How do elections affect business behaviour?

Now that a long Federal election has been called, what impact will this have on business behaviour? The answer from economic researchers around the world is: quite a lot – particularly in closely-fought contests like the one we are expecting in Australia.

As I wrote in my column in Company Director last December (available here), election years have significant effects on business behaviour. The bad news is that those effects are negative – particularly on business investment.

Economists have studied the impacts of election years ever since Franklin Parsons, writing in the Journal of Farm Economics in 1934, showed that U.S. hog prices were decidedly lower in presidential election years. The impact of electoral uncertainty on business investment was first examined by a young Stanford academic in 1983. Many years later, that academic – Ben Bernanke – became Chairman of the U.S. Federal Reserve.

The evidence shows that, on average, investment is about 5% lower in an election year than in other years. Firms’ cash balances also rise, by roughly the same amount as investment falls. This is because elections generate uncertainty about policy change. Heightened uncertainty raises the value of taking options. By deferring investment go/no-go decisions, firms buy “wait-and-see” options: they gain the benefit of making investment decisions after the uncertainty is resolved post- election.

The actual impact on investment of a particular election depends on three factors: how predictable the election result is, whether the incumbent party is favoured to win and whether the likely winner is more “market friendly” than the likely loser.

Investment drops by most – almost 11% – when, the election result is least predictable (polls are neck-and-neck) – as they are in Australia’s Federal election right now. As business investment accounts for about 15% of GDP, a typical election year investment impact could slow GDP growth by 0.5% or more. Investment starts to tail off earlier if governments can call early elections (the election date is uncertain) than if they must run fixed terms.While this is bad news now, it may be a cause for optimism going forward: as election uncertainty may partly explain the significant decline in private business investment over the last year in Australia, we may well see a post-election investment (and GDP) boost once the election uncertainty is resolved,

Research shows that if the incumbent party is almost certain to win, investment hardly changes at all. If the incumbent party (regardless of political persuasion) is almost certain to lose, investment is cut moderately. This is because businesses know the policies of an incumbent government better than those of an opposition; therefore, the perceived risk of policy change increases when the polls favour the opposition. Investment deferral increases as election day draws near; it is less costly to defer investment when an election is only a matter of weeks away.

Electoral uncertainty also affects financial markets. Volatility in both equity and bond markets rises in the lead-up to elections, for largely the same reasons that investment falls. For example, volatility rises by more the less predictable is the result, the more likely it is that the incumbent party will lose and as election day draws closer. Once election uncertainty is resolved, investment bounces back (but only by about half the pre-election drop) and share market volatility drops.


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