Why The Stock Markets Negatively Price Democracy?

Abstract

We utilize panel data on over 65 countries from the Economist Intelligence Unit about its Democracy level, measured by the level of functioning of government, civil liberties and political participation, etc. and show inverse relationship between Democracy and stock market performance. Our results are robust clustering for countries’ characteristics. We conjecture that the larger the space of the democracy, the greater the scrutiny and unrewarded excessive accountabilities on the financial markets; as such cause some inefficiency. We then show that key constitutional factors affect democracies, and hence stock markets return and volatility. Nevertheless, the price of democracy appears to be quite pervasive; not only democracy level matters, but also democracy form, where the Presidential form of democracy has a higher return and lower volatility than the Parliamentary democracy form. This study is critical since there is a great deal of heterogeneity across countries with respect to democracy, with only 5.7% of the world population live in a full democracy. Collectively, the democracy level is a key determinant when we study global financial markets, and it is costly.