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How Does Democracy Affect Financial Markets?

CID Faculty Affiliate Max Miller, Assistant Professor of Business Administration at Harvard Business School, explores how democratization affects financial markets, particularly through the lens of redistribution risk, in his working paper entitled , February 2024. 

Using a dataset covering 90 countries over 200 years, the study shows that democratizations lead to significant declines in stock market valuations, similar to financial crises. These effects are driven by elites' fear of redistribution, which threatens their wealth and power during political transitions.

Key Findings:

• Redistribution Risk and Asset Prices: Successful democratizations elevate risk premia as wealthy elites anticipate redistribution policies, such as higher taxes, larger public sectors, increased economic competition, and pro-labor economic reforms. These policies reduce income inequality but raise risks for capital holders. The model developed in the paper shows that elites perceive democratizations as "rare disasters" due to the uncertainty over how much wealth will be redistributed.
• Empirical Evidence of Redistribution: The study finds that successful democratizations lead to substantial economic changes. Public sector size increases, income inequality decreases, and the labor share of income rises. These effects collectively explain the negative market response to democratizations.
• Causal Evidence from Catholic Church Doctrine: A shift in Catholic Church doctrine in support of democracy in the 1960s is used as a quasi-experiment to show that democratization risk raises equity risk premia, particularly in Catholic-majority autocracies. This natural experiment confirms that the market response is driven by the fear of redistribution rather than generic political instability.
• Autocratizations and Market Reactions: In contrast to democratizations, transitions to autocracy (autocratizations) have a negligible effect on asset prices, reinforcing the idea that democratization imposes risk on elites, whereas autocratizations reflect risks they willingly take.

Policy Impact:  

The study emphasizes the central role of redistribution in democratizations and its impact on financial markets. It has significant implications for political economy models, suggesting that democratization poses a substantial economic risk for elites and informs how political instability is priced in global markets. 

This research is particularly relevant in light of ongoing democratic transitions and backsliding globally, making it vital for understanding how political change affects economic outcomes. While stock market declines should not be seen as a shortcoming of democracy, they indicate tensions between the economic elite and broader societal interests, emphasizing economic representation for balanced financial outlooks.