November 14, 2007
Historical Probabilities and Markets Posted by Fredric Smoler at 11:55 AM EST A friend sent me a link to a paper given earlier this month at Columbia to a group of economic historians. The paper is by Kim Oosterlinck and Marc D. Weidenmier, titled “Victory or Repudiation? The Probability of the Southern Confederacy Winning the Civil War,” and it begins with an abstract, a summary of the argument and conclusions. In this case the abstract reads: “Historians have long wondered whether the Southern Confederacy had a realistic chance at winning the American Civil War. We provide some quantitative evidence on this question by introducing a new methodology for estimating the probability of winning a civil war or revolution based on financial market[s]. Using a unique dataset of Confederate gold bonds in Amsterdam, we apply this methodology to estimate the probability of a Southern victory from the summer of 1863 until the end of the war. Our results suggest that European investors gave the Confederacy approximately a 42 percent chance of victory prior to the battle[s] of Gettysburg/Vicksburg. News of the severity of the two rebel defeats led to a sell-off in Confederate bonds. By the end of 1863, the probability of a Southern victory fell to about 15 percent. Confederate victory prospects generally decreased for the remainder of the war. The analysis also suggests that McClellan’s possible election as U.S. President on a peace party platform as well as Confederate military victories in 1864 did little to reverse the market’s assessment that the South would probably lose the Civil War.” To my ear, possibly a somewhat prejudiced one, the paper itself contains a remarkable assumption—”First, we assume that the probability of debt reimbursement (for the Southern Confederacy) is equal to the probability of victory.” This seems peculiar, and in some ways close to ridiculous. My intuition is that bond prices tell you a lot about investors’ estimates of probabilities, but in many cases little about the probabilities themselves, not least because investors can be wildly wrong. For example, I’d bet that Spanish bond prices in 1898 would under-predict the chances of a U.S. victory against Spain, because of a European sense that we were bumptious, inept savages, and Spain the land associated with the still-remembered and once-feared tercios, and similarly overestimate German chances against the Soviet Union in the summer of 1941, because of a general ignorance of logistics, one that afflicted most observers at that moment. Markets can and do get political risk wrong, and I would imagine that they have no special abilities in assessing military risks. So I think this assumption—that the interest rate in one sense is the probability—may be free-market fundamentalism. Then again, thinking it over, what better method of estimating alternate historical probabilities is there? The defense of taking bond prices as an estimate of a historical probability is that markets are composed of a large number of people with a straightforward interest in assembling all of the relevant information and getting the answer right. They do not have to appeal to an editor or a committee chair; everyone in a market wants to make money and can only hope to do so by accurately weighing risk. Markets are sometimes said to predict the outcome of recent American elections better than do polls or political scientists (I have no idea if this in fact true). On the other hand, in retrospect we sometimes think alternate historical probabilities reflect factors unknown or under-appreciated at the time—to return to the sort of example I gave above, the tyranny of logistics. Rommel needed a given port capacity in Egypt and Libya, which did not exist, to reach Alexandria, if the ground between the sea and the Qattara Depression was defended with modest competence. He did not himself understand this. Why would investors understand this better than did German generals? There is a chance, of course, that they would, although I do not know if they did, and as it happens, I have never looked at British government debt between 1939 and 1941. Maybe I should. Switch from war to politics: investors may or may not understand the stability of Chinese Communist rule and hence over-price or under-price Chinese bonds, but why simply assume that they do or do not get this as right as anyone can? If they do change their estimate of this question next year, and downgrade Chinese debt, does it make any sense to say that the probabilities of a Communist collapse have truly changed, or just the prices? Over the last decade I had the eerie experience, not once but several times, of hearing very intelligent economists say that China cannot fail, then I’ve explained why I thought it could and seen them waver—and I know nothing much about China. Those experiences have made me think that no one knew too much about the stability of the new political economy of China. What seems clear is that intelligent economists repeat the conventional wisdom as readily as do the rest of us, and if they do, what about the much less intelligent myriads in a market for foreign debt? I am curious about what John Steele Gordon thinks about this issue.
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