Democracy comes with many well-known economic benefits. Free societies tend to spur free markets, increasing entrepreneurship and competition, and reducing corruption and income inequality.
But investors don’t always welcome these changes, finds a study that examines stock yields spanning more than 200 years and 90 countries. “Elites” in autocracies tend to see democratization as “rare disasters” for their capital holdings, akin to a financial crisis or unexpected natural catastrophe, explains Max Miller, an assistant professor at Harvard Business School in the article “Who Values Democracy?” forthcoming in the Journal of Political Economy.
Miller’s analysis shows that dividend yields, a measure of perceived risk, spike more than 19% when a country democratizes. This is a large effect, similar to what happens in financial crises. By contrast, when political winds blow towards autocracy, dividend yields rise by just 2.4%, on average.
“That's where there's this disconnect between Wall Street and Main Street—where the policies that are good for Wall Street are not necessarily always the policies that are good for Main Street,” explains Miller. We recently asked him to dive deeper into his analysis in a conversation that has been edited for length and clarity.
What attracted you to this sweeping idea?
I didn't actually set out to write this paper. In the second year of my PhD, I wanted to understand if stock markets predict the outcome of battles: Do you see price swings in anticipation of different battles? I was working on this project with one of my advisers, and there was just really nothing there.
So, I took a break from that project and started reading some of the stuff by Daron Acemoglu and James Robinson on democratic transitions. As I was reading, I thought, “Wow, these models have some pretty major predictions about how stock markets should react to democratizations.”
Since I had all this historical stock market data, I was able to test the models pretty quickly. They just happened to fit the data pretty well!
The reason why these models predict a pretty negative stock market response is because democratizations tend to come with redistribution.
The reason why these models predict a pretty negative stock market response is because democratizations tend to come with redistribution. There's a group of people who have stuff, there's a group of people that don't, and the political system changes. Stock markets respond to the fears and expectations of the people that own the assets, which is why they tank. They’re picking up that democratization makes things worse for the autocratic incumbents.
How did you land on 90 countries and 200 years?
A lot of it is just that most of my data became available after the Napoleonic Wars. I used any country I had data for, so it's really just about where the data is.
And did you see a pattern?
The mean effect is very consistent over time. There's an average effect for countries that have financial markets, but then, of course, lots of different countries have different experiences with democracy and democratization.
So this isn't to say that every country is going to necessarily have this experience. But there is some pretty good evidence that the effect size depends on the perceived risk of redistribution.
How do you define elites?
In the paper, they're the group of people who own most of the capital. Of course, depending on where you are, these are very, very different, different concepts. But the one I have in mind is there's a group of people who own most of the stuff, most of the capital, the productive assets. That's the way I think about the paper.
Can you explain the link between democracy and asset reallocation?
In theory, it’s just that democracy introduces a lot more people into the political process. And the people it introduces tend to have an incentive to vote for redistributive policies. In practice, this comes about in many ways.
I focus on four main ways in the paper:
First, I find that when countries become more democratic, average tax rates tend to rise.
Second, I find they engage in labor market reform. This actively raised the wages of workers at the expense of profits that would have gone to capital holders.
Third, I find that institutional reforms after democratization limit corruption, making it harder for the old incumbents to get favors from the government.
Fourth, I find that the economy becomes more competitive. This means that different groups can start a business relative to the old regime. Some of these businesses might become large and be able to compete with existing monopolies.
What happens as dividend yields go up?
The stock market response I document is in anticipation of all of that redistribution. Dividend yields are rising, this means that stock prices are falling, but the cash flows stocks generate aren’t falling with them. This is a tell-tale sign that risk in the economy is rising.
And what I argue is that the reason why investors perceive risk is rising is that they think that redistribution is coming—or at least the potential for redistribution—conditional on the democratization being successful. And that means that anyone who buys that asset is going to want to pay a lower price for it.
You also talk about how corruption drops. How does that come into play?
One of the findings is that indices of corruption and bribery fall substantially. The way this manifests in practice is that it's just a lot more difficult for existing elites to skim resources off the top and off of government spending in a more transparent system.
I find, historically at least, autocratization comes with a very mild effect on stock markets.
So why don't yields fall when autocracy starts to creep in?
I find, historically at least, autocratization comes with a very mild effect on stock markets. A lot of this is because some autocratizations end up being good for stock markets while others end up sparking some panic.
For example, markets reacted pretty positively to Adolf Hitler taking power in Germany. The same with Augusto Pinochet in Chile. There, you had roughly 40% year-over-year returns for his first two years in power.
That said, there are many episodes with stock markets didn’t like. For example, when Hugo Chavez came to power in Venezuela, stock markets reacted very negatively. And there were still other autocratizations where effects were a bit more muted.
In the model I write down in the paper, the reason stock markets don’t move much is that autocratizations still come with risk for incumbents because there is some risk of failure. But that risk of failure is buoyed by the possibility of gaining a system that is better for elites. These two effects roughly offset one another.
So what's the bottom line for an average person?
There's an argument by many political scientists and commentators that democratic institutions are in crisis. And of course, people who invest money want to understand what that means for the money that they're investing. This paper says, on average, you don't get giant stock market crashes.
Interpret that with a huge grain of salt, because almost all the historical autocratization episodes are in relatively small, relatively new democracies. So you can't really extrapolate to what would happen if, for example, a very developed country were to go completely backwards into autocracy.
But, for smaller movements, I think the paper at least provides a reasonably good benchmark.
You studied the Vatican II policy as a force for democratization. Why?
Vatican II was transformative in many different ways. But one of the primary ways is that it turned the Catholic Church from a bulwark of autocracy to an active advocate of democracy.
And there are political scientists who have argued that this is one of the main reasons that the third wave of democracy, which happened in the 1970s, '80s, and '90s, occurred, and why it was started in mostly majority Catholic autocracies.
I provide some evidence that this seems to be driven by Vatican II. I also find that in this “natural experiment” we also see a pretty large stock market effect coming from Vatican II. It's concentrated in majority Catholic autocracies. And you don't see the same thing happening in non-Catholic autocracies. This helped me provide some additional evidence that democatizations seem to make stock markets riskier.
Image credit: HBS
