The outcomes of democratic political events – which party will win the election, which parties will form the cabinet, who will become Prime Minister – are often predictable. When market actors can easily forecast the political outcome, we expect market behavior to remain relatively stable. On the other hand, when political outcomes are less predictable, market actors will shift their portfolios out of assets whose value is vulnerable to alternative government policies toward assets offering returns that are better insulated. Therefore, we expect returns to be relatively lower in these vulnerable markets during periods of pronounced political uncertainty.

In this chapter, we assess this proposition more systematically. We continue to examine parliamentary politics. But we go beyond the simple periodization of campaigns, elections, and cabinet negotiations to discuss the predictability of coalition formations. To do so, we exploit a highly developed political science literature on cabinet government. This literature has produced models that, given the distribution of legislative seats and the policy positions of the different parties, predict which parties will form the cabinet, which policies the new government will pursue, and how long the new cabinet is likely to last. We draw on these models to develop proxy measures for the predictability of coalition formation events.

To evaluate how the predictability of cabinet formations affects asset markets, we focus on stock and government bond markets rather than currency markets. Foreign exchange trades on intermediated and disintermediated markets around the globe.

Political processes – elections, cabinet formations, referenda, legislative debates – determine a government's economic policies, which, in turn, condition the environment for investment. By anticipating the results of these processes, savvy investors can re-allocate their portfolios to meet a changed policy context. Asset owners, therefore, have a keen interest in predicting political outcomes: Which party will win the election? Who will form the government? What will be the new government's policy priorities?

The collective decisions of investors, in turn, shape how markets respond to political processes. Whether markets react to political events in a systematic manner remains an open issue. Do asset prices behave differently when left parties are in office? Will the election of a particular candidate cause a run on the currency? Does divided government – where the executive comes from a different party than a majority of legislators – cause a market downturn?

The consequences of these market responses extend far beyond questions of portfolio allocation. The investment decisions of asset owners fundamentally shape economic performance. Shifts in asset allocation can sustain an economic upswing or cut-off growth. With the technological and financial integration of asset markets, price movements can cascade across borders and markets, creating a world-wide boom or a systemic crisis.

Changes in market conditions have distributional consequences as well. Economic actors reliant on the stock market for income – firms, pensioners, etc. – are vulnerable not only to falling equity prices but also to volatility in market returns.

With capital accounts more open and technological innovations changing the pace of transactions, financial markets are increasingly integrated. Trading occurs twenty-four hours a day throughout the globe. Fluctuations in one market can affect the behavior of markets across borders. A glance at the worldwide financial news media illustrates this phenomenon: Trading on the New York Stock exchange conditions trading in Tokyo, which, in turn, influences market activity in London, which then affects New York. More spectacularly (and more destructively), the Asian crisis of 1997–98 quickly spread to markets in other developing countries, a process of contagion that has been widely studied in the finance and economic literatures.

As the previous chapter demonstrated, political events do, under certain conditions, affect market performance in domestic equities and bond markets. In a world of integrated financial markets, those political events may touch off reactions in markets in other countries. We investigate this possibility in this chapter. We contend that the configuration of political and economic institutions at both the domestic and international levels can mitigate the effect of cross-border political shocks. To evaluate the argument, we adopt a two-stage research design. Drawing on arbitrage pricing theory, we first measure the size of foreign political shocks. In the second stage, we test alternative explanations for the variation in the size of those shocks. Consistent with the findings in Chapter 3, the results indicate that political events with a predictable outcome have less impact on markets (both foreign and domestic) than unpredictable events.

The predictability of political outcomes conditions how markets respond to political events. Where democratic political events have less predictable outcomes, market returns are depressed and volatility increases. In contrast, where market actors can easily forecast the political outcome, returns do not exhibit any unusual behavior. Across currency, stock, and, to a lesser degree, bonds, we demonstrated empirical support for this proposition using a variety of techniques in a number of markets (spot, forward, and futures). The predictability of outcomes can help explain the variation of market responses to political events.

Further, prior beliefs about an eventual outcome condition how political developments affect market behavior. Where new information confirms expectations, market actors do not adjust their portfolios. But when news causes market actors to update their beliefs, markets actors do reallocate their portfolios, and overall market behavior changes. By investigating information arrival in separate political events, we find empirical support for this argument as well.

In some sense, these conclusions are not controversial. Indeed, anecdotal evidence from the financial news media confirms these arguments almost everyday: Markets are “cautious” in the run-up to a particular election. The “market” is taking a “wait-and-see attitude” towards the new government. Market actors “widely anticipated the cabinet dissolution” and did not move in response to the “expected announcement.”

Prior academic investigations, however, have been less successful in finding systematic evidence that markets respond to politics in this manner.

In this chapter, we investigate the political impact of financial market behavior by focusing on the costs of borrowing. We show that expectations of political outcomes can affect interest rates in both the public and private sectors. As market actors are less confident of the government's economic policy commitments, interest rates increase – with potentially harmful consequences for public finances and economic outcomes.

Higher interest rates complicate the task of balancing the state's finances. Citizen demands for expansive social programs and the increasing pool of citizens eligible for state-sponsored retirement plans have dramatically ratcheted up the debit side of the state's ledger. This would not be problematic if the revenue side were expanding as well. Open financial markets, however, have exacerbated the global competition for tax revenues, leading some political economists to suggest that advanced democracies can no longer sustain generous governmental programs and, instead, must engage in a “race to the bottom.” Given these constraints, governments must issue public debt. High interest rates on government debt can add millions of dollars to government balance sheets in terms of debt servicing, limiting their ability to use fiscal policy to satisfy constituents. The cost of borrowing, therefore, significantly constrains the ability of politicians to expand programs or pursue new initiatives – policies that might help them retain office.

Private economic activity is also affected by interest rate behavior.

Foreign exchange markets are among the deepest and widest financial markets in the world. Technological innovations and market liberalization have made currency markets enormous – by 1992, the volume of transactions topped over one trillion dollars each day. Moreover, economic agents can trade currencies with shocking speed – during the September 1992 EMS crisis, British monetary authorities expended over two billion dollars to support the pegged value of the pound in only a few hours. The behavior of currency markets can affect not only trade flows and international investment, key determinants of economic performance, but also political outcomes. With increasing capital mobility, political disputes over exchange rates have become highly salient, both at the domestic and international level. Indeed, some political economists assert that rapidly adjusting international markets may overwhelm the ability of policymakers to control policy, and, according to the most extreme view, thwart any meaningful democracy. Understanding how currency markets behave, therefore, is a fundamental step to assess accurately how the internationalization of economic activity affects democratic politics.

We investigate how democratic political events influence currency markets, focusing on the relationship between the spot and forward exchange rate markets. The efficient markets hypothesis implies that the forward exchange rate – the price of the currency deliverable 30 days in the future – should be an unbiased predictor of the future spot exchange rate. That is, today's 30-day forward rate should, on average, accurately predict the spot exchange rate one month from today.

INTRODUCTION

The great theorems of social mathematics discovered during the twentieth century can be separated into those that emphasize equilibrium and those that hint at chaos, inconsistency, or irrationality.

The equilibrium results all stem from Brouwer's Fixed Point theorem (Brouwer, 1910): A continuous function from the ball to itself has a fixed point. The theorem has been extended to cover correspondences (Kakutani, 1941) and infinite-dimensional spaces (Fan, 1961) and has proved the fundamental tool in showing the existence of equilibria in games (von Neumann, 1928; Nash, 1950, 1951), in competitive economies (von Neumann, 1945; Arrow and Debreu, 1954; McKenzie, 1959; Arrow and Hahn, 1971), and in coalition polities (Greenberg, 1979; Nakamura, 1979).

The first of the inconsistency results is the Gödel-Turing theorem on the decidability-halting problem in logic (Gödel, 1931; Turing, 1937): Any formal logic system (able to encompass arithmetic) will contain propositions whose validity (or truth value) cannot be determined within the system. Recently this theorem has been used by Penrose (1989, 1994) to argue against Dennett (1991, 1995) that the behavior of the mind cannot be modelled by an algorithmic computing device. A version of the Turing theorem has been used more recently to show that learning and optimization are incompatible features of games (Nachbar, 1997, 2001, 2005). There is still controversy over the meaning of the Gödel theorems, but one interpretation is that mathematical truths may be apprehended even when no formal proof is available (Yourgrau, 1999; Goldstein, 2005).

INTRODUCTION

Mancur Olson's book, The Rise and Decline of Nations (1982a), used ideas from his earlier Logic of Collective Action (1965) to argue that entrenched interest groups in a polity could induce economic sclerosis, or slow growth. These ideas seemed relevant to the perceived relative decline of the United States and Britain during the 1970s. Five years later, Paul Kennedy's The Rise and Fall of the Great Powers (1987) proposed a more general “declinist” argument, that a great power such as the United States would engage in fiscal irrationality through increasing military expenditure, thus hastening its own decline. Neither of these two declinist arguments seem applicable to the situation of the new millennium. Olson's last book, Power and Prosperity, published posthumously in 2000, attempted a more general theoretical analysis of the necessary and sufficient causes of prosperity and growth. For Olson, only “securely democratic societies” could be conducive to long-lived individual rights to property and contract, but democracy itself need not be sufficient for the protection of rights. This chapter attempts to further develop Olson's logic on the connection between prosperity and liberty, by exploring insights derived from Riker's interpretation of U.S. Federalism (Riker, 1964), from the contribution of North and Weingast (1989) to neo-institutional economic theory, and from recent work on war and fiscal responsibility by Ferguson (1999, 2001, 2004) and Stasavage (2002, 2003).

The logic of economic growth is fairly well understood. In the absence of a well-defined system of property rights and the rule of law, economic growth, if it can be made to occur at all, will splutter or induce extreme inequalities that may rend the society apart.

We can agree with Schumpeter that the future will be one of technological change and what is now called “globalization.” We need not accept all of Schumpeter's arguments about capitalism, but we can extend his metaphor of the dynamical system of the “weather” to make some general points about the process of change in the global political economy.

Weather is a dynamical system involving the oceans and the air on the surface of the earth.

INTRODUCTION

It is commonly assumed that politics is inherently one dimensional. In such a world, theory suggests that political candidates would be drawn into the electoral center in order to maximize votes. Against such a tendency would be the motivation of ideological political activists to pull their preferred candidate away from the center. The balance of electoral incentives and activist pull creates the “political equilibrium” at any election.

But is politics inherently one dimensional? This chapter continues with the argument that politics is fundamentally two dimensional. Politics may appear to be characterized by a single cleavage, but this is because the two parties themselves “organize” politics along the dimension that separates them. Party disagreement on one dimension of politics makes that dimension more salient, while the other dimension is obscured by tacit party agreement.

The existence of a submerged or passive dimension of politics transforms the calculus of activist support and electoral preferences. Activists who are most concerned about the dimension of politics on which parties passively agree constitute a pool of disaffected voters who see no perceptible difference between the two main parties on the issues that matter most to them. These disaffected activists often offer a temptation to vote-maximizing candidates who may see them as the potential margin of victory in a close election. Such a development would be resented and resisted by party activists who are most concerned about the active dimension that differentiates the two parties, and would rather see their party go down to defeat than re-orient itself to a new set of policy issues and a new agenda.

INTRODUCTION

[I]t may be concluded that a pure democracy, by which I mean a society, consisting of a small number of citizens, who assemble and administer the government in person, can admit of no cure for the mischiefs of faction. A common passion or interest will … be felt by a majority of the whole … and there is nothing to check the inducements to sacrifice the weaker party. … Hence it is that such democracies have ever been spectacles of turbulence and contention; have ever been found incompatible with personal security, or the rights of property; and have in general been as short in their lives, as they have been violent in their deaths.

A republic, by which I mean a government in which the scheme of representation takes place, opens a different prospect.

The two great points of difference between a democracy and republic, are first, the delegation of the government, in the latter, to a small number of citizens elected by the rest; secondly, the greater number of citizens and the greater sphere of country, over which the latter may be extended.

It may well happen that the public voice pronounced by the representatives of the people, will be more consonant to the public good, than if pronounced by the people themselves …

If the proportion of fit characters be not less in the large than in the small republic, the former will present a greater option, and consequently a greater probability of a fit choice.