Stock Price Volatility and Political Uncertainty : Evidence from the Interwar Period

The extreme levels of stock price volatility found during the Great Depression have often been attributed to political uncertainty. This paper performs an explicit test of the Merton/Schwert hypothesis that doubts about the survival of the capitalist system were partly responsible. It does so by using a panel data set on political unrest, demonstrations and other indicators of instability in a set of 10 developed countries during the interwar period. I show that political risks themselves changed dramatically over the period, and are sufficient to account for a large part of the increase in volatility during the Great Depression. This conclusion is robust to a number of alternative specifications. I derive rolling estimates of the risk of revolution, and demonstrate that the strong reaction to incidents of worker militancy such as strikes and riots can be rationalized as a sensible reaction to the risk of expropriation