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An economic argument behind the Coalition Government's 2004 Federal Election victory.

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Written by Mr Chris Mouratidis [B.Ec(Hons)/B.A]


16th of November, 2004.

1.      Introduction.


            An economic argument can be put to partly describe at the very least, why the Coalition Government[1] commandingly won the 2004 Australian federal election. Predictably, the economic argument surrounds interest rates.  In particular, the majority of the voting public’s expectation of future interest rate rises coupled with a seemingly risk averse[2] voting tendency, were some of the key driving forces behind the government’s successful economic-based campaign. Recently, a prominent columnist from Melbourne’s Herald-Sun, Mr Andrew Bolt, accurately typified this perception:


‘….Howard’s interest-scare worked so well. Howard seemed to be the safe choice precisely because Latham did not. And probably never will….’[3]


Therefore, there may be evidence to suggest the Australian voters who cast their ballots for the incumbent government on the 9th of October, 2004, did so to minimise the risk they were prepared to bear. The risk I am referring to relates to the adverse effects on consumer demand from possible future interest rate rises. Economists often refer to this type of behaviour as a form of ‘rational expectations’[4], where people maximise the use of all available information in order to forecast future trends. It seems that the incumbent federal government convinced enough voters of its economic track record, providing the voters who agreed with them enough confidence to believe future interest rate rises would not be further influenced by relatively unnecessary and adverse government policies; (for example policies that may be inflationary). Whilst the incumbent government maintained the argument that governments can influence interest rates, the opposition argued that governments did not control interest rates. This article aims to put a simple economic argument behind the reasons why some voters may have decided to vote on the basis of interest rates. To enable the explanation, it is important that I explain the basic theoretical role of interest rates in an economy and the reasons why the Reserve Bank of Australia may decide to change interest rates in the future. Then I will explore the role of government budget deficits in influencing upward movements in interest rates. From there, I will examine the roles of risk aversion and the housing boom; both attempting to illustrate consumer behaviour relative to interest rates.


2.      Basic Economic Theory of Interest Rates.


            By using some simple economic theories, we will be able to explain the basic role of interest rates in an economy. Consider two types of agents in an economy, households and firms. One can think of interest rates as the cost of holding money. Households have a choice to make between holding more money in bonds (by saving/investing) and holding more money in their pockets. Firms have a choice between investing at a given level of interest or not. The cost of holding or not holding more money, interest rates, determines whether households/firms considering these options opt for one or the other. Generally when interest rates are low, households may be more likely to hold more money in their pockets, while when interest rates are high, households may be more likely to hold more money in bonds.[5] The reason why households may behave like this relates to the relative returns to saving. If interest rates are high, households yield a greater return from allocating more money into savings than if interest rates were lower. Firms on the other hand may be more likely to invest more when interest rates are lower, since the cost of borrowing is lower in order to finance their investments (and vice-versa for when rates are higher). The interaction between households and firms occurs whereby household’s savings are used by their relevant financial institutions to loan out to firms wishing to finance their investments. If firms’ demand for loans to invest is greater than the supply of loanable funds which come predominantly from household savings, then interest rates will have a general tendency to rise. Hence, lowering interest rates is a good way for central banks[6] to stimulate household consumption demand in an economy suffering from a downturn because consumers will want to save less and hold more money in their pockets, increasing their consumption at that level of interest. Increased consumption increases economic activity that leads to increased output, employment and further multiplier-like effects. It is only when household savings are in disequilibrium relative to firm demand for loans at a given level of interest, which leads to upward or downward pressure on interest rates.[7]


3.      Macfarlane’s Rule?


            For the Reserve Bank of Australia, determining whether interest rates should increase or decrease relative to the economic conditions of the day is a complex and difficult judgement to make. There are so many factors at play that influence interest rates such as inflation and the potential for greater levels of inflation, household savings and debt levels, wages growth, and productivity growth; just to name a few. A macroeconomics lecturer, Prof John King from La Trobe University, Bundoora, Australia, recently illustrated in an honours year class what the Reserve Bank may be using as a guide to factors that may partially influence changes in interest rates. It was named Macfarlane’s Rule, which was supposedly discovered by the current Governor of the Reserve Bank, Mr Ian Macfarlane. Equation 1 illustrates the rule:


                                                P = W - A                                                             (1)[8]


{Where: P - Rate of price inflation;

       W - Rate of nominal wage inflation;    

       A - Rate of average labour growth.}        


Equation one demonstrates the following condition: if the rate of price inflation is greater than the difference between nominal wage inflation and average labour growth, then the Central Bank should increase interest rates to stem any inflationary pressures on the economy. On the other hand, if the rate of price inflation is less than or equal to the difference between nominal wage inflation and average labour growth, then interest rates should not be increased because unnecessary downward pressure on economic activity will probably result from a higher rate of interest, where households will be more inclined to save and firms will be less inclined to undertake new investments. The threshold level between increasing and not increasing interest rates is roughly two to three precent of the Consumer Price Index (CPI).[9] When the calculated CPI exceeds the threshold level, the rate of price inflation is almost always greater than the difference between nominal wage growth and average labour growth. Therefore, the rule requires the Reserve Bank to observe the regularly calculated CPI, in order to ascertain whether interest rates should increase to negate any inflationary dangers to the economy.


4.      The Influence of Budget Deficits.


            The coalition successfully sold itself as the government of budget surpluses in the 2004 federal election; but whether knowingly or not, it accurately depicted the adverse influence budget deficits can have on interest rates. Basic Keynesian theory dictates that governments should run budget deficits when an economy is in recession to stimulate economic activity in order for recovery. Therefore, the following critique of the adverse effects of budget deficits should not be seen as my attempt to denounce their role, but to explain why their role should be non-existent when an economy is going through a boom.


 Governments run budget deficits when government expenditure exceeds government revenue, with the debt usually being financed by borrowings rather than by raising taxes. When budget deficits are financed by borrowings, national savings decrease. Therefore, when savings decrease relative to an unchanged level of firm desire for loanable funds (investment), interest rates have a general tendency to increase because the supply of loanable funds (savings) has dropped relative to the demand of loanable funds (investment). Following basic supply and demand theory, when the supply of a commodity becomes scarcer at a given level of demand, the price of that commodity will increase. The commodity in our context is loanable funds. The supply of loanable funds comes from savings collected from households/government, and the demand for loanable funds comes from firm’s desire to invest. Therefore, a budget deficit causes interest rates to increase when the government debt is financed by borrowings. Many economists call this the ‘crowding out effect’, where an increase in government expenditure causes interest rates to increase and firm investment to fall.[10] This effect is negatively viewed by some economists, preferring to encourage firm investment instead.[11] Others view the role of budget deficits as necessary only in times of recession as the benefits of increased consumption demand[12] negates the ‘crowding-out effect’ on firm investments. Furthermore, advocates of budget deficits during recessions would stress that in the long-run, governments should aim to balance or have a surplus budget while running short-run budget deficits where necessary in a recession, to stimulate economic activity, provided that the increased government expenditures are targeted towards increasing consumption for recovery.[13]


            In the context of the 2004 federal election, the coalition was successful in convincing enough voters (notably the business community) that they would not run a budget deficit during prosperous times. For the business community this meant that interest rates would stay low, enabling them to make further investments in an environment of low borrowing rates, leading to an increase in employment and production. We cannot be sure whether voters realised this explicitly at all. However what became obvious from the coalition campaign was the television advertisements questioning the economic credentials of the opposition leader, Mr Mark Latham. In particular, the advertisements focused on his time as mayor of the Liverpool Council, in New South Wales, Australia. The advertisements highlighted the massive budget deficits that occurred under his leadership, as demonstrated on the advertisement by a council report that effectively denounced his fiscal management ability. The propaganda worked effectively in providing voters with a clear choice between a government that has the record to prove its ability to run budget surpluses during prosperous times, against an alternative leader with a troubled past in fiscal management. The business community and probably a substantial amount of voters realised that under a coalition government, the chances of budget deficits being run during prosperous times were less likely than under the alternative, a Latham-led Labor opposition. By voting for the Coalition, many voters reassured themselves that they took the least amount of risk, which ensured budget surpluses, leading to less pressure on interest rates and hence mortgage repayments.


5.      Risk Aversion and the Housing Boom.


            The recent Australian housing boom has explicitly illustrated how risk aversion can have another role to play, in relation to defining behaviour relative to interest rates. Investments into housing construction increased substantially due to relatively low interest rates and the Australian government’s first home owner’s grant. The first home owners grant seems to have targeted younger adults who were ready to buy their own home from which to live in or use as an investment property. Moreover, the grant seems to have specifically targeted those at the fringe; those who are unsure of whether they could afford such a large investment or not. The grant therefore provided the incentive for those at the fringe to undertake the large investment whereby these ‘fringe individuals’ are more likely to be young adults and therefore are earning just a fraction of a higher average income they will probably earn later in their working life cycle. The interest rate campaign run by the coalition, with the fear of budget deficits, led to incentives for the voters who undertook the first home owners grant to vote for the incumbent government, on the probability that interest rates would not increase since the chances of budget deficits during a boom were slim if the coalition in power, based on their last eight year record. The ‘fringe individual’ voters were concerned with the effect increases in interest rates would have on their disposable income, which dictates their capacity to spend and their ability to meet mortgage repayments. The fear of default on repayments from excessive interest rate rises was the driving factor, a fear that led many to vote on the basis of minimal risk.


The impact of loan defaults can be devastating especially if the economy suffers a recession. For instance, assume income is distributed unequally in an industrialised economy. Then according to Iyigun and Owen’s (2004) paper[14], if certain conditions hold, consumption will become more volatile leading to more volatile growth if and only if a high proportion of low and middle income earners cannot access credit (loans) during an economic downturn. I studied this relationship more closely in my honours thesis which studied the possibility of a relationship between income inequality and macroeconomic volatility. My empirical analysis found results that were consistent with the theory Iyigun and Owen detail in their paper, in particular the effects of more volatile consumption due to credit defaults and unavailability.[15] In the context of the 2004 Australian election, it is possible that the ‘fringe individuals’ undertaking an investment in residential property could represent the individuals from the theoretical model, who would drastically drop their consumption in light of a downturn due to increased mortgage repayments and/or defaulting. Therefore, if enough individuals in the Australian economy cannot meet or surpass the threshold level of income[16] required by financial institutions to grant credit during downturns, then aggregate consumption becomes more volatile resulting in increased growth volatility. If this holds true, the results from the 2004 federal election followed a risk averse voter reaction to uncertain times ahead. The fringe individuals understood that the consequences of volatile economic conditions could be disastrous for their investments. While it is not anticipated that fringe individuals would recognise the possible effects of the theoretical process espoused on the economy, they certainly have the ability to recognise the effects a change in interest rates could have on their own economic welfare. If interest rates increased high enough in order to lower the amount of income ‘fringe individuals’ could consume with due to higher mortgage repayments and/or increase the incidence of loan defaults, then the consequential effects on fringe individual consumer behaviour would be to drastically decrease their consumption, leading to decreases in growth. If the proportion of fringe individuals in the Australian economy is high enough according to Iyigun and Owen’s (2004) model, then aggregate consumption volatility increases, increasing aggregate growth volatility. Interest rate rises have the potential to set off this chain reaction. What we cannot be sure of is whether this will happen in the real world because unlike the traditional sciences, economists cannot conduct perfectly controlled experiments where certain strict results can be obtained. What economists often are able to rely on at best is past historical data and correct mathematical derivations that hold true given the assumptions that are made.


6.      Conclusion


For our purposes, the threat and possibility of possible tumultuous economic times ahead linked to an expected increase in interest rates scared fringe individuals as well as other Australian voters in the recent federal election. Voters made a decision based on the available information before them, taking the least risky option to minimise the possible effects of high interest rate rises. The minimal risk option appeared to be the incumbent government based on their economic record. Voters seemed to have countered the uncertainty of tomorrow by choosing a proven economic record against an untested, alternative option where questions were in the air over its leader’s past positions and questionable capacity to manage a economy, however big (Australia) or small (Liverpool Council) that economy may be. The Coalition may have won the 2004 election on the back of interest rates and its capacity to convince voters that it can minimise the effects government policies may have on interest rates. What the opposition failed to convince voters of was its own capacity to manage the eight hundred billion dollar economy, but more importantly, the important weaknesses of the coalition’s eight years of economic management. The Australian economy currently suffers from a huge current account deficit problem, six percent of Gross Domestic Product.[17] This simply means more money is leaving our shores than is coming in. Inflation in the non-traded sector[18] is at four percent and private debt is at alarmingly high levels.[19] The coalition won by convincing voters of its strengths of economic management, but the opposition lost on the back of its own reputation and its inability to expose the weaknesses of the coalition’s economic credentials. Voters reacted in a risk averse manner, acting on the information before them, trying to insure themselves from the risks or more rightly, any possible gloomy economic conditions ahead.

[1] By this we mean the Liberal/National Party Coalition, which has retained federal government in Australia since 1996.

[2] By this we mean individuals who are ‘risk averse’ prefer obtaining certainty over facing a gamble. [See Hal.R Varian, Intermediate Microeconomics. A Modern Approach., W.W. Norton & Company. U.S.A., 2003, pp. 225 & 226.] Therefore, one may easily claim that the majority of the Australian population who voted for the coalition, partly did so on the basis of preferring the certainty that the Coalition provided from their economic track record, over the gamble of an un-tested, relatively unknown Latham-led ALP alternative government.

[3] Andrew Bolt, ‘ALP’s eternal loser’, Herald-Sun., Wednesday, October 27, 2004., Melbourne, Australia, p.19.

[4] N. Gregory Mankiw, Macroeconomics. Fourth Edition., Worth Publishers, U.S.A., 2000, P.372.

[5] Notice how I often refer to ‘more likely’, because individuals often differ in an economy on preferences, the level of risk they are prepared to bear etc. Also, some individuals may be prepared to hold money in bonds when interest rates are low because they will still earn interest as opposed to holding it in their pockets.

[6] By this we mean an independent body responsible for monetary policy in a country. For example, the Reserve Bank of Australia.

[7] Mankiw, op.cit, p.61.

[8] Prof. John King, Macroeconomics 4 (ECO41MAE), Lecture Notes Week 6, La Trobe University, Bundoora, Victoria, 07/04/04.

[9] The Consumer Price Index can be used as a means to calculating the rate of price inflation.

[10] Mankiw, op.cit, p.62.

[11] I will not attempt to resolve the debate over the ‘crowding-out effect’ in this article.

[12] …that result from increased government expenditure targeted towards increasing the consumption of the majority of the population.

[13] Joseph Stiglitz, The Roaring Nineties. Why We’re Paying the Price for the Greediest Decade in History  Penguin Books, London, England, 2003, p.270.

[14] M.F Iyigun & A.L Owen, ‘Income Inequality, Financial Development and Macroeconomic Fluctuations’, in The Economic Journal, vol.114, no.453, Blackwell Publishing, Oxford, U.K, 2004.

[15] Chris Mouratidis, Is There An Economically Significant Relationship between Income Inequality and Macroeconomic Volatility? A Theoretical and Empirical Analysis, with Reference to Policy Implications., Economics Honours Thesis, La Trobe University, Bundoora, Victoria, Australia, October 2004.

[16] The threshold level of income was identified by the literature review of Chris Mouratidis’ 2004 honours thesis of Iyigun and Owen’s 2004 journal paper as being the level of income where any individuals with an annual income greater than or equal to that threshold level will be granted access to credit during downturns. See Mouratidis’ literature review (2004) or Iyigun and Owen’s journal paper (2004).

[17] Nicholas Gruen, ‘Political Style Over Economic Substance’, Ceteris Paribus, Economic Society of Australia, Victoria, Australia, November 2004, p.1.

[18] By ‘non-traded sector’ I mean goods that are not sold internationally, rather only sold domestically.

[19] ibid.

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