Why do stock markets negatively price democracy?

Abstract

We employ panel data from the Economist Intelligence Unit, covering more than 65 countries, to assess the impact of their Democracy Index on the stock market performance. This index is measured by the level of government functionality, civil liberties, political participation, and other related factors. Our analysis demonstrates an inverse relationship between Democracy Index and stock market performance. Our results exhibit robustness when clustered for countries' characteristics. We posit that a larger degree of democracy correlates with increased scrutiny and unreciprocated excessive accountabilities within financial markets, leading to inefficiencies. Furthermore, we illustrate how key constitutional factors impact democracies, consequently influencing stock market returns and volatility. This study holds significance due to the substantial heterogeneity among countries concerning democracy, as only 5.7% of the world's population resides in a full democracy. Collectively, the level of democracy emerges as a pivotal determinant in the examination of global financial markets, incurring associated costs.