Well-functioning capital markets and the low interest rates that often accompany them are important for economic development and growth. High interest rates, for example, can deter governments from borrowing to finance investments on which to base future economic growth. High rates are often due to risk premiums that reflect the possibility that the government will default.
It seems likely that the risk of default is lower if a country has better political institutions. Although this hypothesis seems intuitive, no scholarly work documents or tests whether in fact institutions that improve electoral accountability and foster more democracy reduce the risk of default and therefore lower risk premiums. This paper tests whether changes in political institutions have a direct effect on financial markets, measured as a reduction in the risk premium.
Previous work estimates the effects of institutions on economic growth and documents that some institutions improve it. This work is based on the theoretical contributions of, for example, Shleifer and Vishny (1993), who argue that the structure of government institutions is important for economic development. Also Acemolu et al (2005) make a theoretical case that institutions provide an important role for economic development.
They show evidence by pointing out that the development of democratic institutions in Great Britain in the 18th century played an important role in Great Britain’s economic development. Institutions that have been found to slow economic growth include corruption and insecure property rights (e.g., Mauro, 1995; Keefer and Knack, 2003; Acemoglu, Johnson, and Robinson, 2005). Determinants of insecure property rights and high corruption include the timing of elections and the lack of checks and balances (Keefer 2004).