Comparative politics and quasi-rational markets

ABSTRACT

This article synthesises psychology, economics and political science theories that can explain market reaction to elections. In order to test the theories, we conduct event studies of the impact of elections on the interest rates on government bonds for 122 elections in 19 countries. The efficient market hypothesis states that rational markets immediately incorporate all information relevant to asset prices. According to psychology, human decision-making is quasi-rational. Market actors should be slow to accept evidence that conflicts with previously held opinions, leading them to under-react to new information. We show that markets under-react to elections and that under-reaction is greater in majoritarian countries because they provide more information to the market. Assuming fully rational markets underestimates the impact of elections and variations in impact across political systems. Most of the literature on market constraint assumes rational markets and may thus be underestimating the extent of market pressure in the aftermath of elections and its distribution across different types of electoral systems. Our results suggest that markets can calculate risk around elections, but are slow to do so, thereby suggesting that the role of uncertainty and the resort to heuristics is relatively minor.

KEYWORDS:

• Elections
• political economy
• democracy
• behavioural economics
• financial markets

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes on contributors

Iain McMenamin is an Associate Professor of Politics in the School of Law and Government at Dublin City University. He is the author of If Money Talks, What Does It Say? Corruption and Business Financing of Political Parties (Oxford University Press 2013) as well as many articles on comparative politics in journals such as World Politics, the European Journal of Political Research, European Union Politics, International Studies Quarterly, and the British Journal of Political Science.

Michael Breen is a Senior Lecturer in the School of Law and Government at Dublin City University. He is the author of The Politics of IMF Lending (Palgrave Macmillan 2013) and recent articles on sovereign debt in International Studies Quarterly and European Union Politics.

Juan Muñoz-Portillo is a Philomathia Post-doctoral Research Associate in the Department of Politics and International Studies at the University of Cambridge. His research interests lie in comparative political economy and the politics and sovereign debt. His recent work on debt has been published in European Union Politics.

Notes

1. The uncertain information hypothesis (Brown et al. 1988) generates different predictions from a rationalist perspective. Since it is a less prominent theory and receives no support from our data, we do not elaborate it here.

2. Bounded rationality includes consideration of limited information and time, as well as cognitive limitations (Simon 1955). We study only the latter.

3. We exclude Germany because we cannot have identical dependent and independent variables.

4. There is no theoretical approach to the identification of the event window, so we follow others in adopting an empirical approach (Bølstad and Elhardt 2015: 9).

5. We conducted the Engle and Granger (1987) test for co-integration using the critical values of McKinnon (2010).