The Price of Paralysis: Markets Are Mispricing Political Gridlock

Cristian Abarca
May 5, 2025
7 min read

Abstract

Investors have historically rewarded divided governments for the policy stability they are perceived to create. Yet this conventional wisdom is becoming increasingly untenable in an era of deepening political fragmentation. The nature of gridlock has evolved from a source of healthy checks and balances to a driver of dysfunctional paralysis, creating significant, and often mispriced, medium- to long-term risks. Through case studies of fiscal decay, erosion of state capacity, and executive overreach, prolonged gridlock is now manifesting as material market risks, from sovereign credit downgrades to heightened currency and bond market volatility.

1. A Warning Shot from Bogotá

In May 2024, a political standoff in Colombia sent a shockwave through its financial markets, providing a stark illustration of the argument at the core of this research note. President Gustavo Petro, frustrated by a gridlocked Congress that refused to approve an increase in the nation’s debt ceiling, threatened to “cease payments” on government debt and declare an economic emergency. The market reaction was swift and severe. The Colombian peso, which had been a top performer, plunged, and government bond yields surged as investors priced in a sudden and unexpected risk of default.

What made the episode so alarming was that it occurred in a political environment that many investors had previously viewed as favorable. Petro’s lack of a legislative majority was seen as a key safeguard, a form of “benign gridlock” that would constrain his more radical policy ambitions. Yet, in this instance, the gridlock itself became the source of instability, transforming a political dispute into a full-blown fiscal crisis. This event was not an anomaly; it was a warning shot. It signals that the traditional investor playbook, which reflexively favors divided government, is dangerously out of date and is causing markets to systematically misprice the growing risks of political paralysis.

2. The Traditional Investor Playbook: A Preference for Paralysis

For decades, the consensus on Wall Street and in other global financial centers has been clear: political gridlock is good for markets. This view is underpinned by three core beliefs:

Policy Stability: A divided government, with power split between competing political forces, is less likely to enact radical policy shifts, raise taxes, or otherwise disrupt the status quo. This perceived stability allows businesses and investors to make long-term plans with greater confidence. The market’s relief when a divided government was confirmed after the 2020 U.S. election is a classic example of this principle in action.
Forced Moderation: Gridlock forces even the most ideologically committed leaders to moderate their positions. In Chile, the 2021 election of the young leftist Gabriel Boric was initially met with trepidation, but his need to build alliances with a pro-business opposition in a fragmented congress quickly led to more market-friendly cabinet appointments and policy pledges . Similarly, in Argentina, the firebrand libertarian Javier Milei has been forced to water down his radical reform agenda in the face of a recalcitrant legislature.
Fiscal Discipline: Perhaps most importantly, divided governments are seen as a check on profligate spending. The difficulty of passing controversial spending bills in a gridlocked legislature is believed to lead to smaller deficits and more prudent borrowing, a dynamic that is particularly attractive to bond investors. The expectation that Brazil’s right-of-center congress would ensure fiscal prudence under the left-wing administration of President Luiz Inácio Lula da Silva was a key factor in the positive market sentiment following his election .

This playbook is not without empirical support. The S&P 500 has, on average, delivered stronger returns under divided governments in the U.S. The inverse is also true: markets often react negatively to the prospect of a unified government, as seen in the sharp sell-off of Mexican assets following the landslide victory of Claudia Sheinbaum and her MORENA party in June 2024. However, this singular focus on the risks of unified government is creating a critical blind spot to the new and growing dangers of dysfunctional gridlock.

3. The New Face of Fragmentation: Why This Time Is Different

The nature of political gridlock has changed. It is no longer simply a product of healthy democratic competition but a symptom of a deeper and more corrosive political fragmentation. This new landscape is characterized by several key features that make it far more dangerous than the gridlock of the past:

The Intensity of Fragmentation: The sheer number of political parties has exploded in many countries. Data from the V-Dem Institute shows a dramatic increase in the Effective Number of Parties (ENP) in many emerging markets, particularly in Latin America. This is not a benign diversification; it is a splintering of the political system that makes forming stable governing coalitions nearly impossible. Peru is the poster child for this phenomenon, with a congress so fractured that no single party can effectively lead.
The Collapse of the Ideological Center: As party systems fragment, the political center is eroding. Politics is increasingly dominated by the extremes, making compromise and consensus-building on critical economic issues ever more difficult. This is not just a feature of emerging markets; it is a defining characteristic of the political landscape in many developed nations as well.
The Transition from “Benign” to “Malignant” Gridlock: The key insight from our research is that there is a spectrum of gridlock, ranging from “benign” (healthy checks and balances) to “malignant” (dysfunctional paralysis). The trends described above are pushing more and more countries towards the malignant end of the spectrum. While mild fragmentation may still produce the stability that investors crave, severe fragmentation, as seen in Colombia and Peru, leads to a breakdown in governance that carries immediate and material market risks.

4. The Material Costs of Malignant Gridlock: Three Transmission Channels

The negative consequences of this new, more virulent strain of gridlock are no longer theoretical. They are manifesting as concrete, market-moving events through three primary transmission channels.

4.1. The Fiscal Channel: From Prudence to Paralysis

The traditional belief that gridlock enforces fiscal discipline is breaking down. In cases of severe fragmentation, it can have the opposite effect, preventing governments from making necessary fiscal adjustments and even threatening the basic functioning of the state. The Colombia debt ceiling crisis is the most acute example, but the dynamic is also visible in the developed world.

In France, the inability of President Emmanuel Macron’s government to build a stable legislative coalition has severely hampered its efforts to address the country’s mounting budget deficit. This persistent gridlock was a key factor in Moody’s decision to downgrade France’s credit rating in December 2024, a move that caused the spread between French and German government bonds to widen significantly .

4.2. The State Capacity Channel: The Erosion of Governance

Malignant gridlock can lead to a broader erosion of state capacity, undermining a country’s ability to provide basic services, maintain the rule of law, and respond to crises. In Peru, the political chaos that has followed the election of Pedro Castillo has had a devastating impact on the country’s security situation. The government’s inability to pass effective anti-crime legislation has coincided with a sharp rise in violent crime, creating a more challenging operating environment for businesses and contributing to S&P’s decision to revise the country’s sovereign debt outlook to negative.

This erosion of state capacity can also have a direct impact on a country’s economic competitiveness. In both Chile and Peru, political gridlock has stalled much-needed investment in the countries’ vital copper mining sectors, threatening the long-term viability of an industry that is crucial to both countries’ economies and to the global energy transition .

4.3. The Executive Overreach Channel: The Authoritarian Response

Perhaps the most insidious consequence of legislative paralysis is the growing tendency for executives to bypass the legislature altogether. When faced with a gridlocked congress, presidents are increasingly resorting to rule by decree, a practice that fundamentally undermines democratic checks and balances and creates a new and dangerous source of policy volatility.

Latin America has become a hotbed of this phenomenon. In Argentina, President Javier Milei has made extensive use of his decree powers to implement his radical economic agenda. In Colombia, President Petro has used decrees to pass his budget, and in Ecuador, President Daniel Noboa has declared a state of emergency, suspending constitutional rights. This shift towards executive governance replaces the predictable, if slow-moving, process of legislative deliberation with the arbitrary and often erratic whims of a single leader, creating a level of policy volatility that is deeply inimical to long-term investment.

5. An Investor Framework for Navigating Gridlock

The traditional investor playbook on political risk is broken. A more nuanced framework is required to distinguish between benign and malignant gridlock. We propose a simple two-factor model based on the severity and duration of gridlock.

Gridlock Type	Characteristics	Market Implications
Benign	Moderate fragmentation, functioning coalitions, respect for institutional norms.	Positive. Leads to policy stability and fiscal prudence. (e.g., Uruguay, post-2022 Kenya)
Malignant	Severe fragmentation, unstable coalitions, frequent legislative-executive conflict, rise of anti-system parties.	Negative. Leads to fiscal paralysis, erosion of state capacity, and executive overreach. (e.g., Peru, Colombia)

Investors should monitor the following warning signs - beyond how they are already used - that a country is moving from benign to malignant gridlock:

Rising Use of Executive Decrees: A clear sign that the normal legislative process has broken down.
Stalled Budgets and Debt Ceiling Crises: An indicator of fiscal paralysis.
Credit Rating Agency Warnings: Agencies are increasingly citing governance and political fragmentation as key risk factors.
Sustained Underperformance of State-Owned Enterprises: Often a leading indicator of a broader erosion of state capacity.

Conclusion: Pricing the Price of Paralysis

The benign view of gridlock as a source of stability is no longer tenable. The short-term comfort offered by a divided government is increasingly being outweighed by the long-term costs of legislative paralysis. The market is beginning to wake up to these new realities, but the process is still in its early stages. The investors who will succeed in this new and more volatile political landscape are those who can look beyond the headlines, differentiate between benign and malignant gridlock, and correctly price the growing risk of political paralysis.