The Financial and Economic Dangers of Democratic Backsliding

Layna Mosley is Professor of Politics and International Affairs at Princeton University. This post is based on her report.

The last decade has witnessed the erosion of democratic institutions and practices in a wide range of countries, including established democracies, newer democracies, and countries thought to be on the path from autocracy to democracy. In its 2023 report, the V-Dem Institute details this trend, noting that, for the first time in more than twenty years, there are more closed autocracies than liberal democracies in the world. This shift includes increased government repression of civil society organizations, deteriorations in election quality, and increased government censorship of media.

Although the features of political institutions in the United States have not changed substantially in recent years, some political actors have grown more willing to use these institutions to undermine democratic practices. In the November 2022 elections in the United States, election-denying candidates had modest success in statewide races for governor, attorney general, and secretary of state. The decentralized nature of U.S. election administration, however, means that the actions of even a single state-level official could wreak significant havoc on national electoral processes.

The high-profile losses in statewide races also conceal more ominous signs at other levels. Counting statewide elected officials, candidates for the House and Senate, and state legislative candidates, 226 election-denying candidates prevailed, or about 66 percent. Across 17 states, 23 election-denying officials now hold positions that oversee voting and electoral administration. Indeed, U.S. states can serve as laboratories not necessarily for improved public policies and democratic practices, but also for the erosion of democratic institutions. Moreover, many members of the majority party in the U.S. House of Representatives are election deniers. The erosion of democratic practices and norms therefore remains a serious threat in the United States, especially as the 2024 elections approach.

Such an erosion is a threat not only to our country’s political well-being, but also to economic and financial outcomes. In a report recently ­­­released by the Governance Program at the Brookings Institution and the States United Democracy Center, I detail the potential risks to institutional investors of democratic backsliding in the United States. Given such threats, institutional investors may have a fiduciary responsibility to take actions – ranging from undertaking analyses more attentive to political risk to reconsidering investment holdings in certain states and firms.

My report draws on a range of social scientific studies which examine the various links between the nature of political institutions, on the one hand, and economic and financial outcomes. These analyses employ quantitative data from larger samples of wealthy as well as low- and middle-income countries, examining (for instance) the higher costs of capital for in non-democratic political systems.

Because of the size and unique position of the United States in the global economy, such analyses often exclude the United States from their datasets.  This choice usually makes sense from the point of view of statistical analyses; but we should expect the dynamics relating political risk to economic outcomes to be similar in the United States. Indeed, investors in the United States may stand to lose more from democratic backsliding than their counterparts in other countries (see below). While most large investors have thus far assumed that the United States is somehow exceptional – insulating financial markets from the risk of democratic backsliding – this may well prove incorrect.

What do we know about how the weakening of political institutions affects economic outcomes? It is worth noting that the material effects of deteriorations in governance are far from limited to countries experiencing coups and civil conflicts. Rather, they can matter in more subtle ways. In the report, I discuss three such channels. First, weak rule of law – that is, a de facto lack of respect, often on the part of government officials, for de jure protections – undermines longer-term investment. Around the world, investors prefer political systems in which the rule of law is respected. When rule of law is weaker, firms worry more about the security of their investments. Investment also is lower, all else equal, when governments are less transparent in their provision of information — another hallmark of non-democratic political systems.

Certainly, multinational firms do invest in countries with weak political institutions, because they sometimes find other features of those economies sufficiently attract. But, when doing so, they tend to make investments that are more easily reversible. In other instances, they hope that investor-state dispute settlement mechanisms will address their concerns – although such mechanisms also depend on the willingness of governments to respect legal processes.

Second, political uncertainty often disrupts asset markets, such as those for equities, currencies and bonds. Elections and government turnover often are sources of market uncertainty and volatility. When investors worry about whether an election will generate a radical shift in government policies, or about whether election results will be respected, decreases in stock market valuations, higher interest rate premiums and currency crises can follow. Furthermore, the more democratic a country’s national political institutions are, the better able governments are to access sovereign credit markets. The positive effect of democratic political institutions on access to credit is especially pronounced when global financial conditions are tighter, as they have been recently.

Third, the political actors who seek to undermine democratic practices often have a populist orientation. Populist political actors espouse anti-elite as well as strongly nationalist views, and they tend to oppose (and often actively seek to undermine) international institutions as well as economic globalization. As such, the electoral success of such candidates would erode many of the gains that many firms, consumers and investors have experienced in the post-World War II era. While the multilateral institutions on which the post-World War II liberal international order was based (such as the World Trade Organization) may need reform, a broader abandonment multilateralism and economic integration would be very harmful to many parts of the U.S. economy.

When considering political risk in other countries, professional investors regularly consider these mechanisms. Yet they often assume that the United States is an exceptional market, by virtue of its size, liquidity, and global role. Paradoxically, this exceptionalism may make the erosion of democratic practices in the United States could be even riskier.

Why? First, many institutional investors are overweight in US-based investments. This widely documented “home country bias” means that any sharp increase in risk and volatility in within the U.S. will have a pronounced effect on investment portfolios. Second, given the continued centrality of the U.S. in the global economy, as well as the continued importance of the U.S. dollar to global transactions, events in U.S. markets are likely to quickly spread to other markets. This was true, for instance, in 2008, when a U.S.-based housing and financial crisis was quickly transmitted to other parts of the world. It is difficult for investors to diversify away from risks that emanate from the center of the global financial system.

What, then, ought investors to do? I argue that it is important, as attention increasingly shifts toward 2024 U.S. electoral contests, for the American public generally and for U.S.-based institutional investors specifically to remain cognizant of the very real threats to U.S. democracy. At a minimum, investors have a fiduciary duty to monitor political risks associated with threats to democracy in the United States. Doing so will allow them to safeguard the assets of shareholders and beneficiaries. Beyond this, when seeking to acquire existing operations or launch new ones in the U.S., investors should consider the state’s voting laws and assurances of full access to the ballot, as well as any state-level efforts to interfere with the democratic process.

Furthermore, institutional investors should advocate full disclosure of corporate lobbying expenditures, as a means of ensuring that lobbying is consistent with corporate strategy, as well as with respect for democratic political institutions. Relatedly, a recent analysis by Li and DiSalvo suggests that corporate campaign donations shifted in the months following the January 6, 2021 insurrection at the U.S. Capitol building; the pattern of these shifts was predicted, in part, by the political ideology of shareholders, consumers and employees.

Responses to democratic backsliding, however, ought to cut across ideological lines: investors and firms of all partisan stripes have a material interest in protecting democracy and the rule of law. Institutional investors may find that certain types of portfolio companies are more responsive to concerns about U.S. political risk. Focusing first on those companies could prove a useful path to addressing – and even helping to stave off – threats to democratic erosion.

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