Financial Markets and the Political Center of Gravity

Mark Roe is a professor at Harvard Law School. This post is based on a recent paper authored by Professor Roe and Travis Coan, lecturer in politics at the University of Exeter.

In Financial Markets and the Political Center of Gravity, Travis Coan and I investigate the link between left-right market-friendliness across the developed world and financial markets. Academics across multiple disciplines and policymakers in multiple institutions have in recent decades 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 during the 1990s in Europe, when social democratic parties governed and financial markets deepened, basic left-right explanations fail to explain financial market strength. Hence, more complex political explanations are needed, 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 in the paper, first, that conceptually it’s not relative local placement of the governing coalition on the nation’s left-right spectrum that counts, nor the party’s historical policies or name, which may be a legacy, 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.) Tony Blair’s Labor government, for example, was much more market-oriented than his predecessors in the same party. An accurate examination of the left-right impact on financial markets must account for left-right placement on an absolute scale and must control for such shifts over time.

Second, we bring forward data showing that there has been 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.

The complete paper is available for download here.

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