Introduction Construction Understanding Effects Robustness Conclusions Appendix

Measuring Geopolitical Risk

Dario Caldara Matteo Iacoviello

Federal Reserve Board

North Carolina State University February 22, 2018

Disclaimer: The views expressed are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of anyone else associated with the Federal Reserve System. Introduction Construction Understanding Effects Robustness Conclusions Appendix

Geopolitical Risks Receive a Lot of Attention...

Geopolitical risks often cited by policy-makers, investors, and media as key determinants of economic decisions. 2017 Gallup Survey: 75 % of investors worried about geopolitical risk for business environment. Geopolitical Risk part of ‘uncertainty trinity’ that could have significant adverse economic effects. Carney (2016) Geopolitical Risk salient risk to outlook (IMF 2017, ECB 2017, WB 2018) Introduction Construction Understanding Effects Robustness Conclusions Appendix

...but their Consequences are Unclear

Little research devoted to quantify the macroeconomic and financial impact of geopolitical risks. Introduction Construction Understanding Effects Robustness Conclusions Appendix

What We Do

1. Construct an indicator of geopolitical risk—GPR Index—measuring frequency of articles in leading newspapers discussing rising geopolitical tensions.

I Focus on risks associated with wars, , tensions between states;

2. High GPR induces:

I adverse effects on US employment, IP, and trade;

I drop in US stock market: heterogeneous response across industries;

I decline in real activity and stock prices in advanced economies;

I capital outflows from emerging economies to safe havens.

3. Economic impact of GPR mostly driven by threat of adverse geopolitical events rather than their realization. Introduction Construction Understanding Effects Robustness Conclusions Appendix

Why We Do It

Existing indicators not amenable to empirical analysis:

I No definition or unclear definition of geopolitical risk;

I Constructed judgmentally with unknown criteria;

I Little variation or short sample availability; Examples

I Constructed as combinations of outcome variables (gold, VIX, dollar, oil prices).

Complement research on effects of wars and terrorist attacks. Blomberg & al (2004); Tavares (2004); Glick & Taylor (2010)

Relationship to proxies for macroeconomic uncertainty:

I Exogeneity of GPR index; Ludvigson & al (2015); Caldara & al (2016)

I Control for effects of realization of events. Introduction Construction Understanding Effects Robustness Conclusions Appendix

Plan of the Talk

Construction of the GPR Index

Understanding the GPR Index

Domestic and International Effects of Higher GPR

Robustness

Conclusions Introduction Construction Understanding Effects Robustness Conclusions Appendix

CONSTRUCTION OF THE INDEX Introduction Construction Understanding Effects Robustness Conclusions Appendix

Definition: Geopolitics and Geopolitical Risk

Geopolitics is a word that encompasses multiple definitions.

We define Geopolitical Risk as the “risk associated with wars, terrorist acts, and tensions between states that affect the normal and peaceful course of international relations.”

Geopolitical risk captures both risk that these events materialize and new risks associated with escalation of existing events. Definition excludes some “geopolitical” phenomena:

I Major economic crisis (e.g. GFC, Eurozone debt crisis)

I Major democratic political events (e.g. Brexit)

I Climate change, civil right movements... Introduction Construction Understanding Effects Robustness Conclusions Appendix

Measurement: Newspaper Searches

Our methodology mimics what Baker, Bloom, Davis (2016) do for EPU Index. The geopolitical risk (GPR) index measures the frequency of articles in 11 newspapers mentioning rising geopolitical tensions. Benchmark index (from 1985):

I United States: Boston Globe; Chicago Tribune; Los Angeles Times; NYT; WSJ; WaPo.

I United Kingdom: Daily Telegraph; FT; Guardian; Times.

I Canada: The Globe and Mail.

Historical index (from 1899): NYT, Chicago Tribune, and WaPo Risks as covered/perceived by the English-speaking press. More weight to events with U.S. involvement. Introduction Construction Understanding Effects Robustness Conclusions Appendix

Not as Simple as Searching for ’Geopolitical’ AND ’Risks’

Language has changed:

I Term ”Geopolitical risk” popular after 9/11

I ”War risks” used to be ”War perils”

I ”Terror Threats” used to be ”Terrorist Menaces”

News articles content has changed:

I Focus shifted from ’chronicles’ to ’opinions’.

Nature of risks has changed:

I From wars to nuclear threats to terrorism. Introduction Construction Understanding Effects Robustness Conclusions Appendix

Measurement: Selection of Search Terms

We define6 search groups based on pilot audit of articles likely mentioning geopolitical risks.

Audit set of articles (E) containing Geopolitics or War or Military or Terrorism/t – most RECURRING WORDS in geopolitics books.

In 2,500 articles in E, about 50% discuss high geopolitical risk (E 1).

Most articles in E 1 contain additional words related to risks or threats, tensions between states, beginning of wars.

Construct search categories based on content of articles in E 1. Exclude from searches phrases overwhelmingly associated with false positives (E 0):

I E.g. movies, anniversaries, obituaries, end of the war. Introduction Construction Understanding Effects Robustness Conclusions Appendix

Measurement: The Search Terms

Search Category Words 1. Geopolitical Geopolitical AND (risk* OR concern* OR tension* OR uncertaint*) Threats ”United States” AND tensions AND (military OR war OR geopolitical OR coup OR guerrilla OR warfare) AND (”Latin America” OR ”Central America” OR ”South America” OR OR Africa OR ”Middle East” OR ”Far East” OR Asia)

2. Nuclear (”nuclear war” OR ”atomic war” OR ”nuclear conflict” OR ”atomic conflict” OR Threats ”nuclear missile*”) AND (fear* OR threat* OR risk* OR peril* OR menace*) ”war risk*” OR ”risk* of war” OR ”fear of war” OR ”war fear*” OR ”military 3. War Threats threat*” OR ”war threat*” OR ”threat of war”

(”military action” OR ”military operation” OR ”military force”) AND (risk* OR threat*)

”terrorist threat” OR ”terrorist threats” OR ”menace of terrorism” OR ”terrorism 4. Terrorist menace” OR ”threat of terrorism” OR ”terrorist risk” OR ”terror risk” OR ”risk Threats of terrorism” OR ”terror threat” OR ”terror threats”

5. War Acts (beginning OR outbreak OR onset OR escalation OR start) ”of the war” (war OR military) AND (”air strike” OR ”heavy casualties”)

6. Terrorist Acts ”terrorist act” OR ”terrorist acts” Introduction Construction Understanding Effects Robustness Conclusions Appendix

The Benchmark Geopolitical Risk Index

GPR Benchmark Index (GPR) Index (2000-2009 = 100) 600

500 ISIS TWA Hijacking invasion Iran/Nuclear Escalation Paris 400 US bombs 9/11 Tensions Libya Iraq Disarmament Madrid annexes attacks Kuwait Crisis 1998 bombings Crimea North 300 Invasion London Syrian Civil War Korea US Invasion bombings Escalation of Panama Arab Spring: 200 Syrian & Lybian War 100

0 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

GPR Index updated monthly and available at https://www2.bc.edu/matteo-iacoviello/gpr.htm Introduction Construction Understanding Effects Robustness Conclusions Appendix

Geopolitical Threats vs. Geopolitical Acts

GPR index captures a convolution of shocks to first and higher order moments of the distribution of geopolitical events.

I Spikes in risk often coincide with realization of big events.

We organize searches to separate threats that do not immediately materialize from acts that reveal an underlying threat.

I Geopolitical Threats (GPT): Search categories 1 to 4;

I Geopolitical Acts (GPA): Search categories 5 to 6. Introduction Construction Understanding Effects Robustness Conclusions Appendix

Geopolitical Threats vs Geopolitical Acts Correlation coefficient: 0.60

GPR THREATS AND ACTS Index (2000-2009 = 100) 600 GPR Threats GPR Acts 500 Iraq ISIS TWA Hijacking Gulf War invasion Iran/Nuclear Escalation 400 US bombs 9/11 Tensions Libya Iraq Disarmament Madrid Russia annexes Kuwait Crisis 1998 bombings Crimea Paris 300 Invasion London Syrian Civil War attacks US Invasion bombings Escalation of Panama Arab Spring: 200 Syrian & Lybian War 100

0 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 Introduction Construction Understanding Effects Robustness Conclusions Appendix

Geopolitical Threats vs Acts in 1991 and 2003

Gulf War Iraq Invasion 400 600 GPR Threats GPR Threats GPR Acts GPR Acts 500 300 400

200 300

200 100 100

0 0 1990 1991 2002 2003 Introduction Construction Understanding Effects Robustness Conclusions Appendix

The Historical Geopolitical Risk Index

GPR Historical Index (2000-2009 = 100) 700 WW1 Begins 600 US Joins WW1

Beginning of WWII 500 Iraq Invasion

Attack on Pearl Harbor 400 Gulf War 9/11

Falklands War Begins 300 US Bombing of Libya Russia annexes Crimea Able Archer 83

200 Grain Embargo against USSR Beginning of Russian-Japanese War US Bombing of Iraq Yom Kippur War Italian Invasion of Ethiopia Soviet Union Resumes Nuclear Tests : First Battle of Quang Tri Middle East Tensions pre-6 Day War Hitler threatens Czechoslovakia Suez Crisis Escalation of First Balkan War Begins Second Boer War and Boxer Rebellion Japan attacks Shanghai and Nanking

Second Taiwan Strait Crisis 100

0 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Introduction Construction Understanding Effects Robustness Conclusions Appendix

Audit: Reading and Manually Coding Articles

Pilot Audit: Sample 2,500 articles from set E consisting of articles containing: geopolitics, war, military, terrorism/t. 1 0 I Goals: inform and refine search terms; understand true E and false E positives; build audit guide

Full scale Audit: Sample of 6,125 articles (50 per quarter) from E. 1 I Goal: construction of “human GPR”=E /U; I Correlation between GPR index and “Human GPR”: 84%.

Ex post Evaluation: Sample of 2,500 articles only from set selected by automated searches.

I 87% mention high or rising geopolitical tensions. I 4% mention low or decreasing geopolitical tensions. I Correlation between GPR and audited-GPR is 0.98 Introduction Construction Understanding Effects Robustness Conclusions Appendix

Human vs GPR Index

600 GPR Index 500 Human Index

400

300

200

100

0 1985 1990 1995 2000 2005 2010 2015 Introduction Construction Understanding Effects Robustness Conclusions Appendix

UNDERSTANDING THE GPR INDEX Introduction Construction Understanding Effects Robustness Conclusions Appendix

Risks Captured by our Index

Our index captures geopolitical risks as perceived and chronicled by the press in English-speaking countries, particularly in the United States.

The behavior of the index over time shows how different events move the balance of risks over long horizons and at daily frequencies

The index by definition captures media attention towards geopolitical risks, but appears exogenous to major newsworthy events of non-geopolitical nature Introduction Construction Understanding Effects Robustness Conclusions Appendix

The Historical Geopolitical Risk Index: Components

Words in the Historical Index

600 Geopolitical Threats Nuclear Threats War Threats War Acts 500 Terrorist Threats Terrorist Acts

400

300

200 Historical Index (2000-2009=100) Index Historical 100

0 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Introduction Construction Understanding Effects Robustness Conclusions Appendix

The Daily GPR Index

1985 A1985/06/17: TWA Hijacking A1986/04/16: U.S. Bombing of Libya 1987 A1987/04/17U.S-Russia negotiations over nuclear weapons A1987/10/20: War Threats in Persian Gulf 1989 A1989/12/21: U.S. Invades Panama A1990/08/04: Iraq Invades Kuwait 1991 A1991/01/15 : Gulf War. Operation Desert Storm

1993 A1993/01/14 : Air Strikes against Iraq A1993/06/28: U.S. Raid on Baghdad

1995

A1996/09/04 : U.S. Raid on Iraq 1997 A1998/02/18: Clinton Makes Case for Strike Against Iraq 1999 A1998/12/17: Iraq Disarmament Crisis Escalation A1999/12/25 : Holidays' Terrorist Concerns 2001 2001/09/12 : 9/11 Terrorist Attacks A2001/10/08 : U.S. invades Afghanistan A2002/09/25: War Fears U.S. / Iraq 2003 A2003/03/19: Beginning of the A2004/03/23: Assassination of Sheik Yassin, Middle East Tensions 2005 A2004/08/03: Terrorist threats in New York and Washington A2005/07/08: London Bombings 7/7 A2006/08/11: Transatlantic Aircraft Plot 2007 A2007/05/01: War and Terrorism Concerns, Protests in Turkey

A2008/08/12: South Ossetian War Escalation 2009 A2009/12/29 : Flight 253 Failed Bombing Attempt

2011 A2011/05/03: U.S. Announces Death of Osama Bin Laden

2013 A2013/08/28 : Escalation of Syrian Crisis A2014/03/04: Russia invades Crimea A2014/09/02 : Escalation Ukraine/Russia 2015 A2015/11/17: Paris Terrorist Attacks A2016/07/16: Turkish Coup Attempt 2017 A2016/07/07: Middle East Concerns; Chilcot Report Released A2017/08/10: Escalation of Tensions Between U.S. and North Korea

0 200 400 600 800 1000 1200 Introduction Construction Understanding Effects Robustness Conclusions Appendix

Daily GPR Index Figure A.12: Newspapers’ front pages on days of heightened geopolitical risk

(a) January 7, 1991 (b) January 17, 1991

.

(c) September 12, 2001 (d) October 3, 2001

.

(e) August 10, 2017 (f) August 23, 2017

A.17 Introduction Construction Understanding Effects Robustness Conclusions Appendix

GPR and Natural Disasters

800 GPR Natural Disasters Index

600 Hurricane Katrina Hurricane

400 Tsunami Ocean Indian

California Wildfires California

Loma Prieta Earthquake Prieta Loma

Tohoku Earthquake Tohoku Northridge Earthquake Northridge

200 Indexes: 2000-2009 = 100 = 2000-2009 Indexes:

0 1985 1990 1995 2000 2005 2010 2015

GPR Index is not correlated with changes in media coverage of unpredictable newsworthy events. → No difference between objective geopolitical risks and media attention towards them Introduction Construction Understanding Effects Robustness Conclusions Appendix

GPR and Sport Events

600 GPR 500 Sport Events Index

400

300

200

100 Indexes: 2000-2009 = 100 = 2000-2009 Indexes:

0 1985 1990 1995 2000 2005 2010 2015

GPR Index is not correlated with changes in media coverage of predictable newsworthy events. Introduction Construction Understanding Effects Robustness Conclusions Appendix

GPR and Newspaper Slant

600 GPR Left-Leaning Newspapers 500 GPR Right-Leaning Newspapers

400

300

200

100 Indexes: 2000-2009 = 100 = 2000-2009 Indexes:

0 1985 1990 1995 2000 2005 2010 2015

GPR Index does not reflect newspaper political slant. Introduction Construction Understanding Effects Robustness Conclusions Appendix

GPR and ICB Database

400 GPRH ICB: Number of International Crisis 10 300 8

200 6

4 Count Crisis 100

2 Historical Index (2000-2009=100) Index Historical 0 0 1900 1920 1940 1960 1980 2000

GPR displays more high-frequency variation, allowing to establish the importance of GPR for stock returns over relatively short samples. Introduction Construction Understanding Effects Robustness Conclusions Appendix

GPR and War Deaths

600 7000 GPR 500 Total Deaths due to war and terror (right scale) 6000 Civilian Deaths due to terrorism, US & Europe (right scale) 5000 400 4000 300

3000 Deaths 200 2000

100 1000 GPR Index (2000-2009=100) Index GPR

0 0 1985 1990 1995 2000 2005 2010 2015 Introduction Construction Understanding Effects Robustness Conclusions Appendix

GPR and EPU GPR vs EPU EPU GPR Iraq 250 Debt Ceiling Debate Fiscal Cliff 600 invasion Govt. US bombs Euro Crisis Shutdown Libya Gulf War Lehman Failure 500 Kuwait Russia Madrid and TARP 200 Invasion 9/11 annexes bombings Crimea Bush Election Stimulus Debate 400 Ukraine Black Russian Crisis/LTCM Transatlantic and ISIS Monday aircraft plot Paris 150 Clinton Election 300 attacks London bombings 200 100 100

50 0 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

GPR vs VIX 2002 VIX correction GPR 90 Kuwait Asian 9/11 600 Invasion Financial Iraq Lehman Euro 80 Black Crisis LTCM invasion crisis Monday 500 70

60 400

50 300 40

30 200

20 100 10

0 0 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 GPR vs EPU EPU GPR Iraq 250 Debt Ceiling Debate Fiscal Cliff 600 invasion Govt. US bombs Euro Crisis Shutdown Libya Gulf War Lehman Failure 500 Kuwait Russia Madrid and TARP 200 Invasion 9/11 annexes bombings Crimea Bush Election Stimulus Debate 400 Ukraine Black Russian Crisis/LTCM Transatlantic and ISIS Monday aircraft plot Paris Introduction150 Construction Clinton ElectionUnderstanding Effects Robustness Conclusions Appendix 300 attacks London bombings 200 GPR100 and VIX 100

50 0 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

GPR vs VIX 2002 VIX correction GPR 90 Kuwait Asian 9/11 600 Invasion Financial Iraq Lehman Euro 80 Black Crisis LTCM invasion crisis Monday 500 70

60 400

50 300 40

30 200

20 100 10

0 0 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 Introduction Construction Understanding Effects Robustness Conclusions Appendix

EFFECTS OF HIGHER GPR Introduction Construction Understanding Effects Robustness Conclusions Appendix

Economic Effects of GPR

How could GPR matter?

1. Standard Uncertainty/Macro Channels.

2. Effects on Stock Returns.

3. Effects on Capital Flows. Uncertainty could reshuffle portfolios towards safe havens. Introduction Construction Understanding Effects Robustness Conclusions Appendix

Effects of Higher GPR: A VAR Analysis

Sample: 1985M1 to 2016M12. US benchmark VAR: 1. GPR Index; 2. Economic Policy Uncertainty (EPU); 3. Consumer sentiment; 4. US industrial production; 5. Private payroll employment; 6. US Imports + Exports; 7. Value-weighted S&P 500 Index; 8. Oil price; 9. Yield on 2-Year Treasury.

Extra variable: Industries Excess Return over S&P 500. Identification: GPR Index ordered 1st in Cholesky ordering. Shock sized to match typical increase in GPR after major events Introduction Construction Understanding Effects Robustness Conclusions Appendix

The Macroeconomic Impact of Increased GPR

GPR Index EPU Index Consumer Sentiment 30 10 150 20 5 100

10 (%) 50 0 0 0 -5 -10 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

Industrial Production Employment Gross Trade 0.5 2 0 0 0

-0.5

(%) (%) (%) -1 -0.5 -2 -1.5 -4 -2 -1 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

S&P500 Real Oil Price 2-Year Treas. Yield 5 5 40

0 20 -5

0 0

(%) (%)

-10 (BPS) -15 -20 -5 -20 -40 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24 Introduction Construction Understanding Effects Robustness Conclusions Appendix

Increased Geopolitical Risk and Stock Returns Cumulative Excess Return Over S&P 500 - Selected Industries

Defense Oil Aircraft 15 15 15

10 10 10

5 5 5

(%) (%) (%) 0 0 0

-5 -5 -5

-10 -10 -10 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

Steel Works Mining Insurance 15 15 15

10 10 10

5 5 5

(%) (%) (%) 0 0 0

-5 -5 -5

-10 -10 -10 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24 Introduction Construction Understanding Effects Robustness Conclusions Appendix

Effects of Higher GPR: Acts vs Threats

Modify VAR used to study effects of GPR on US economy.

Replace GPR with GPA and GPT.

Identification: GPA ordered 1st and GPT 2nd in Cholesky ordering.

I GPA shocks move GPT on impact.

I GPT shocks do not move GPA on impact.

GPA shocks convolution of shocks to first and higher moments of geopolitical events distribution.

GPT shocks primarily shocks to uncertainty and risk. Introduction Construction Understanding Effects Robustness Conclusions Appendix

The Impact of Increased GPR: Acts Selected Variables from US VAR

GPA (Acts) Index GPT (Threats) Index EPU Index 300 30

150 20

200 100 10 0 50 100 -10 0 -20 0 -50 -30 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

Industrial Production Gross Trade S&P500 5 6 1 4 0 2

0

(%) (%) (%) 0 -1 -2 -2 -4 -5 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24 Introduction Construction Understanding Effects Robustness Conclusions Appendix

The Impact of Increased GPR: Threats Selected Variables from US VAR

GPA (Acts) Index GPT (Threats) Index EPU Index 300 30

150 20

200 100 10 0 50 100 -10 0 -20 0 -50 -30 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

Industrial Production Gross Trade S&P500 5 6 1 4 0 2

0

(%) (%) (%) 0 -1 -2 -2 -4 -5 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24 Introduction Construction Understanding Effects Robustness Conclusions Appendix

The Impact of Increased GPR: Acts Cumulative Excess Return Over S&P 500

Defense Oil Aircraft 15 15 15

10 10 10

5 5 5

(%) (%) (%) 0 0 0

-5 -5 -5

-10 -10 -10 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

Steel Works Mining Insurance 15 15 15

10 10 10

5 5 5

(%) (%) (%) 0 0 0

-5 -5 -5

-10 -10 -10 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24 Introduction Construction Understanding Effects Robustness Conclusions Appendix

The Impact of Increased GPR: Threats Cumulative Excess Return Over S&P 500

Defense Oil Aircraft 15 15 15

10 10 10

5 5 5

(%) (%) (%) 0 0 0

-5 -5 -5

-10 -10 -10 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

Steel Works Mining Insurance 15 15 15

10 10 10

5 5 5

(%) (%) (%) 0 0 0

-5 -5 -5

-10 -10 -10 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24 Introduction Construction Understanding Effects Robustness Conclusions Appendix

International Effects of Higher GPR

Three models chosen depending on data availability and timing of effects. 1. International Macro Impact: VARs (dynamic effects):

I GPR Index; I EPU; I Country/Region ’X’ industrial production.

2. Stock Returns: Univariate regressions

ri,t = µi + αi GPRSHOCKt + εi,t ,

(monthly data from pre-WWII)

3. Capital Flows y: Panel regressions

yi,t = αi + ρ1yi,t−1 + βGPRt + ΓXt + ui,t , Introduction Construction Understanding Effects Robustness Conclusions Appendix

1. The International Impact of Increased GPR Industrial Production for Selected Countries and Regions

World Advanced Economies Emerging Economies 2 2 2

1 1 1

0 0 0

(%) (%) (%)

-1 -1 -1

-2 -2 -2

0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

Canada United Kingdom Mexico 2 2 2

1 1 1

0 0 0

(%) (%) (%)

-1 -1 -1

-2 -2 -2

0 6 12 18 24 0 6 12 18 24 0 6 12 18 24 Introduction Construction Understanding Effects Robustness Conclusions Appendix

2. Geopolitical Risk and Stock Returns

Table 2: GPR and World Stock Market Returns

Country GPR Historical GPR Benchmark (1) (2) (3) (4) GPR -0.45 -0.74 0.31 (0.27) (0.35) Crisis Index -0.16 -0.16 0.24 0.23 (0.15) (0.15) (0.34) (0.34) GPA -0.10 0.35 (0.30) (0.23) GPT -0.31 -0.99 (0.22) (0.36)

Note: Estimation of the effect of geopolitical risk on world stock market returns between 1919 and 2016. We standardize the GPR, GPA and GPT indexes so that the coefficient measures the percent change in stock returns to a 1 standard deviation innovation in a given index. The variable crisis is the total number of crises in a month, normalized by 2.41, the average number of active crisis in our sample. Standard errors reported in parentheses are corrected for autocorrelation using the Newey-West method. See Section 5.2 for additional details. Source: Global Financial Data and International Crisis Database.

32 Introduction Construction Understanding Effects Robustness Conclusions Appendix

2. Geopolitical Risk and Stock Returns: Countries

Table 3: GPR and Country Stock Market Returns

Country GPR Historical GPR Benchmark (1) (2) (3) (4) (5) Coefficient Std. Errors Sample Start Coefficient Std. Errors Australia -0.30 (0.22) 1900 -0.25 (0.30) -0.70 (0.31) 1900 -1.32 (0.42) Canada -0.62 (0.23) 1914 -0.64 (0.25) Finland -0.20 (0.36) 1923 -0.45 (0.58) -0.59 (0.33) 1900 -1.18 (0.53) -0.09 (0.62) 1918 -1.44 (0.64) India -0.49 (0.50) 1922 -0.67 (0.58) Italy -0.90 (0.38) 1905 -1.50 (0.55) Japan 0.07 (0.32) 1914 -0.34 (0.35) Netherlands -0.30 (0.37) 1919 -1.28 (0.50) Peru -0.59 (0.71) 1933 -1.05 (0.96) Portugal -0.27 (0.52) 1934 -0.95 (0.43) -0.27 (0.32) 1915 -0.83 (0.49) South Africa -0.84 (0.23) 1910 -1.33 (0.32) Sweden -0.40 (0.28) 1906 -0.83 (0.53) United Kingdom -0.56 (0.23) 1900 -0.96 (0.37) United States -0.43 (0.29) 1900 -0.78 (0.35)

Note: Estimation of the effect of geopolitical risk on individual countries’ stock market returns. We standardize the GPR index so that the coefficient measures the percent change in stock returns to a 1 standard deviation innovation in a given index. Column (3) reports the year in which the monthly data on stock returns are available for each country, while the sample ends in 2016 for all countries. Standard errors reported in parenthesis are corrected for autocorrelation using the Newey-West method. See Section 5.2 for additional details. Source: Global Financial Data.

33 Introduction Construction Understanding Effects Robustness Conclusions Appendix

3. Geopolitical Risk and Capital Flows

Table 4: GPR and Capital Flows

(1) (2) (3) Inflows/GDP Inflows/GDP Inflows/GDP Variables Emerging Economies Advanced Economies United States

Lagged Inflows 0.30 0.16 0.51 (0.06) (0.06) (0.08)

GPR Index, standardized -0.23 1.00 0.44 (0.12) (0.32) (0.36)

VIX, standardized -1.09 -1.54 -0.88 (0.18) (0.59) (0.37)

Lagged GDP Growth 0.29 1.61 0.01 (0.09) (0.36) (0.62)

Observations 1,932 2,305 119 R-squared 0.170 0.047 0.329 Number of countries 23 22 1 Country Fixed Effects YES YES — Clustered Standard Errors YES YES —

Note: Estimation of effects of geopolitical risk on gross capital inflows. We standardize both the GPR index and the VIX, so that the coefficients report the response of the ratio of inflows to gdp (in percentage points) to a 1 standard deviation innovation in GPR and the VIX. Robust standard errors reported in parenthesis. See Section 5.3 for additional details. Source: IMF’s Balance of Payments Statistics database.

34 Introduction Construction Understanding Effects Robustness Conclusions Appendix

ROBUSTNESS Introduction Construction Understanding Effects Robustness Conclusions Appendix

Robustness Analysis

Investigate the following modifications to the baseline VAR specification: 1. Censored GPR index: Keep only 9 largest peaks. 2. Dummy for 9/11. 3. Alternative Cholesky ordering

4. Replace EPU with the VIX.

Alternative specifications of GPR index: 1. Broader and narrower list of search terms; 2. Exclude articles mentioning economic consquences of GPR. Introduction Construction Understanding Effects Robustness Conclusions Appendix

Censoring + 9/11 Dummy

GPR Index EPU Index Consumer Sentiment 30 10 150 20 5 100

10 (%) 50 0 0 0 -5 -10 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

Industrial Production Employment Gross Trade 0.5 2 0 0 0

-0.5

(%) (%) (%) -1 -0.5 -2 -1.5 -4 -2 -1 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

S&P500 Real Oil Price 2-Year Treas. Yield 5 5 40

0 20 -5

0 0

(%) (%)

-10 (BPS) -15 -20 -5 -20 -40 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

Baseline 9/11 Dummy Censored GPR Introduction Construction Understanding Effects Robustness Conclusions Appendix

Ordering GPR Last

GPR Index EPU Index Consumer Sentiment 30 10 150 20 5

100 10 (%) 50 0 0 -10 0 -5 -20 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

Industrial Production Employment Gross Trade 0.5 1 2

0 0

0

(%) (%) (%) -2 -1 -0.5 -4 -2 -1 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

S&P500 Real Oil Price 2-Year Treas. Yield 10 5 40 0 5 20 -5

0 (%) (%) 0 -10 (BPS) -15 -20 -5 -20 -40 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24 Introduction Construction Understanding Effects Robustness Conclusions Appendix

Replacing EPU with the VIX

GPR Index VIX Consumer Sentiment 30 10 150 20 5 100

10 (%) 50 0 0 0 -5 -10 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

Industrial Production Employment Gross Trade 0.5 1 2

0 0

0

(%) (%) (%) -2 -1 -0.5 -4 -2 -1 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24

S&P500 Real Oil Price 2-Year Treas. Yield 5 40 5 0 20 -5

0 0

(%) (%)

-10 (BPS) -15 -20 -5 -20 -40 0 6 12 18 24 0 6 12 18 24 0 6 12 18 24 Introduction Construction Understanding Effects Robustness Conclusions Appendix

Conclusions

We construct a quantitative measure of geopolitical risk.

For many countries, the GPR index is perhaps more ”exogenous” to economic conditions than other uncertainty measures.

Geopolitical risk has adverse effects on real activity and stock returns in advanced economies.

The effect on US stock returns varies across industries.

Adverse effects of geopolitical risk are mostly driven by the threat of adverse geopolitical events.

We are currently working on constructing country-specific GPR indexes. Introduction Construction Understanding Effects Robustness Conclusions Appendix

Available Indices 1: Doomsday Clock Introduction Construction Understanding Effects Robustness Conclusions Appendix

Available Indices 2: Geopolitical Heat Maps

Back Introduction Construction Understanding Effects Robustness Conclusions Appendix

Most Frequent Words in Geopolitics Textbook

1200

1000

800

600

400

200

0

war unit

polit

state code

world terror

global

nation power

leader

countri

conflict

geopolit boundari

Back Introduction Construction Understanding Effects Robustness Conclusions Appendix

Content of Articles in Pilot Auditing

Scatter plot of the 4 principal components from analysis of the top 50 bigrams from 2,500 newspaper abstracts classified as E 1.

Back Introduction Construction Understanding Effects Robustness Conclusions Appendix

Frequent Unigrams in Flint’s Geopolitics Textbook

1200

1000

800

600

400

200

0

war unit

polit

state code

world terror

global

nation power

leader

countri

conflict

geopolit boundari

Back Introduction Construction Understanding Effects Robustness Conclusions Appendix

Increased Geopolitical Risk and Investment Nonresidential Investment and Consumer Durables

Estimation of quarterly VAR from 1985 to 2016.

GPR Shock GPA Shock GPT Shock 2 2 2

1 1 1

0 0 0

-1 -1 -1

(%) (%) (%) -2 -2 -2

-3 -3 -3

-4 -4 -4

-5 -5 -5 0 2 4 6 8 0 2 4 6 8 0 2 4 6 8 Quarters Quarters Quarters Introduction Construction Understanding Effects Robustness Conclusions Appendix

GPR Index for

GPR-CHINA 900

800

700 Tiananmen Sq. Massacre Sq. Tiananmen 600 Protests Sq. Tiananmen

500

400

300 Incident Island Hainan Missile Testing Missile

200 "9/11"

100

0 1985 1990 1995 2000 2005 2010 2015

“China AND (tensions/risk*/fear/chaos/uncertainty/unrest/violence...) AND (military/war/geopolitical/coup/guerrilla/warfare/army/terrorism)”, scaled by 1-year MA of newspaper articles mentioning China. Introduction Construction Understanding Effects Robustness Conclusions Appendix

GPR Index for Korea

GPR-KOREA 800

700

600 June Democracy Movement Democracy June

500

DPRK Nuclear Crisis Nuclear DPRK

Cyber Attack Cyber Tensions Border Escalated

400

Yeonpyeong Island Incident / G20 / Incident Island Yeonpyeong DPRK Nuclear Test Nuclear DPRK

300 858 Air Korea

Team Spirit Ultimatum Spirit Team

Naval Skirmish w/ DPRK w/ Skirmish Naval

Presidential Election Presidential

Inter-Korean Summit 2 Summit Inter-Korean

DPRK Incursion DPRK Border Fire w/ DPRK w/ Fire Border 200

100

0 1985 1990 1995 2000 2005 2010 2015

“Korea AND (tensions/risk*/fear/chaos/uncertainty/unrest/violence...) AND (military/war/geopolitical/coup/guerrilla/warfare/army/terrorism)”, scaled by 1-year MA of newspaper articles mentioning Korea. Introduction Construction Understanding Effects Robustness Conclusions Appendix

GPR Index for Ukraine

GPR-UKRAINE 1800

1600

Ukrainian Revolution Ukrainian Crisis Crimean

1400

1200 Independence of Declaration

1000 Independence Military Announce

800

600

Orange Revolution Orange

Political Crisis Political Crimean Referendum Crimean

400 Statement Trilateral Vrancea Eathquakes Vrancea

200

0 1985 1990 1995 2000 2005 2010 2015

“Ukraine AND (tensions/risk*/fear/chaos/uncertainty/unrest/violence...) AND (military/war/geopolitical/coup/guerrilla/warfare/army/terrorism)”, scaled by 1-year MA of newspaper articles mentioning Ukraine.