proved remarkably adept at evaluating events and predicting the future, even the turning points of war&#8220-:

During the American Civil War, for example, when Confederate forces lost at Gettysburg, Confederate cotton bonds traded in England dropped by about 14 percent. During World War II, German government bonds fell 7 percent when the Russians started their counterattack at Stalingrad in 1942, and French government bonds rose 16 percent after the Allied invasion at Normandy in 1944. Many such examples of the prescience of financial markets have been documented by economic historians.

Of course a few cherry picked examples, while suggestive, should not be considered conclusive.

Chris Masse, in a post about negative comments on the war by a just-retired high ranking military officer, said:

We can’t rely on retirees to tell us the truth. We need an anonymous information aggregation mechanism that gives an incentive to people who come forward with advanced information: the prediction markets.

While bond markets might be useful as a stand in for prediction markets, presumably well-designed prediction markets could provide a somewhat more articulated position than can be extracted from a twenty-year bond market.

NOTE: Greenstone&#8217-s paper, &#8220-Is the &#8216-Surge Working? Some New Facts,&#8221- is available from the SSRN.