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Measuring Geopolitical Risk

Journal: American Economic Review

Date: 20220401

Author: Caldara, Dario; Iacoviello, Matteo

Abstract:
We present a news-based measure of adverse geopolitical events and associated risks. The geopolitical risk (GPR) index spikes around the two world wars, at the beginning of the Korean War, during the Cuban Missile Crisis, and after 9/11. Higher geopolitical risk foreshadows lower investment and employment and is associated with higher disaster probability and larger downside risks. The adverse consequences of the GPR index are driven by both the threat and the realization of adverse geopolitical events. We complement our aggregate measures with industry- and firm-level indicators of geopolitical risk. Investment drops more in industries that are exposed to aggregate geopolitical risk. Higher firm-level geopolitical risk is associated with lower firm-level investment.

Link: Google Scholar

Key Findings

Geopolitical Risk Impact

High geopolitical risk reduces U.S. investment by 1.7%, employment by 0.4%, and negatively affects stock market levels within one year of increased risk

Threats vs Acts

The adverse effects of geopolitical risk are primarily driven by threats of future events rather than actual geopolitical acts

Industry Effects

Industries have varying exposure to geopolitical risk - firms in highly exposed industries reduce investment by 3.8% compared to 1.8% average decline

Macroeconomic Effects of Geopolitical Risk

  • Investment drops 1.7% within one year after geopolitical risk shock
  • Employment declines 0.4% after one year
  • Stock market drops 2.5% within two quarters

Geopolitical Acts vs Threats Impact

  • Threat shocks have larger and more persistent effects than actual events
  • Investment decline is primarily driven by threat component
  • Effects of threats persist for up to 8 quarters

Industry Exposure to Geopolitical Risk

  • Precious metals, petroleum, and defense industries have negative exposure (outperform during tensions)
  • Coal, transportation, and entertainment have positive exposure (underperform during tensions)
  • Investment drops 2% more in high-exposure industries

Contribution and Implications

  • First systematic measurement and analysis of geopolitical risk's economic effects
  • Demonstrates that geopolitical threats, rather than acts, drive economic uncertainty
  • Provides evidence for industry-specific vulnerability to geopolitical tensions
  • Develops new methodological framework for measuring geopolitical risk through media coverage

Data Sources

  • Macroeconomic effects chart based on VAR analysis results shown in Figure 8 of the paper
  • Threats vs Acts comparison derived from Table 3 and Figure 9 regression coefficients
  • Industry exposure visualization based on firm-level analysis results in Figure 11 and Section 5.2