Government Size and Stock Market Performance in the G7 Countries: Some Robust Bilateral Causality Tests

Abstract

This paper performs robust bilateral Granger causality tests between government size and stock market performance for the G7 countries. The robust test procedures involve the use of recently developed time series analysis of non-stationary data with possible structural breaks. Applying such tests, the paper finds the underlying data to be generally non-stationary and non-cointegrated, even after allowing for possible breaks in the data, thus implying that the standard bilateral Granger causality tests conducted in the first differences of the variables are robust. The empirical results indicate the presence of one-way causality from the stock market to government size for all the countries in the sample. Thus, we find no evidence that government size matters to the performance of the stock market. In addition, to the extent that stock prices discount future economic performance, our findings show that, if anything, it is economic prosperity that determines government size. Our findings thus refute some recent assertions that the current financial crisis is an expression of the market angst regarding the growing size of the public sector in recent decades.

Key words: Stock market performance; Government size; Time-series data