Economics of the Surge

Posted by Deepish Thinker on September 12, 2007
Current Events, Economics, US Politics

I just came across this intriguing article on using the dollar auction as a model for understanding the war in a Iraq. This is not the only applicable economic model. For example, you could gain insight into the administration’s decision making on Iraq by considering the Asset Substitution Problem.

Imagine a firm that is mostly financed by debt. The bondholders of the firm will tend to prefer that management adopt a conservative strategy, in order to maximize the chance that the debt will be paid off.  However a conservative  strategy has little appeal for shareholders, since low risk implies low return and thus low net profits.  For this reason the shareholders will tend to prefer higher risk/higher reward strategies, since these increase the probability that there will be something left over after the debt has been paid.

Since the shareholders control the firm, they can have management adopt a strategy that increases the chance of losses for the bondholders in the hope that there will be some return to the shareholders. In effect, the shareholders can choose to gamble with bondholder’s money.

Applying this model to the situation in Iraq, the American public are the bondholders while the the administration takes the role of shareholder.

At this point the President’s reputation is pretty much shot. If he adopts a conservative strategy in Iraq, say phased withdrawal, his administration will almost certainly be remembered as one of the worst in US history. If however he adopts a riskier strategy, like continuing the surge, there is a slight chance that the situation will turn around, which in turn might redeem his standing.

From the President’s perspective there is nothing to lose, his reputation already being shot, and everything to gain. A small chance at redemption is very much better than no chance at all. It should thus not come as a surprise that the President is vigorously opposed to any admission of defeat in Iraq.

It should also not be surprising that the American public, who will ultimately carry the cost of the much more likely negative outcome of gambling in Iraq, are less than enthusiastic about doubling down.

In the commercial world bondholders control the gambling tendencies of stockholders through including covenants (contractual limitations on management) in debt agreements, which is generally effective.

In the political sphere, Congress is supposed to counter any executive tendency towards gambling with the lives and treasure of the nation. However, with the focus on not appearing soft in the run-up to the 2008 election, there seems to be little stomach in Congress for reigning in the President. For the moment it appears that our only alternative is to hope that the President’s gamble pays off.