Taking Stock Seriously: Equity-Market Performance, Government Policy, and Financial Globalization

Are equity markets just another facet of global finance, or are they unique in their responses to—and influences on—government policies and institutions? Recent work has explored the impact of political factors on bond market behavior and foreign direct investment, but little attention has been paid to stock markets. On the basis of the particular concerns of equity investors, we hypothesize a positive association between stock-market valuations and levels of democracy, shareholder rights, legal traditions, and capital-account liberalization, a negative association with real interest rates, and no association with fiscal deficits or surpluses. We assess our expectations by analyzing the political and institutional determinants of aggregate price-to-earnings ratios for a sample of up to 37 countries from 1985 to 2004, using both cross-sectional and time-series cross-sectional analyses. We find support for most, but not all, of our hypotheses. Our findings suggest that we must disaggregate the effects of different asset markets to understand the impact of economic globalization on government policies.