The Political Sources of Systematic Investment Risk: Lessons from a Consensus Democracy

Abstract

This study examines the relationships between democratic politics and systematic (or country-specific) financial risk. Low financial risk is crucial to any well-functioning economy, as it encourages capital investment, facilitates growth, and enhances overall economic performance. Up until now, scholars have not analyzed how politics affects uncertainty about investment conditions on financial markets. This study distinguishes pre-electoral, post-electoral, and institutional factors and examines how these influence financial risk using daily stock market data from Germany. In line with the hypotheses the results suggest that more (less) favorable and reliable investment conditions during the incumbency of right(left)-leaning governments lead to lower (higher) financial risk. This partisan effect is stronger, the more inflation increases and depends on whether government is unified or divided. Investors also anticipate the effect of government partisanship: Systematic risk decreases (increases) if the electoral prospects of a right(left)-leaning government enhance. Finally, grand coalition governments as well as periods of coalition formation trigger higher financial risk.

Keywords: Political economy, stock market, politics, financial risk

JEL Classification: P16, N20, E44