Political instability has long been associated with negative economic consequences, particularly through its presumed effect on investment. Conventional wisdom suggests that regime changes – such as resignations, coups, or assassinations – create uncertainty that drives away investors and stunts economic growth. Our research challenges this assumption by revealing that political instability’s effect on financial markets are more nuanced than previously thought, and importantly, not all types of political instability discourage investment.

We examine the immediate impact of political instability on national finance indices across countries that experienced irregular regime changes. A key takeaway is that the market’s response to political events depends heavily on the nature of the regime change and the expectations it sets about future economic conditions.

For example, when political leaders resign, markets often react positively (+4% on average), as resignations typically follow the departure of an ineffective leader and may signal increased stability. This contrasts sharply with the response to assassinations, which tend to create a climate of uncertainty and on average result in a market downturn of -2%.

In the case of military coups, the effects on investment are more variable. While most coups lead to negative market reactions (around -2%), there is a notable exception: coups that result in a pro-business regime shift tend to trigger large positive returns, with increases of up to 10% following the failed ouster of Hugo Chavez’s regime. This suggests that markets do not react to coups purely as threats to stability but also consider the potential for economic reforms that could enhance growth prospects.

Our research also sheds light on the differential effects democratic and authoritarian regime changes on investment. When countries shift towards more authoritarian and/or anti-business governments, capital flight is more likely to occur as investors seek safer environments. In contrast, changes that lead to more democratic or pro-business governments tend to contribute to more stable conditions, promoting investment. These findings challenge the traditional view that political instability automatically reduces investment. Instead, the market response depends on how investors perceive the potential for future growth under the new regime.

There are important implications for policymakers. First, our finding that even anti-democratic irregular regime changes can have a positive impact on investment when the replacement government is clearly pro-business implies that investor actions may be at odds with regime stability. Second, immediate and large financial outflows following most coups and assassinations suggest that a weakened economy are likely to accompany these kinds of regime changes. More optimistically, pro-democracy regime changes that clearly signal a commitment to democracy and the rule of law may result in increased investment in a country’s firms.

Ultimately, our study provides a more nuanced view of the effects of political instability on international capital flows. Unexpected changes in ruler virtually always increase market volatility, but flows are not always negative. Markets can even be given a boost when a new regime is expected to offer a more stable, democratic, or pro-business environment than the previous one.

The 2024 David P. Baron Award has been awarded to Devin Incerti and Trevor Incerti for their article “Are regime changes always bad economics? Evidence from daily financial data“, published open access in Volume 26, Issue 4 of Business and Politics.