Introduction
Financial crises teach a recurring lesson that markets have proven slow to internalize: the signals investors rely on to price risk may not only be imperfect but also systematically wrong, in predictable directions, and for extended periods of time. The European sovereign debt crisis of 2010–2012, the Asian financial crisis of 1997–1998, and the Mexican peso crisis before it followed a recognizable pattern.Footnote 1 Sudden reassessment of sovereign risk, rapid capital flight, and contagion that spread well beyond its original source followed a long period of apparent stability, during which capital flowed freely, yields converged, and external assessments of creditworthiness remained favorable. In the European case, investors who had poured money into Greek and Italian sovereign debt for years on the strength of favorable ratings and the implicit legitimacy of eurozone membership were caught flat-footed because the signals they relied upon had systematically understated the accumulating risk.Footnote 2 When Greece’s true fiscal position was disclosed, capital fled not only Greece but the neighborhood. Portugal and Spain faced crisis conditions driven by contagion from a signal failure they had not caused.Footnote 3
The response to the 2008–2010 financial crisis included sustained scrutiny of the credit rating industry. Regulators and scholars documented how ratings agencies had failed in predictable ways: they were slow to downgrade deteriorating credits, quick to upgrade recovering ones, and susceptible to optimistic assessments of newly developing markets that reflected the preferences of issuers and investors rather than underlying institutional reality.Footnote 4 The Dodd-Frank Act,Footnote 5 the European Securities and Markets Authority’s oversight regime,Footnote 6 and parallel reforms in other jurisdictions all reflected a common diagnosis—that ratings were not merely noisy, but asymmetrically distorted, underweighting risks during periods of growth, and overweighting recovery signals during periods of adjustment. The reform project rests on a simple premise that a signal that effectively allocates trillions of dollars of capital should be held to standards of accuracy and symmetry that the pre-crisis regime failed to meet.
This essay argues that we need to apply the same diagnostic lens and reform ambition to political risk measurement. The indices that investors, firms, lawyers, and policymakers rely upon to assess the rule of law in a given country exhibit a structural pathology similar to the one credit ratings displayed before 2008. They lag behind and understate deterioration and prematurely record and overstate recovery, embedding optimism in both directions that the underlying institutional reality does not support. The result is a familiar pattern of misallocation: capital that should adjust its risk pricing instead remains in place during long periods of index-certified institutional stability, even as the actual institutional environment erodes. When corrections come, they can be abrupt and contagious. And before they come, capital that fails to leave or arrives prematurely does not sit neutrally but sustains the regime whose institutional deterioration the indices have failed to register.
Each distortion in the political risk information environment produces a characteristic pattern of capital misallocation: dormancy where flight would be warranted, or premature entry where caution would be appropriate. This essay documents these distortions, traces their consequences for firms and investors, and argues for a reform agenda modeled on the post-2008 reform of credit ratings.
The Asymmetry
The root of the asymmetry problem is institutional: it is much easier and faster to undermine the rule of law than it is to (re)build it.Footnote 7 Institutional destruction can be carried out through a concentrated sequence of legal changes—constitutional amendments, court-packing, executive norm violations, and legislative capture—that fundamentally reshape the institutional landscape within a few years.Footnote 8 Restoration, by contrast, is bound by the legality it seeks to restore. Reformers must work through a judiciary the prior regime staffed (and perhaps packed), rebuild legal culture and administrative capacity in a politicized bureaucracy, and sustain reform coalitions across electoral cycles.Footnote 9 The deeper the capture, the greater the asymmetry. Decline and recovery are not mirror images of each other but operate on different timescales and face different obstacles.
This asymmetry in the underlying process has direct consequences for measurement. Indices such as the World Justice Project’s Rule of Law Index, the World Bank’s Worldwide Governance Indicators, the Varieties of Democracy Rule of Law Index, the Bertelsmann Transformation Index, and Freedom House’s rule of law index are composite annual scores (collectively “rule of law indices”). They rest overwhelmingly on subjective inputs: expert coders working from a limited set of standard sources, and perception surveys of citizens and foreign investors, sometimes bundled with other indices’ scores.Footnote 10 Whether such measures should track inputs—formal institutions and rules—or outcomes—whether contracts are enforcedFootnote 11 and governments lose casesFootnote 12 —is itself contested. Existing indices lean toward inputs and perceptions of them. That choice drives the asymmetry: input scores lag on the way down, as damage to a few inputs is averaged away, and lead on the way up, as new inputs are counted before they yield outcomes.
Indices also average dozens of dimensions of the rule of law into a single number.Footnote 13 Expert coders may anchor on last year’s score and on the visible, legible harms that make news. And investor surveys report a business climate that reflects investors’ own accommodation, not the institutions they have learned to route around.Footnote 14 The result is a systematic lag in the detection of decline and a systematic inflation of apparent recovery.
Deterioration Is Undercounted and Delayed
Among democratic countries with developed economies, Hungary provides a clear illustration of the lag problem. The transformative dismantling of Hungary’s institutional guarantees of the rule of law was essentially complete within the first few years of Viktor Orbán’s second administration. By the early 2010s, the constitution had been replaced, the constitutional court had been weakened, the judiciary packed, the media landscape captured, and the electoral rules rewritten.Footnote 15 Yet, as lagging and averaging predict, rule of law indices depicting Hungary’s institutional trajectory showed a continuous, gradual decline over that decade.Footnote 16 The index signal was detached from the actual institutional trajectory in two respects: it failed to register the concentrated early damage, and it continued registering decline long after the destruction was essentially complete, tracking instead the slower consolidation of political and economic capture that followed.
Hungary’s continued deep economic integration illustrates the dormancy dynamic. While rule of law indices started declining in 2010—depicting a country still in manageable institutional decline—economic ties remained extensive. EU Structural and Cohesion Funds disbursed to Hungary from 2004 to 2023 may have mobilized up to €150 billion in private co-investment;Footnote 17 intra-EU trade accounted for 78 percent of Hungary’s exports by 2020;Footnote 18 and major foreign investors, including Audi and Mercedes-Benz, committed billions to Hungarian manufacturing facilities well into the period of consolidation of the Orbán regime.Footnote 19 This was not irrational; it reflected the signals available to investors, including favorable country risk ratings and the implicit legitimacy halo of EU membership.Footnote 20 Those signals operated within a broader political risk information environment that portrayed Hungary’s deterioration as moderate and gradual rather than concentrated and transformative. Rule of law indices reinforced that environment.
Because they rely on expert perceptions, rule of law indices may react more readily to legible, visible harms than to diffuse institutional change. Commercial country risk ratings may inherit a similar bias toward legible, visible harm. Investors may remain inattentive to deteriorating country risk until it materializes in an asset price shock. The credit rating literature has documented this procyclicality since the Asian crisis,Footnote 21 but the political risk literature has yet to reckon with the same dynamic.
Development and Recovery Are Celebrated Prematurely and Overstated
When the rule of law improves as part of a recognized development or democratization process, indices respond quickly and loudly. Donors, development agencies, and the index producers themselves are eager to certify institutional progress—and the efficacy of their own assistanceFootnote 22 —and that eagerness often outpaces the reality of what has been built. Indices overstate positive trends, registering the formal existence of courts, constitutions, and legislation without capturing whether they are supported by legal culture, institutional infrastructure, trained legal professionals, or the legal consciousness necessary to sustain them.
The history of post-conflict and post-transition state-building shows how swiftly apparent success stories can unravel. Indices may respond to the construction of formal institutions even when those institutions remain fragile. Iraq is a familiar example: institutions were built, scores increased, optimistic assessments circulated, and then the underlying institutions did not hold.Footnote 23
If Hungary illustrates the lag in detecting decline among democratic countries with developed economies, Poland illustrates the opposite distortion: the rapid, premature inflation of apparent recovery. When the Law and Justice party (PiS) lost its parliamentary majority in the 2023 elections, indices fairly quickly restored their scores for Poland to levels close to those recorded before PiS’s institutional takeover began in 2015.Footnote 24 In reality, PiS-appointed judges across the judiciary—including, critically, in the constitutional tribunal—remained in placeFootnote 25 and continued to block reform efforts. The PiS-aligned president exercised veto power over legislation, paralyzing the Tusk government’s reform agenda even after it won its parliamentary majority.Footnote 26 Restoring the rule of law has proven to be a prolonged, contested, and structurally complicated project. Yet indices had already declared, in effect, that recovery was largely complete.
As Poland’s example shows, indices reflect not only institutional inputs but also the evaluative frameworks and expectations of their producers and expert respondents. The measurement community and its principal users such as donors and investors may have institutional incentives to recognize progress quickly. When a government seen as the problem loses an election and a reform-oriented successor takes office, an index may register hope as much as institutional repair. The result is a systematic overstatement of the speed and completeness of institutional recovery. This is the political risk equivalent of a ratings upgrade following a change of management at a distressed firm, where the signal responds to the narrative of improvement, not to the structural resolution of the underlying problem.
After more than fifteen years of consolidated Orbán rule, Hungary now offers a real-time test of the recovery bias. The regime’s capture of state resources and the economy and pervasive autocratic legalismFootnote 27 run deeper than PiS achieved during eight years in power in Poland. The April 2026 TISZA landslide and the peaceful transfer of powerFootnote 28 will, if the Polish pattern holds, lead rule of law indices to record a rapid recovery that outpaces institutional reality. Yet the Orbán regime’s entrenchment across the economy, judiciary, independent agencies, and civil service will outlast the electoral transition. The recovery-bias distortion runs in both directions: while new entrants may be pulled in prematurely, co-opted incumbents now face succession exposure that indices did not register and special deals cannot shield them from.
Implications
The asymmetry has direct implications for how cross-border transactions should be structured. When indices overstate recovery, firms and their advisors relying on those signals may underestimate the residual institutional risk and forgo protective deal structures that remain warranted: international arbitration provisions, structuring to secure bilateral investment treaty coverage, tighter material adverse change provisions, or payment-timing adjustments. Conversely, when indices lag deterioration, firms may structure transactions on the assumption that standard contract protections are adequate, not yet knowing that the judicial environment in which those protections would be enforced has already been captured. Prudent transaction structuring requires looking past the index score to the underlying institutional trajectory.
Distorted signals also shape firms’ broader adaptive strategies. Firms relying on lagged index signals to time adaptive responses—negotiating bilateral certainty with a government, seeking case-by-case regulatory exemptions, or pursuing direct executive access as a substitute for stable legal frameworks—may do so either too late or too confidently, depending on the direction of the distortion. Firms making adaptation decisions on the basis of inflated recovery signals, in particular, may miscalculate the time horizon of their exposure and absorb reputational damage from visible accommodation of governments whose institutional deterioration runs deeper than the index suggests.
Finally, firms’ shift to international enforcement can reveal deterioration that composite indices miss. When domestic courts lose independence and contract enforcement becomes unreliable, investor-state dispute settlement provides a partial substituteFootnote 29 —an alternative channel through which foreign investors can seek protection outside the domestic judicial system. To the extent that this substitution works, it suppresses the visible economic costs of institutional failure: firms remain, trade continues, and the perception-based components of composite indices may remain stable even as domestic enforcement deteriorates.Footnote 30 A country whose domestic rule of law score holds steady while its international arbitration exposure rises may be one in which investors are increasingly routing enforcement elsewhere. The divergence between index scores and the international treaty-breach record is, in this sense, structurally analogous to the divergence between a sovereign credit rating and credit-default-swap spreads: an alternative signal is registering risk that existing indices do not incorporate.Footnote 31
The post-2008 reform of credit rating oversight did not abolish ratings but demanded greater transparency, methodological accountability, and competition among producers. Rule of law and political risk measurement should follow suit by supplementing composite scores with event-level data, disclosing methods for independent validation, and acknowledging directional bias.
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