The Financial and Economic Dangers of Democratic Backsliding

This report is a joint publication of the Governance Studies program at The Brookings Institution and the States United Democracy Center.

By: Layna Mosley^{1 Professor, School of Public and International Affairs and Department of Politics, Princeton University.
Email: layna.mosley@princeton.edu.}

In the November 2022 elections in the United States, election-denying candidates had modest success in statewide races for governor, attorney general, and secretary of state. Thirty-three percent of election denying candidates (15 out of 46 in the general election) prevailed in their statewide races.^{2 States United Action, Replacing the Refs, December 2022, https://statesuniteddemocracy.org/resources/replacingtherefs/ .} An additional eight election deniers occupy those offices but were not up for re-election in 2022.^{3States United Action, Replacing the Refs.}

The decentralized nature of U.S. election administration, however, means that the actions of even a single state-level official could wreak significant havoc on national electoral processes. Although the nature of political institutions in the United States has not changed substantially in recent years, some political actors have grown more willing to use these institutions to undermine democratic practices.

The high-profile losses in statewide races also conceal more ominous signs at other levels. Counting statewide elected officials, candidates for the House and Senate, and state legislative candidates, 226 election-denying candidates prevailed, or about 66%.^{4Elaine Kamarck and Norman Eisen, “Democracy on the ballot – Hobbs finishes off election denial (for now),” FixGov (blog), The Brookings Institution, November 15, 2022, https://www.brookings.edu/blog/fixgov/2022/11/15/democracy-on-the-ballot-hobbs-finishes-off-election-denial-fornow/.} Many members of the majority party in the U.S. House of Representatives are election deniers. Election-denying officials also have assumed important positions in many state legislatures. Thus, the erosion of democratic practices and norms remains a serious threat in the United States.

Moreover, the behavior of election deniers and insurrectionists in the United States serves to inspire antidemocratic forces abroad. The Jan. 8, 2023, attacks on Brazil’s Congress, presidential palace, and Supreme Court appeared directly inspired by the Jan. 6, 2021, attacks on the U.S. Capitol. Brazil’s former president, Jair Bolsonaro, refused to concede defeat in the October 2022 presidential election; during the campaign, he stated that were he to lose, falsified election results would be to blame ^{5Jack Nicas et al., “How Bolsonaro Built the Myth of Stolen Elections in Brazil,” New York Times, October 25, 2022, https://www.nytimes.com/interactive/2022/10/25/world/americas/brazil-bolsonaro-misinformation.html.} “#BrazilWasStolen” spread on social media. U.S. elections also provide an example to anti-democratic 2 forces abroad.^{6Anne Applebaum, “What the Rioters in Brazil Learned from Americans,” The Atlantic, January 8, 2023, https://www.theatlantic.com/ideas/archive/2023/01/brasilia-riot-bolsonaro-lulatrump/ 672677/?utm_source=newsletter&utm_medium=email&utm_campaign=atlantic-dailynewsletter& utm_content=20230111&utm_term=The%20Atlantic%20Daily.} Direct links among far-right groups in the U.S., Europe, and Latin America likely exist; but even absent those links, anti-democratic practices and views may diffuse transnationally.^{7Marlies Glasius, Jelmer Schalk, and Meta de Lange, “Illiberal Norm Diffusion: How Do Governments Learn to Restrict Nongovernmental Organizations?,” International Studies Quarterly 64, no. 2 (June 2020): 453-468, https://doi.org/10.1093/isq/sqaa019; Seva Gunitsky, “Corrupting the Cyber-Commons: Social Media as a Tool of Autocratic Stability,” Perspectives on Politics 13, no. 1 (March 2015): 42-54, https://doi.org/10.1017/S1537592714003120; Susan D. Hyde, “Democracy’s backsliding in the international environment,” Science 369, no. 6508 (September 2020): 1192-1196, https://doi.org/10.1126/science.abb2434.}

As attention shifts toward 2024 U.S. electoral contests, it is important—for the American public generally and for U.S.-based institutional investors specifically—to remain cognizant of the very real threats to U.S. democracy. Investors often treat the United States as an exceptional market, by virtue of its size, liquidity, and global role. Indeed, cross-national academic analyses in political economy and finance often exclude the United States, because it is an outlier in many ways.

Yet these same features also heighten the potential impact on investment portfolios of political shifts in the United States. Most institutional investors’ portfolios are overweight in U.S. investment, the result not only of the United States’ important global position, but also of a more general “home bias” among investors.^{8Lieven De Moor and Rosanne Vanpée, “What drives international equity and bond holdings? An empirical study,” Applied Financial Economics 23, no. 13 (2013): 1067-1082, https://doi.org/10.1080/09603107.2013.795273; Martin Wallmeier and Christoph Iseli, “Home bias and expected returns: A structural approach,” Journal of International Money and Finance 124, (June 2022): 102634, https://doi.org/10.1016/j.jimonfin.2022.102634; Linda L. Tesar and Ingrid M. Werner, “Home bias and high turnover,” Journal of International Money and Finance 14, no. 4 (August 1995): 467-492, https://doi.org/10.1016/0261-5606(95)00023-8.} A large negative shock to U.S. assets and markets would heavily impact these overweight portfolios. Moreover, given the position of the United States globally, U.S.-based shocks would likely reverberate throughout the global economy. This spillover, as evidenced by the 2007-2008 U.S. subprime crisis, would likely generate far-reaching effects. It therefore is difficult to “flee to safety” when the United States—typically viewed as a safe haven when political risk elsewhere increases—experiences heightened political risk.

Polities in which the rule of law is less well-respected often experience a decline in firms’ activities and innovations. The uncertainty associated with an erosion of democratic values can generate volatility as well as higher costs of capital, for business as well as for municipal and sovereign borrowers. When the institutions of democracy are strong, volatility in economic policy appears less worrying to investors; in the face of institutional decay, however, weak policy is likely to have more negative effects. And, to the extent that democratic backsliding is associated with populist—nationalist, anti-foreigner, and anticosmopolitan— ideologies, it threatens the liberal international order on which so much U.S. prosperity has rested.

This report therefore argues that U.S. institutional investors have a fiduciary duty to continue to closely monitor the political risks associated with potential democratic erosion in the United States. The paper begins by conceptualizing democratic backsliding and summarizing the state of democracy, both globally and in the United States. The report then discusses existing academic scholarship on the ways in which political risk matters for economic and financial outcomes, including fixed income, equities, and longerterm investment. The bulk of this work analyzes political risk in other countries and regions, including advanced as well as emerging and frontier market economies. The report then discusses what lessons these analyses hold for the United States. It concludes with a discussion of what institutional investors can do to monitor and respond to these risks.

Read the full Financial and Economic Dangers of Democratic Backsliding report.