When Markets Are Hostage to Political Flux

by Lubos Pastor and Pietro Veronesi

Bloomberg
November 10, 2011

Politics are dominating financial markets. Day after day, prices react to news about what governments around the world have done or might do.

The markets were jubilant two weeks ago when European politicians announced a deal cutting Greece’s debt in half. U.S. stocks soared 3.4 percent on Oct. 27, while French and German stocks gained more than 5 percent. Early last week, equities gave back those gains when Greece’s prime minister, George Papandreou, announced his intention to hold a referendum on the bailout. When other Greek politicians voiced their opposition to that initiative, markets rejoiced again.

It is stunning that the pronouncements of politicians from a country whose gross domestic product is smaller than that of Michigan can instantly create or destroy hundreds of billions of dollars of market value around the world.

Yet, despite its obvious importance, political uncertainty is notably absent from mainstream finance theory. Indeed, it would be a waste of time to search financial textbooks for models that take into account uncertainty about future government actions.

In a recent paper, we tried to fill this void by developing a simple model of financial markets in which the government has the option to intervene. Since the officials’ political motives are somewhat unpredictable, investors cannot fully anticipate what a government is likely to do.

How do governments affect stock prices? Our model highlights two opposing effects.

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