Academic journal article Journal of Business and Behavior Sciences

Government Shutdown: A Test of Market Efficiency

Academic journal article Journal of Business and Behavior Sciences

Government Shutdown: A Test of Market Efficiency

Article excerpt

INTRODUCTION

If Washington policy makers cause a government shutdown, this research shows the consequences of the failure of the decision making process and offers important implications for future decision makers. The enormous costs associated with gridlock ought to be measured and weighed in the decision making process. One way to quantify the economy's reaction to a government shutdown is to examine how the stock market reacts.

Tests for market efficiency can show the effect of a government shutdown on the stock market. There are three types of market efficiency: weak-form efficiency, semi-strong-form efficiency and strong-form efficiency. These various levels of efficiency have different implications for the market's reaction to an event such as a Federal Government shutdown. According to weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned by using investment strategies based on historical share prices or other historical data. Semi-strong-form efficiency is characterized by share prices adjusting quickly to publicly available information. The market will respond quickly and will be unbiased so that no excess returns can be earned by trading on information in the form of public announcements such as a government shutdown. With strong-form efficiency, stock prices reflect all information, public and private, and no one can earn excess returns by acting on inside information.

The purpose of this event study is to test market efficiency theory by analyzing the impact of the government shutdowns of 1995/1996 and 2013 on two samples of 50 firms each. This research tests whether the information embedded in a government shutdown announcement exhibits weak or semi-strong market efficiency. This study tests the effects of the government shutdowns on the risk adjusted returns of 100 government contracting firms using the standard risk adjusted event study methodology in the finance literature. It is reasonable to expect government contracting firm to be highly sensitive to a potential federal government shutdown since the revenue of these firms depends on a government that is open for business. If a strong and swift correlation exists between the event date or the date of the government shutdown and an immediate equity market price change, there may not be opportunity to earn an above normal return and evidence would support efficient market theory.

LITERATURE REVIEW

Stock prices react so fast to public information that no investor can earn an above normal return by acting on any public announcements, such as the US government shutdown; one in 1995 and one in 2013. The US government entered a shutdown October 1, 2013 through October 16, 2013, the second longest since 1980 and the most significant measured in terms of employee furlough days (.Impacts and Costs, 2013). This shutdown most operations of the government after Congress failed to reach an agreement on the U.S. Federal budget for the 2014 fiscal year and President Obama's healthcare bill; this was the first government shutdown in 17 years. During the shutdown, approximately 800,000 federal employees were furloughed (Hankel, 2013), for a combined total of 6.6 million days (.Impacts and Costs, 2013). What happened to the companies that relied on government contracts? Was there an impact to their stock prices?

The budget wars in 1995 resulted in the government shutting down for six days, November 14-19, and again from December 15, 1995-January 6, 1996 (Kosar, 2004). A dispute between President Bill Clinton and Speaker of the House Newt Gingrich caused the shutdown. They could not agree on domestic spending cuts in the fiscal year 1996 (Drew, 1996). Did both of these shutdowns in 1995/96 and 2013 have a similar impact on the stock market? How fast did the market react to both shutdowns? Is the market efficient with respect to a government shutdown? Answers to these questions offer significant implications for policy makers in Washington as they weigh the economic costs associated with gridlock and failure to compromise on a budget deal to keep the government open. …

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