When Investors Enjoy Less Policy Risk: Divided Government, Economic Policy Change, and Stock Market Volatility in Germany, 1970-2005

Swiss Political Science Review, Vol. 14, No. 2, pp. 287-314

28 Pages Posted: 16 Mar 2008 Last revised: 29 May 2013

Michael M. Bechtel

Washington University in Saint Louis

Roland Füss

University of St. Gallen - School of Finance

Abstract

How does divided government affect the probability of economic policy change, and thus policy risk on financial markets? In contrast to the standard balancing model we argue that divided government, i.e., partisan conflict between the executive and the legislative branches, negatively affects the possibility of economic policy change. Using a simple spatial model we demonstrate that one should expect divided government to increase the probability of policy gridlock. Since divided government reduces the probability of economic policy change, financial markets can operate under lower policy risk in times of divided than in periods of unified government. For the empirical evaluation we exploit the fact that stock return volatility provides us with a measure of risk. If the gridlock argument does hold, stock return fluctuations should be lower under divided than under unified government. Our results confirm that divided government has a volatility reducing effect on the German stock market. This supports the view that divided government lowers policy risk.

Keywords: Divided Government, Economic Policy, Financial Risk, Volatility, Stock Markets

JEL Classification: P16, N2

Suggested Citation

Bechtel, Michael M. and Füss, Roland, When Investors Enjoy Less Policy Risk: Divided Government, Economic Policy Change, and Stock Market Volatility in Germany, 1970-2005. Swiss Political Science Review, Vol. 14, No. 2, pp. 287-314. Available at SSRN: https://ssrn.com/abstract=1106166

Michael M. Bechtel (Contact Author)

Washington University in Saint Louis ( email )

Campus Box 1063
One Brookings Drive
Saint Louis, MO 63130-4899
United States

Roland Füss

University of St. Gallen - School of Finance ( email )

Rosenbergstrasse 52
St.Gallen, CH-9000
Switzerland
+41 (0)71 224 70 42 (Phone)
+41 (0)71 224 70 88 (Fax)

HOME PAGE: http://www.sbf.unisg.ch/en/Lehrstuehle/Lehrstuhl_Fuess.aspx

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