Financial Markets and the Political Center of Gravity

Abstract

In recent decades, academics across multiple disciplines and policymakers in multiple institutions have searched for the economic, political, and institutional foundations for financial market strength. Promising theories and empirics have developed, including major explanations from differences in nations’ political economy.

A common view among multiple academic observers is that, particularly because many pro-market corporate reforms occurred in Europe during the 1990s, when social democratic parties governed and financial markets deepened, basic left-right explanations fail to explain financial market depth. Hence, more complex political explanations are in play, and the correlation of left governments, market-oriented reforms, and financial deepening present an unexpected paradox. This finding might be interpreted to indicate that left-right orientation is unimportant in affecting financial development and that either nonpolitical institutional issues or different political considerations are more central.

We show here, first, that conceptually it’s not relative local placement of the governing coalition on the nation’s left-right spectrum that counts, but whether the polity as a whole — i.e., its political center of gravity or its dominant governing coalition — is left or right on economic issues. If interests and opinion shift in a nation, such that its political center of gravity is no longer statist and anti-market, then even locally left parties could and often would implement pro-market reforms. (And conversely, in an earlier era when interests and opinions were statist and anti-market, one should not expect to see even locally right parties pushing pro-market financial reforms forward.)

Second, we bring forward data showing substantial movement over recent decades of political parties and governing coalitions; these shifts must be accounted for in assessing the impact of left-right divisions on financial and securities markets. In large measure, these political shifts correlate with financial markets shifts. Left-right matters not only in the fixed-in-time cross-section, but also the left-right economic shifts over time make an often significant empirical difference. The result from this data and study, in our view, leads to results and correlations that comport with most observers' intuitions about the impact of left-right politics on financial market depth. The results thereby further buttress the importance of a nation’s basic left-right political orientation in explaining financial market outcomes.

Keywords: corporate governance, ownership separation, securities markets, agency cost, financial markets, party politics, median voter, economic policy, capital market development, party manifestos, social democracy, political determinants

JEL Classification: A13, P16, P12, O16, N82, N83, N84, N80, K22, J50, G38, G34