Politics and efficient markets: the impact of political information on financial market performance

Abstract

The extent to which financial markets are rational, efficient processors of information has perhaps never been as much in doubt as it is now during the ongoing global financial crisis. This paper engages with this debate directly by investigating the effects of one particular type of information, political information, on financial markets. Politics can be the precipitating event that turns a stable financial market equilibrium into an unstable one and can also be the cause of volatility. While previous studies have tended to make arguments about the impact of specific types of political events on financial market performance (e.g. elections, changes to parliamentary coalitions, cabinet formations and cabinet dissolutions), in this paper I make a broader theoretical argument: political information has a systematic tendency to be poorly interpreted by financial market participants. This is because political information is imprecise and open to greater subjective interpretation. Both of these features have been shown in recent economic models to have negative consequences for financial market performance. Thus, this article draws on these existing models and demonstrates, through a series of econometric (GARCH) models, that the unique features of political information make it systematically likely to increase financial market volatility