If 2008 was a sharp reminder that banking matters, then 2016 has reminded us that politics matters too — and, in both cases, the reminder has not been especially welcome. How should economists respond?
Until recently, both banking and politics tended to be something of a niche interest in the economics profession. This isn’t quite as insane as it might seem: if you want to analyse a complex world, you’re going to have to make some simplifying assumptions. For a generation or more, in rich countries, both banks and politicians have seemed complicated and not terribly important, so many economists have ignored them.
Development economists have paid closer attention to politics and have been rewarded for their efforts. Daron Acemoglu won the John Bates Clark Medal in 2005, and the late Elinor Ostrom, a political scientist, won the Nobel Memorial Prize in Economics in 2009. The reason for their interest is obvious: malfunctioning political institutions are a major reason that poor countries are poor.
In the wake of the Brexit vote, Trumpism, the rise of Marine Le Pen and the coming constitutional referendum in Italy, it no longer seems tenable to ignore the economic effects of politics in the western world. But how best to take them into account?
Some economists argue that financial markets are actually an excellent window into politics. For example, Justin Wolfers, an economist at the University of Michigan, tracked US stock futures prices during the first presidential debate. Stocks rose as Hillary Clinton got the better of Donald Trump, and betting markets upgraded the prospect of a Clinton victory. Implicitly, the market was saying that a Trump presidency would knock more than 10 per cent off the profitability of corporate America — and was relieved to see that risk fading.
More here – Tim Harford