Democratic Processes and Financial Markets: Pricing Politics

William Bernhard and David Leblang examine the conditions under which democratic events, including elections, cabinet formations, and government dissolutions, affect asset markets. Where these events have less predictable outcomes, market returns are depressed and volatility increases. In contrast, where market actors can forecast the political result, returns do not exhibit any unusual behavior. Further, political expectations condition how markets respond to the political process. When news causes market actors to update their political beliefs, market actors reallocate their portfolios, and overall market behavior changes. To measure political information, the authors employ sophisticated models of the political process. They draw on a variety of theories of market behavior, including the efficient markets hypothesis, capital asset pricing model, and arbitrage pricing theory, to trace the impact of political events on currency, stock, and bond markets. The analysis will appeal to academics, graduate students, and advanced undergraduates across political science, economics, and finance.

William Bernhard is Associate Professor of Political Science at the University of Illinois at Urbana-Champaign. His work has appeared in the American Journal of Political Science, the American Political Science Review, International Organization, International Studies Quarterly, the Journal of Politics, and the Quarterly Journal of Political Science.

David Leblang is Professor of Political Science and Research Associate at the Institute for Behavioral Sciences at the University of Colorado. He previously taught at the University of North Texas and at the College of William and Mary. His work has appeared in the American Journal of Political Science, the Quarterly Journal of Political Science, the International Journal of Finance and Economics, International Organization, and International Studies Quarterly.

Professors Bernhard and Leblang have jointly received the Franklin L. Burdett Pi Sigma Alpha Award from the American Political Science Association and the Robert H. Durr Award from the Midwest Political Science Association.

Contents

Acknowledgments

Authors generally express gratitude to those who provided assistance in the preparation of the manuscript. We will be no different and offer acknowledgment, appreciation, and absolution to those who helped us. Many colleagues have supported our work but two deserve special recognition for providing challenging critiques and reassuring encouragement: John Freeman and Jim Alt. John Freeman embodies the spirit of collaborative scholarship. He offered theoretical, analytical, and empirical advice on every aspect of this volume. Though we were not able to meet all of his challenges, we are extremely grateful for the time he devoted to our project. Jim Alt has been an exceptionally thoughtful discussant on more conference panels than we can count. His enthusiasm for this project was so contagious that it helped us focus on the goal of completing the book. Along with John and Jim, we also received insightful comments on our initial prospectus from Jerry Cohen, Jeff Frieden, and William Keech. Without their input, we would likely have written a very different book.

Other colleagues providing comments and advice on various elements of the manuscript include: John Aldrich, Lee Alston, Chris Anderson, Brock Blomberg, Lawrence Broz, Menzie Chinn, William Clark, Harold Clarke, Jerry Cohen, Jamie Druckman, Barry Eichengreen, Robert Franzese, Jeff Frieden, Tim Frye, Andrew Gould, Jim Granato, Clive Granger, Mark Hallerberg, Campbell Harvey, Jude Hays, Mike Herron, John Huber, Robert Jackman, William Keech, Keith Krehbiel, Nolan McCarty, Fiona McGillivray, Robert McNown, Andrew Martin, Michael Melvin, Helen Milner, Layna Mosley, Will Moore, Burt Monroe, Bumba Mukherjee, Michael Munger, Dennis Quinn, Stephen Quinn, Ron Rapaport, Dan Reiter, John Robertson, Peter Rosendorff, Brian Sala, Shanker Satyanath, Steve Shellman, Andy Sobel, Allan Stam, Scott Tarry, Michael Tomz, Michael Wallerstein, Michael Ward, Tom Willett, and Chris Zorn.

Members of our respective departments were remarkably tolerant of our attempt to integrate literatures with which we had only a basic familiarity but in which they have substantial expertise. We appreciate the help of Scott Adler, Ken Bickers, David Brown, Steve Chan, Edward Greenberg, John McIver, and Vanessa Baird at Colorado and Scott Althaus, Wendy Cho, Brian Gaines, Larry Neal, and Bob Pahre at Illinois.

We have presented parts of this book at numerous conferences and colloquia. We appreciate the comments and feedback provided by participants at the University of California at Davis, the Claremont Graduate University, Duke University, Emory University, the University of Michigan, the University of Minnesota, New York University, the University of Pittsburgh, Washington University, and the University of Wisconsin.

We are grateful to Robert Franzese for providing an opportunity for us to present our work at a day-long seminar during the 2003 EITM summer program at the University of Michigan, sponsored by the National Science Foundation. This occasion allowed us to think about the project as a unified whole rather than as a number of separate papers. Rob, Jude Hays, Jim Alt, John Aldrich, and the student participants provided extremely useful comments.

Lawrence Broz, Barry Eichengreen, and Jeff Frieden also gave us a chance to present a large portion of our work at the 2004 meeting of the Political Economy of International Finance Research Group. The interdisciplinary group of scholars participating in that meeting provided helpful suggestions from a variety of perspectives.

This book could not have been completed without a substantial amount of data. We are grateful to Heather Bell of Dow Jones, Inc.; Andre Gibson of the Chicago Mercantile Exchange; Helmut Stix of the National Bank of Austria; Jan Frazer of the Reserve Bank of New Zealand; Ashok Mody of the International Monetary Fund; Martin Boon of ICM; Andrea Volkens at the Manifesto Research Group; Dennis Quinn; Charles Franklin; Robert Erickson; and Christopher Wlezien for sharing data.

We received excellent and patient research assistance from Chad Atkinson, Rand Blimes, David Doherty, Amber Elms, Sang-Hyun Lee, Andrea Limbago, Jennifer Oats-Sargent, Dan Pemstein, Lindy van Landingham, and Kirsten Wandschneider. Financial support from the Undergraduate Research Opportunities Program at the University of Colorado and from the National Science Foundation is gratefully acknowledged.

Scott Parris and the Cambridge University Press team have provided outstanding editorial support.