Monday, April 18, 2011

Are Democrats or Republicans better for the Economy?

Larry Bartels has frequently argued that Democrat Presidents are better for the economy. Here's the takeaway graph:

Just observing a correlation between the partisan identity of a President and some economic outcome isn't the most convincing argument in the world. Jim Manzi and James Campbell present reasons to be skeptical that this is a causal relationship. Among the reasons to be skeptical are that the state of the economy drives political results (ie, reverse causation); and that it's difficult to imagine the exact mechanism driving this result. Presidents can't wave their arms and force a given result -- Congress passes laws. Yet you don't see this same relationship if you graph Congressional partisan identity against economic outcomes.

I've long thought that a better way to think about this would be to do an event study on the stock market before/after an election, using past polling data as a way to get a
sense of what the market was "expecting" before the final electoral outcome. Justin Wolfers and co-authors have a new paper arguing in favor of this strategy (with prediction markets instead of polls), which uses this question as a motivating example:

First, we show that in the 2004 U.S. Presidential election, candidate convergence did not occur, as predicted by Downs (1957) and many other models. Specifically, the stock market rose 2% in value on news of a Bush victory (over Kerry). Secondly, we show this difference of 2% between Republicans and Democrats has been remarkably consistent over time, appearing in an analysis of all elections between 1880 and 2004. This suggests that whatever the changes in party structure and policy issues over that period, Republicans have consistently been the party of capital, and Democrats the party of labor. Finally, we show that the stock market declined in response to the news of a Democratic victory in the Senate (and House) in 2006, suggesting that,contrary to conventional wisdom, markets do not prefer divided control of the legislature and executive to unified control of both branches. [emphasis added]

Aside from representing a more statistically sound way of figuring this question out, this result has the advantage of consistency. The Republican-Democrat difference does vary from election to election, but is at least typically in one direction. There is also consistency between the Congressional and Presidential outcomes here. Here's a sample graph:

To be sure, the exact mechanisms behind this result remain opaque. A differing partisan propensity to levy capital gains taxes could be enough. Nor do better stock markets settle the question of which party is uniformly "better" for the economy -- even if Republicans are better for company profits, they may also institute other policies that alter the income distribution. The authors suggest that this makes Democrats "the party of labor;" but it is at least possible that higher stock prices reflect a greater earnings potential for the economy, which could filter down to all workers.

But what is clear is that this approach is a million times better than interpreting a correlation for causation. It's also better than just looking at how the stock market behaved before/after an election, as this takes into account the prior expectation that a given President was going to be elected. With the growing reach of InTrade, this method could probably be used for all sorts of things--the impact of PPACA on health company profits, etc. The only caveat I have is that what the authors call "the predicted probablility from InTrade" probably can't be interpreted as easily as they suggest.

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