Politics and Finance: The Political Economy of Financial Markets
May 27, 2022
20 min read
The political economy of financial markets is something that isn’t easy to cover in only a few sentences.
In the simplest of terms, we can see that the economy, and financial markets specifically, are heavily influenced by politics and political instability. However, it isn’t just a simple solution to find a way to fix political instability and call it good.
This is because political instability is also influenced heavily by economic instability, which can create a cycle that is almost impossible to recover from.
Here, we will talk about various parts of political economy and how the study of political economy can lead to better research and changes in the future.
Table of Contents
- Introduction to Political Economy
- What is Political Economy?
- What is the Role of Political Economy?
- What is Political and Economic Theory?
- How Does Political Instability Affect the Economy?
- What are the Four Main Types of Political Economy?
- The Political Economy of Financial Markets
- How Does Political Economy and Events Affect the Markets?
- Political Economy: The Conclusion
Introduction to Political Economy
Traditionally, political economy and economics were interchangeable terms. However, they have recently begun to branch out on their own and now have distinct purposes in modern society.
Where economics focuses primarily on how to influence and foresee the changes in the economy, political economy focuses more on how certain factors to do with the design of the economy affect people and what influences they have upon each other. It combines the study of politics with the observation of economics.
What is Political Economy?
There are three main types of political economies that we see throughout the world.
Political economy is the study of these three economies and the connections between politics and the economy as well as how they influence the government and people in the region or country. Though it is called political economy, those that study it look at sociology, economics, and political science to learn how they influence one another.
Some influential factors that people in the political economy sector look at are:
- Production of various goods and services
- How wealth is distributed
- Property ownership
- Supply and demand
- Public policy’s influence on society
- Government influence on society
- Who profits most
What is the Role of Political Economy?
The role of political economy is to combine standard economics with new research and discoveries in both politics and economics. Since political economy focuses on how politics influences the economy and vice versa, they can notice common trends and gather an idea of what important factors are at play and have been at play historically.
Not only does it allow people to understand individual societies and their actions better, but it can also offer solutions on how to change those societies for those interested. Since it looks at historical trends, it can also help us to understand what is happening and what to expect in the future.
Production and Trade Relations with Law
Political economy has deep roots in the legislature of many countries that dictate how a country trades with others as well as within its borders. For example, the Commerce Clause in the United States Constitution is the most extensive section of the law that is concerned with such trade.
Production and Trade Relations with Government
In each of the three main political economy theories, the government plays some role concerning production and trade. Usually, there are branches of the central government like the United States Department of Commerce and the International Trade Administration that oversee and promote economic growth. On an even larger scale, Congress has exclusive control over what goods and services individual states produce and then trade between each other as well as internationally. This is also an excellent showcase of how political economy, government, and law all interact with each other.
Distribution of Income and Wealth
Political economy tries to define how individuals and other groups receive their incomes as well as the accumulation of wealth and power. This is where political-economic theories stand out from each other through policies of bridging the gap between the rich and the poor, or the lack thereof.
What is Political and Economic Theory?
Capitalism in Political Economy
This political economy theory, most prevalent in the United States, describes the idea that profit and personal gain are the incentive and driving force behind the economy and progress. Individual people and other actors in the economic market have their interests and that is what drives their decisions. They control the production and distribution of their goods and services, set their prices in an attempt to generate a net profit or remain competitive, and create their supply and demand chains.
Socialism in Political Economy
In socialism, the political-economic theory is that the production and distribution of goods and profits should be controlled by society as a whole instead of a small subset of people like in capitalism. The underlying argument and support for this political economy are that the wealth produced by the social collective is generated by willing participants without regard to those individuals’ status, wealth, lineage et cetera. The goal of socialism is to lessen or even close the gap between the elite few who are vastly rich and powerful, and the greater majority that does not have significant wealth or power.
Communism in Political Economy
Communism is often misinterpreted as socialism by confused individuals. The vital difference is that the production and distribution of all shared resources and assets should be regulated by a central government as opposed to the entire society. Another important distinction is that under socialism, private individuals can hold and own property. This political economy was famously theorized by Karl Marx who understood how capitalism could create a great divide between the rich and the poor within a single economy.
How Does Political Instability Affect the Economy?
Several studies have shown that political instability causes reduced or even negative economic growth. This has been studied and researched to the point that it is common knowledge. However, some studies have delved deeper to show exactly how political instability causes a negative reaction in the economy.
What they found was that political instability not only lowers the productivity growth in the country but also reduces the number of goods produced and even the amount of people. This is an important realization as human capital, or growth directly impacts the number of physical goods produced. Human capital is considered the primary engine that pushes economic growth forward.
So political instability not only reduces physical growth, but human growth as well showing that it directly cuts through what causes the economy to grow. This means that until political instability is solved and the problems are fixed, economic growth will continue to slow or decline.
Throughout history, we can see that every country has a reduced economy the year before elections occur. This is due to a variety of factors.
The first is that many political leaders will implement a lot of changes to welfare and anything else that can be done quickly to draw in voters. This is especially true if that political leader has the chance to be elected again.
These leaders rely on the short-term benefits and how they impact voters. Traditionally, voters tend to be more interested in short-term benefits than longer-term ones as far as deciding on a new leader. However, this can lead to a lot of debt on the government’s side as they spend a lot of money to make these benefits go through quickly.
This is the same with reduced taxes. If a political leader decides to increase taxes, or keep them the same, it may shine them in a bad light in front of potential voters. For this reason, taxes may be reduced for a while before an election.
Many businesses and industries also refrain from making large decisions or investments too close to an election. If someone else comes to power, policies and laws may be changed that can harm them. This affects banks as well, as they aren’t giving out as many loans.
As mentioned above, pretty much everyone in the country focuses on short-term problems when it is close to election time. Businesses aren’t thinking about long-term effects or growth, so economic growth slows down for a while.
Finally, we see that inflation often increases close to elections. Various parties competing for power spend a lot of money to promote themselves and put down their opponent. This means that a lot of money is going out into the world that was originally locked away in a bank account.
With the surge of money comes inflation of commercial goods, which causes prices to increase with no regard for the increase of pay for citizens.
In places where elections are constant, such as the United States, where they run every 4 years, not including minor elections, we can see how issues can arise and create almost constant declines in economic growth.
In the United States, the economy is often voted as the number one election issue during election years. However, we still see how people vote for new presidents based on their short-term promises over their long-term ones.
There are exceptions to the above study, however. Canada seems to be one of them. Since they are heavily dependent on international trade. Because of this, the economy does not seem to depend on its elections. It stays stable even around election years. However, this does mean that Canada’s economy relies heavily on the economy of the countries they export the most heavily to.
They are a country that runs on demand. If the global economy is decreasing and the countries they trade with aren’t able to make as big of a purchase as they traditionally would, Canada’s economy will start to decline as well.
In the last few years, Europe has faced a lot of political instability. With various problems such as Brexit and large political instability in various countries. However, that isn’t what many political economists identify as one of the main problems.
In Europe, the cause of the economic decline and political instability seems to depend on the younger generation’s desperation and people that are untrustworthy and unsatisfied with the government. Some of this is in part to do with the United Kingdom being extricated from the rest of the European Union.
That alone has caused a lot of unrest and uncertainty, despite measures to make the process smoother for all parties involved. The ECB (European Central Bank) had previously made steps to promote investments and lending to increase the economy, but it seems to have caused higher inflation and caused higher cases of impoverishment.
Due to this distrust, there is a lot of political instability, which causes economic variability, often leaning towards decline.
Disillusionment itself is a huge factor in political instability and economic decline. With youth that is of the age to vote and make a change being in the mindset that their opinion makes no difference.
Due to this reasoning, many of those in the younger generation doesn’t make an effort to vote or change policies, as they see themselves as not making a difference. This leads to an increase in instability, and the impression of an increase in instability, whether or not that is occurring.
Even in moments of stability, the younger generations tend to expect it to not stay for long, which causes the economy to decline as they fear instability even when not present.
The fight of younger generations against poor business and management practices also causes a lot of economic instability, as they are fighting for changes that better the workers. However, that fight, lack of workers, and the inability to continue current business practices also cause instability while these issues are being worked out.
In countries that are near the borders of Africa and Asia, specifically Arab countries (Jordan, Egypt, Lebanon, and Tunisia), studies show that corruption is one of the biggest political instability factors that influence economic growth, while issues like regulatory quality are the lowest.
Interestingly, one study showed that macroeconomic variables are not related to political instability, and change very slowly in response to conflicts of any kind.
Another interesting result from this research found that large company investments such as Shell do well with policy instability in lower-income countries. There is a positive correlation between investments and policy instability in the long term.
The parts of Africa that have managed to fight for their independence are still showing signs of political instability and economic decline since they became their entity. Unfortunately, in the past, people have seen this as an excuse for why some countries or areas need to be controlled without looking at the actual cause.
Political economists, however, have begun to look at why countries that recently gained their freedom struggle and show such a large decline in economic growth. What they found is similar to what we are now starting to expect: that economic growth depends heavily on political stability.
With the knowledge we have now, it makes sense that when a country completely and quickly backs out of supporting another, there is a slew of political instability and economic decline in its wake.
This leads to problems that are hard to get out of, even with good, strong leaders. Since economic decline also impacts political instability, both problems have to be managed at once. However, with people only looking at short-term fixes during election years, these problems are not going to be resolved and in fact, may grow worse over time.
South America and Latin America have been stuck in a negative decline for close to 30 years. There is a great deal of political instability and economic fragility. The pandemic has not helped and crippled the government more than it already was.
Since political instability causes a decline of human capital or human growth, it makes sense that extreme losses of life like that, which came about with the COVID-19 pandemic, caused similar reactions in the economy. Peru alone lost almost 1000 people per million people in the country and had the highest deaths in the world per population during the pandemic.
Chile and Ecuador were the next highest deaths per population. In 2021, they headed into election periods and had decimated economical situations and unhappy and disillusioned voters. Not only is political instability-high, but there is also the fear of social unrest increasing to dangerous levels.
However, these countries have good results for investors, due to their mining and copper production. Though the last two decades have shown good growth for investors, there are a lot of risks involved, as political instability created a lot of issues and disruptions when it comes to supply chains globally.
Political instability is painfully high in these countries. There aren’t only issues with leaders, but the cabinets as well are constantly rotating out and getting rid of previous policies every time.
Studies show that Peru has about a 75% chance of experiencing more declines over the next few years. There are scandals, the collapse of national parties, and race unpredictabilities that lead to dramatic changes in the foreseeable future.
What are the Four Main Types of Political Economy?
Because political economy combines economics, politics, and their theories as well as how they interact, economic systems are vital to understanding the political economy as a whole. Economic systems define how factors of growth and production such as land, raw capital, manual labour, and physical resources are controlled.
There are four main economic systems that each function based on unique conditions and assumptions but also have basic characteristics that are shared between all of them.
The oldest of the four economies, this system has established trends based on goods, services, and lots of work. This system is not affected by the political economy as much as others because it is most commonly found in very rural communities in poorer regions of the world where there are scarce natural resources or access to them is very limited.
The primary industries generate most of the products and income in this type of economy, especially farming. The traditional economy is very sustainable and has low amounts of waste from overproduction since the model is inherently unable to produce a surplus of desirable goods in most situations.
Free Market Economy
As the name suggests, this economic system is based on the concept of free markets with little to no interference from central governing bodies. Even raw resources are not regulated or allocated by the government; the relationship between supply and demand of goods is the core of what regulates this kind of economy and comes almost entirely from the people.
However, this economic system is rarely seen in the real world because, thanks to political economy, all prominent economies are influenced in some way by a form of authority. Instances of these laws and interferences are most often seen regulating fair trade and industrial monopolies.
Command economies, also known as planned economies, are often closely tied to the political economy more than the other systems because they are controlled by a single central authority like the government.
This model, therefore, blends well with communist societies since shared resources and production choices are regulated by the government. The government in this political economy tightly controls valuable and important resources like oil when there are a great many resources available to the economy.
Other industries and sectors deemed less important are then handed off and regulated by the people. These include industries like agriculture. Command economies are particularly rigid and react slowly to changes in trade and production because of the centralized control of power.
This makes them more vulnerable to crises within the economy since they cannot quickly pivot to account for constantly evolving conditions. In theory, though, this system works well with a communist political economy assuming that the central power uses its control in the best interests of the general population - this is not often the case, however.
Also known as dual systems, these economic systems are sometimes used to describe a free market system that has heavy regulatory control over it. Most developed countries, especially in the western hemisphere, employ a mixed economy where most industries are private but this system tends to be the de facto system of political economies the world over.
The government then controls the rest of the sectors which end up being almost entirely public services. The theory behind this economic system is supposed to combine the best aspects of both the free market and command systems.
However, as with command systems, this is not typically seen in practice because striking the correct balance is remarkably difficult. In the end, governments universally tend to exercise far too much control over the economy than is truly necessary.
The Political Economy of Financial Markets
Financial markets tend to respond quickly to new policies. This can make it hard to get an idea of real-time impacts. Also, often data is collected in wide-ranged intervals such as monthly or even semi-annually when the information is changing daily or even faster.
However, historical data has shown us that, as with the rest of the economy, financial markets affect politics the same way that politics impact the financial markets interdependently.
Unfortunately, looking at historical data also leads to issues, as though the policy is the direct influence on financial markets, it was often overlooked in traditional economics. This means that policy announcements were often not studied in full in how they influence financial markets.
More recently, this influence has been studied more thoroughly with political economy. Now, people are studying how financial markets can better respond to political instability and policy changes in a healthy way.
This kind of study showed that financial ethics erosion may have caused or heavily contributed to the global financial crisis. This realization has prompted a focus on how to make financial practices sounder and how more ethical solutions can be encouraged and enforced.
How Does Political Economy and Events Affect the Markets?
The political economy always has the potential to affect markets and stocks but recorded history and trends have shown that the impact is relatively small and indirect.
Uncertainty and political instability also play a role in the fluctuations of stock markets albeit only in the short term in most cases. In the end, any regulation coming from politics that trickles down to companies and then investors only affects true change in the market if there is a change in the bottom-line of companies.
Typically, in the United States, Republican political leaders are favoured more than Democratic candidates because the Republican party is more inclined toward deregulation in general and specifically around trade but not to the point of the policy becoming laissez-faire.
This leads to a boost in the bottom line for banks and companies, producing an economic boon if a Republican candidate is voted into office.
Fixed Income Markets
A subset of assets and securities, fixed income markets are a term used to describe set payouts to investors, usually in the form of fixed interest or dividends pre-determined on the date of investment.
When most of these assets have reached maturity, the investor is then repaid the original amount invested on top of the interest earned over the course of the asset’s maturation. The two most common kinds of fixed income markets are corporate and government bonds. Other examples include treasury bonds, municipal bonds, and certificates of deposit.
One of the most common forms of fixed income markets, these bonds are not insured by the Federal Deposit Insurance Corporation in the United States. Instead, if a company’s bottom line is healthy and the industry is growing, the bond is backed by the viability of the company’s finances.
The political economy typically does not affect these markets assuming that the bondholder chooses to hold on until the maturity date as they will then be repaid the principal amount invested. Should a bondholder choose to sell the bond before it fully matures, there could be gains or losses to be made depending on how the market and political economy have fluctuated.
Another very common form of fixed income market, government bonds are issued by their namesake to support the spending and various other obligations of the government. These are relatively low-risk investments that typically have low-interest rates since the government is backing the debt security. These kinds of investments are typically shielded from the effects of the political economy although they are still susceptible to inflation. In such cases, the fixed income interest rate is quickly matched or even outpaced by rising inflation percentages in the worst of economic crises.
Political Economy: The Conclusion
As you can see, the study of political economy can lead to better practices in the future. With enough study and historical research, it may be able to help out countries that are plagued with political and economic instability that would otherwise be near impossible to get out of.
However, there is still a lot of research that needs to be done. Though we understand the basic influences on political imbalances and the economy, it isn’t easy to determine and control every factor that impacts both. There are still a lot of unknown variables and forces that we are unable to control, even if we did understand how they impacted political economics.
What is interesting is that every country runs fairly the same. No matter the history, government type, or economy type, politics and economy both directly and indirectly impact each other in negative ways, and factors such as disillusioned youth influence both in similarly negative ways in every country and continent.
Even in countries such as Canada where their political instability isn’t as much of an influence as others, their economy is influenced by the political instability of countries they trade with since most of their economy is influenced by their exports.
We still have a lot more to learn if we want to be able to fix the problems plaguing many countries today. There’s a lot we still don’t know and a lot of factors changing situations all at once that makes it almost impossible to have a solution that fixes everything at once.
Instead, it looks likely that small changes on all sides are the best solution to fix the problems we face, but only time will tell.