1 Australian Economic Review Forthcoming

21/10/2016

“We will end up being a third rate economy …a banana republic”: How behavioural economics can improve macroeconomic outcomes

Ian M McDonald

University of

Abstract

To address the economic problems facing in 1986 required wage restraint which required in turn overcoming loss aversion by workers with respect to their wages. The Prices and Incomes Accord was able to do this. Attempts to address Australia’s current economic problems are stymied by tax resistance. Addressing tax resistance requires overcoming loss aversion by voters with respect to their post-tax incomes. The success of the Accord suggests that Accord-type policies could reduce tax resistance by broadening people’s perspective beyond their post-tax incomes to the broader spread of benefits for them and others.

Short abstract

The Prices and Incomes Accord overcame loss aversion and delivered wage restraint. Can Accord-like policies overcome loss aversion and deliver the increases in taxation that will address Australia’s current economic challenges?

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“We will end up being a third rate economy …a banana republic”: How behavioural economics can improve macroeconomic outcomes

1 Ian M McDonald

University of Melbourne

30 years ago, faced with a large fall in the terms of trade occurring in a situation of high unemployment, high inflation, a high government budget deficit and a high current account deficit, , the Treasurer of Australia, warned the public that Australia faced the prospect of becoming a banana republic.2

Keating's iconic statement arose in the context of an elaborate economic program, called The Prices and Incomes Accord, aimed at improving Australia's economic performance. Keating was one member of the team that led this program, which included , Prime Minister, Bill Kelty, Secretary of the Australian Council of Trade Unions (ACTU), Peter Walsh, Minister for Finance, and , President of the ACTU.

In this paper, I discuss the economic and institutional context of Paul Keating's banana republic comment, interpret its impact and draw implications for some of the major economic problems that face Australia today. My analysis draws on behavioural economics, especially prospect theory and its component concept of loss aversion, due to Kahneman and Tversky (1979), and also the concept of "narrative" as discussed by Akerlof and Snower (2016).

The context

Figure 1 Terms of trade, Australia, March 1959 to March 1986 85 80 75 70 65 60 55 50

As shown in Figure 1, Keating’s banana republic comment followed a dramatic drop in the

1 This paper is based on an invited lecture given at the Australian Conference of Economists, Adelaide, 2016, in a plenary session to commemorate the 30th anniversary of Paul Keating's banana republic comment. I thank John Freebairn and Joe Isaac for discussion and comments. 2 “If this Government cannot get the adjustment, get manufacturing going again, and keep moderate wage outcomes and a sensible economic policy, then Australia is basically done for. We will end up being a third rate economy... a banana republic”, Paul Keating speaking to John Laws on Radio 2GB, 14 May, 1986 (as reported on Wikiquote, accessed 11/8/2016).

3 terms of trade to a historically low level. As shown in Figures 3 to 7, this was in a situation where, in March 1986, unemployment was high, the wage share, having fallen from its peak during the 1982 wage explosion, remained high-ish 3, inflation of the consumer price index (CPI) was high, having bounced back from low rates in the 1983 recession, the government budget deficit was high and the current account deficit was high.

The nightmare

A decrease in the terms of trade leads to a reduction in the gross domestic product (GDP) deflator relative to the CPI. The average price of what we produce decreases relative to the average price of what we consume. This causes a shift downwards in the labour demand curve, drawing the curve with real wages measured in consumer purchasing power. In these circumstances, real wage resistance, that is a resistance to a reduction in the real wage as measured by consumer purchasing power, could lead to increased unemployment, increased inflation, an increased government budget deficit, and an increased current account deficit.

Figure 2 The historic association between unemployment and the terms of trade 20 18

16 y = -0.4761x + 35.313 14 12 rate of unemploy ment 10 8 6 4 2 0 40 60 80 100 120 Terms of trade

The historic relation between unemployment and the terms of trade supports the nightmare. In Figure 2 I show this relation using yearly data for the period 1900-01 to 2014-15. To derive this relation I have split the data into two sets, the set with high levels of the terms of trade, which is levels greater than 60, and the set with low levels of the terms of trade.4 The two large dots on the chart show the average rates of unemployment and terms of trade for these two sets. The downward sloping line runs through these two dots.

3 For the ‘-ish’, see below. 4 I excluded the five data points from the Second World War shown as the five small diamonds in the south-west corner of figure 2 because they were associated with unusual circumstances. These points also suggest a behavioural economics story.

4

Clearly low terms of trade are associated with higher rates of unemployment. Indeed, the downward sloping line running through the two dots shows quite a steep relation, suggesting that a one point decrease in the terms of trade leads to a half a percentage point increase in the rate of unemployment. Of course this is not a sophisticated approach in that it ignores the many other factors that influence unemployment and does not establish the line of causality, but it is enough to cause the Treasurer nightmares.

Paul Keating tells it as it is

Keating rang the alarm bells, saying in his typically frank on 14 May 1986 that Australia "will end up being a third rate economy… A banana republic".

What happened?

Figure 3 Unemployment and the terms of trade, Australia, March 1985 to December 1986 13.5

12.5

11.5

rate of 10.5 unemployment 9.5

8.5

7.5 50 55 60 65 Terms of trade

Figure 3 shows that following the banana comment a further fall in the terms of trade did not increase unemployment in line with historic experience. To the left of the large round dot, which indicates the June quarter 1986, the dotted line shows that unemployment only increased slightly even though the terms of trade fell by 4.7% According to the historic relation shown by the light continuous line beginning at the round dot, unemployment would have increased by 1.2 percentage points.

However, note that unemployment had remained fairly constant all during the dramatic decline in the terms of trade from March 1985 to December 1986 (given by the dotted line), which includes a year of experience before the banana republic comment. There was more to it than just the banana comment. Indeed quite a lot more. Had Australia followed the historic relation for the whole period of the collapse, we see from the red line in the chart that unemployment would have increased by about five percentage points.

5 Figure 4 The wage share, Australia, September 1959 to June 1989 60

55

50

45

Perhaps the banana comment had its own impact on real wage restraint. After March 1986 the wage share decreased quite sharply relative to the downward trend that began in September 1982, see Figure 4. Whatever, economic reasoning suggests that real wage restraint from September 1982 onward, in fact a decrease in the real wage relative to productivity, may have helped prevent unemployment increasing.

Real wage restraint was also associated with movements in other economic indicators. As shown in figures 5, 6 and 7, CPI inflation didn't increase after March 1986, the government budget balance improved and the current account improved. The improvement in the current account didn't last, partly reflecting the strong growth in the Australian economy in the latter 1980s. But given that the government budget balance moved into surplus, it is reasonable to agree with economic commentators, especially John Pitchford (1990), who argued that with flexible exchange rates a current account deficit financing self-interested private sector investment was not a problem.

Figure 5 Consumer price index inflation, Australia, March 1959 to June 1989 20

15

10

5

0

-5

6 Figure 6 The government budget balance, Australia, 1961-62 to 1988-89, % of GDP 2.5

0

-2.5

-5

-7.5

Figure 7 Current account balance, Australia, Sept 1959 to Jun 1989, % of GDP 4 2 0 -2 -4 -6 -8

The Prices and Incomes Accord

The banana republic comment was part of the Prices and Incomes Accord. It was one piece of inspired communication within a comprehensive program aimed at tackling the economic problems of the Australian economy. Wage restraint was a crucial part of this program.

The Accord was a tripartite approach between government, the ACTU and employers. Within this tripartite approach, the government and the ACTU were the major partners, having the most intense interactions.

There were several forums between the three partners, including the National Economic Summit in April 1983, a few months after the government came to power, and the National Tax Summit in July 1985. Several bodies were set up as part of the Accord, including the Economic Planning Advisory Council and the National Occupational Health & Safety Commission.

The ACTU played a leading role in wage restraint. It changed its position from the previous decade, for example in its document "Australia Reconstructed" the ACTU moved away from targeting the wage share.

7 To encourage wage restraint, the Accord appealed to notions of fairness and of a fair burden of sacrifice across the community. To this end the notion of the social wage played an important role. The social wage included the government services which people received and also redistribution to lower income people. This was aimed at broadening people's perspective beyond simply their post-tax earnings and emphasising the value of paying taxes in terms of the benefits that taxes enable. Finally, as rewards for wage restraint, the government offered reductions in tax rates, the so-called wage-tax deal, and introduced a superannuation scheme with compulsory employer contributions.

Thus through leadership, cooperation and the notion of social justice, the Accord reduced the wage share and saved Australia from an increase in unemployment, an increase in inflation and an increase in the government budget deficit.

The Accord and Loss Aversion

Economists are teased for asking that "it may have worked in practice but did it work in theory?" So how did the Accord work in theory? To answer this question I will use behavioural economics, starting with the concept of loss aversion and then bringing in the concept of narrative. We will see that loss aversion can form the basis of a theory of wage inflation which can explain how the Accord generated wage restraint.

Loss aversion is a component of prospect theory. From a great deal of evidence from research in psychology, Kahneman and Tversky (1979) concluded that decision-making is based on the comparison of outcomes with a reference level and that in these comparisons the loss of value associated with a shortfall of the outcome below the reference level is larger than the gain in value from an outcome that exceeds the reference level. It is generally thought that the ratio of loss to gain is about two. Losses loom large. This is loss aversion.

Since their study, a large body of empirical evidence supporting the idea that people are subject to loss aversion has accumulated in many fields of economics, especially financial economics but also in labour economics, see eg Barberis (2013), Camerer et al (1997), Dunn (1996).

To understand the determination of wage inflation, loss aversion has been shown to be a valuable perspective through empirical studies of the inflation-unemployment relation for Australia, see Lye, McDonald and Sibly (2001) and Lye and McDonald (2004), (2006a), (2006b), (2008) and for the US, Driscoll and Holden (2004), Lye, and McDonald (2008). These studies find that the loss-aversion approach outperforms the natural rate approach, which adds to the case for using the loss-aversion approach to examine how the Accord worked.

Note that loss aversion arises from comparing an outcome with the reference level. But what determines the reference level? While the determination of reference levels is a relatively underdeveloped aspect of prospect theory, it is usually thought that reference levels are affected by people's ideas of what they deserve. That is, by ideas of fairness. And so loss aversion is the natural concept to use in thinking about the operation of incomes policies such as the Accord.

The simple economics of wage determination with loss aversion

Through loss aversion, wage outcomes can be determined by the reference wage. This link is central to understanding how the Accord generated wage restraint. However, the link depends on macroeconomic conditions. With loss aversion, when demand is low the desired wage is

8 determined by the reference wage. However when demand is high, the desired wage exceeds the reference wage. These propositions are illustrated as follows.

In Figure 8, the union indifference curve, UIC1, which shows the union's trade-off between wages and employment, has a kink at the wage equal to the reference wage. Because wages below the reference wage cause union members to feel loss aversion, the compensating increase in employment has to be large, that is large relative to the trade-off for wages in excess of the reference wage. Hence the kink. Assuming the union chooses the best possible outcome, given the constraint of the labour demand curve, LD1 in Figure 8 the union’s chosen wage is equal to the reference wage. (For clarity I have linearised the two arms of the union indifference curve: it is hard to bring out a kink in the indifference curve if one draws these two arms with their usual convex pattern.)

9 Figure 9 shows how a decrease in the reference wage can cause a decrease in the desired wage. Establishing a new reference wage at reference wage 2 reduces the desired wage down to be equal to reference wage 2, as implied by the new position of the kink in the union’s indifference curve, in the union’s indifference curve, at UIC2.5 As we will see, I will argue that this is how the Accord worked

To see the role of macroeconomic conditions, Figure 10 shows that high demand, which corresponds to low rates of unemployment, leads to a desired wage that exceeds the reference wage, as shown by the tangency point of the union indifference curve and the labour demand curve. (Note: I have introduced some curvature in the left-hand arm of UIC3 to demonstrate this point.) Thus, a situation of high demand puts upward pressure on wages.

The loss-aversion based Phillips curve for Australia

As noted above, a series of papers have estimated the loss-aversion based Phillips curve for Australia. The estimation technique allows for the short-run Phillips curve (SRPC) to have a horizontal section. At unemployment rates within this section, wage rates are determined by reference wages, as in the low demand states described above. The lower bound of the horizontal section in the SRPC is called umin, for minimum equilibrium rate of unemployment. This lower bound is an inflation barrier – to attempt by aggregate demand policy to push unemployment below it would cause excess demand in the labour market and increasing inflation, as in the high demand states described above. umin is determined by labour market factors: in particular the econometric studies show that unemployment benefits and union density are important influences in Australia.

5 Note that the two indifference curves shown in this diagram cross, thereby violating one of the axioms of revealed preference.

10 Figure 11 Unemployment, 1954:1 to 2016:1 and umin, 1964:2 to 2005:4, Australia 12 10 8 unemployme 6 nt 4 2 0

Figure 11 shows for Australia the actual rate of unemployment for the period 1954:1 to 2016:1 and the estimate of umin for the period 1964:2 to 2005:4 from Lye and McDonald (2006b), which is the most up to date estimate for Australia. By comparing the actual rate of unemployment with umin, one can infer that in 1980:2 the Australian economy moved from the high demand state to the low demand state, where it remained with one exception for the rest of the period of estimation. Thus, from 1980:2, wages were determined by reference wages while before 1980:2 wages were influenced by excess demand in addition to reference wages. 6 This suggests that the influence of the Accord on actual wages was through its 7 effect on reference wages.

The Accord reduced wages relative to the CPI

To test and measure the possible impact of the Accord on wages, Lye and McDonald (2006b) included dummy variables for the various marks of the Accord in their estimate of the loss- aversion based Phillips curve. They also included dummy variables for the other incomes policies used during the period of estimation

6 There are three exceptions. In 1969:4 and 1972:1 the economy moved temporarily for one quarter into the low demand state and in 1989:3 there was a temporary move of one quarter into the high demand state. 7 Thus real wages were not high enough to force the economy into the high-demand state. Even so, their decrease did contribute to favourable outcomes for employment, inflation, the government budget deficit and the current account deficit. This is why earlier I described the wage share in March 1986 as ‘high-ish’.

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Table 1 The Accord reduced wages relative to the CPI

Estimates of incomes policy dummies from Lye and McDonald (2006b)

75:2-76:2 (Mark 1 guidelines) -0.420

76:3-78:2 (Mark 2 guidelines) -0.090

78:3-79:3 (Mark 3 guidelines) -1.297

79:4-81:2 (Mark 4 guidelines) 0.439

83:1-83:2 (Wage pause) **-2.246

83:3-85:2 (Accord-Mark I) **-1.613

85:3-86:4 (Accord-Mark II) **-1.807

87:1-88:2 (Accord-Mark III) **-1.935

88:3-89:2 (Accord-Mark IV) -0.357

89:3-90:3 (Accord-Mark V) -1.018

90:4-93:2 (Accord-Mark VI) **-1.844

91:4-01:1 (Enterprise bargaining) **-0.051

** significantly different from zero at the 95% level

Table 1 reports the estimates of the impact of incomes policies on wages as measured by unit labour costs from Lye and McDonald (2006b). 8 One can see that each of Mark I, Mark II and Mark III reduced wages relative to the CPI by significant amounts. The coefficients on the three dummies add up to 5.3. This implies that in this period the Accord reduced real wages by 5.3%. Given that wages were measured by unit labour costs, this implies that the Accord reduced the wage share.

8 For definitions and sources of the classification into incomes policies, see Lye and McDonald (2004). The incomes policies of the 1970s were guidelines set by the Commonwealth Conciliation and Arbitration Commission.

12 Figure 12 Employees involved in industrial disputes, Australia, 1978 to 1990, % of total employees 35 30 25 20 15 10 5 0

The decrease in the wage share in the 1980s seems to have been accepted widely across workers. For example, industrial disputes did not increase as the wage share fell, see Figure 12, which shows that the proportion of workers involved in strikes remained roughly constant up until the 1988-89 boom. And this acceptance occurred even though most workers would have kept their jobs even if there had been less wage restraint. It is only a minority of the workforce that would have been pushed into unemployment. Bob Gregory (1986) pointed out that feelings of job insecurity were not high. Thus the general acceptance by workers of wage restraint was a generous act.

The wage pause in 1983:1 to 1983:2 also had a significant downward effect on wages. This pause was initiated by the Fraser government and endorsed by the Hawke government.

It is noteworthy that the incomes policies during 1975 to 1981 did not have a significant effect on wages. This is consistent with the loss aversion interpretation. In that period the estimate of the loss-aversion based Phillips curve suggests that the effect of reference wages on wage outcomes was limited because the rate of unemployment was less than umin, that is the labour market was in a situation of high demand, as defined earlier. Thus to control inflation, incomes policy had to counter the force of wage demands tending to exceed reference levels. In the 1980s the situation was different. The labour market was not in a situation of high demand, the rate of unemployment being greater than umin according to the estimates of the loss-aversion based Phillips curve, and this gave incomes policy a greater chance of success.9

Would real wages have fallen anyway? Loss aversion is not an immutable barrier. If firms are under extreme pressure such that their survival or the survival of a plant is threatened then it is in the interest of their workers to accept a wage cut and the associated loss aversion to save a wholesale loss of jobs. Henle (1973), Bewley (1995) and Akerlof, Dickens and Perry (1996) find evidence that wage cuts do occur when firms, to use the words of Akerlof, Dickens and Perry (1996, p.9) “are under extreme duress”. Thus, had there been no Accord during the time of the terms of trade

9 According to Joe Isaac (2012), the incomes policies of the 1970s had rather weak support from government, indeed he says the government acted perversely. The incomes policies were designed and put into effect by the Commonwealth Conciliation and Arbitration Commission. Perhaps with strong government support these policies would have been more effective. Whatever, the loss aversion interpretation suggests that the possibility of achieving success in incomes policies in the 1970s was less than in the 1980s.

13 decrease, the threat to the survival of some firms or plants may have reduced wages. But this would probably not have prevented some increase in unemployment because the threat would not have been believed in all cases. Furthermore, the centralised nature of the Australian wage system at the time would have made difficulties for agreements at the plant level to reduce wages. A desire by workers at marginal plants with low levels of profitability to negotiate reductions in their wages to save their jobs may have been frustrated by their unions being dominated by the interests of workers at the intra-marginal plants.

The banana republic comment and The Accord as a narrative

Akerlof and Snower (2016) argue that “narratives” can influence economic decision-making. Narratives are simplified accounts of events and their causal connections which use mental constructs to interpret experience. They focus attention on a particular way of understanding the environment. Balancing issues of importance to human well-being such as the interests of individuals with the interest of the group is a central role of narratives. Narratives, they argue, can define social identities, assign social roles and establish social norms and power relationships. In their paper they illustrate their concept of narrative by developing the Bolshevik-spawned narrative that dominated the history of the Soviet Union.

Let us consider the Accord as an example of a narrative.

Reflecting on the experience of enacting The Accord, Kelty said "You were trying to change people's ideas", reported in Lucas (2013). As Akerlof and Snower (2016) point out, mainstream economics takes people's preferences as given. There is no changing of people’s ideas. In the loss aversion analysis of The Accord years in this paper, it is argued that people's preferences did change in that workers paid less attention to the post-tax wage as a reference level, at least for long enough to be effective in improving macroeconomic outcomes. This change in preferences was not easily won. Kelty commented “''What do you think – everybody said 'That's a nice idea - a real wage reduction would be good, can I have another one next year please'?'', quoted in Lucas (2013). But it did happen. In effect, workers were persuaded to look away from their kinked indifference curves and to refocus on a broader conception of their income which included the benefits from government services and to rebalance their interests with the interests of the less well off. Refocusing, eg “attending less to their previous concerns”, Akerlof and Snower (2016, p.12), and rebalancing of interests are constituents of Akerlof and Snower’s conception of a narrative.

The Accord also changed power relationships by granting a greater influence to the trade union movement. As noted above, Akerlof and Snower (2016) argue that defining power relationships is another constituent of narratives.

A feature of The Accord was charismatic leadership by especially Hawke, Keating and Kelty. Akerlof and Snower (2016) implicitly acknowledge the charismatic leader of Lenin in their account of the Soviet Union. Presumably the charismatic leadership of Stalin was also important. However they do not discuss whether charismatic leadership is a necessary condition for a game-changing narrative.

There are good and bad narratives. As Akerlof and Snower (2016, p.24) say, narratives “are not always benign”. Lenin’s narrative was a humanitarian disaster.10 The Accord was a success

10 Lenin's narrative exemplifies a shortcoming in the utilitarian/human well-being approach. Simply adding up utils can justify huge sacrifices for the reward of bliss. Karl Popper (1957) argued that this shortcoming can be avoided if we recognise our lack of knowledge about the results of revolutionary change and thus stick to

14 for human well-being, at least as judged by the macroeconomic indicators reported in this paper. And it achieved this success without the bitterness that accompanied a somewhat similar exercise carried out in the UK by Margaret Thatcher. Thatcher without tears perhaps?

One possible negative of The Accord is that it may have led to a reduction in trade union power which in turn may have contributed eventually to increased inequality. This is somewhat ironic since in the short run it increased the role of the trade union peak body in economic decision-making.

Today's economic problems

Can the success of the Accord in overcoming the barrier of loss aversion teach us anything about tackling today’s economic problems?

Consider three major economic problems facing Australia today. First unemployment is high. Extrapolating the estimates of the umin equation for Australia using today’s values of unemployment benefits and union density suggests that the high demand state with labour market pressures on inflation would not appear unless the rate of unemployment went below 2.5% The slack labour market is further suggested by concerns about the growing labour underutilisation rate and the high youth unemployment rate. However, an important influence on the Reserve Bank of Australia (RBA) that constrains the setting of and thus contributes to higher unemployment is the fear of instability in house prices.11 This constraint on monetary policy would be eased if the ability to negatively gear was wound back and if the capital gains tax concession on non-owner occupied housing was reduced or eliminated.

The second problem is high greenhouse gas emissions. The solution to this is to price the emissions, either by a carbon tax or an emissions trading scheme.

The third problem is the fiscal pressure from an ageing population. Projections by various researchers suggest that the pure effect on government outlays of the ageing population is an increase of about five percentage points of GDP, a rough average of the projections in Guest, and McDonald (2000), Kudrna, Tran, and Woodland (2015) and (2013). This is the increase that would be required to maintain the living standards of old people relative to younger people. To address this problem, increases in taxes across the board are called for.

Thus the sensible economic response to each of these three problems involves an increase in taxation. However an increase in taxation appears to be stymied by tax resistance.

The general problem of tax resistance

Tax resistance may be encouraged by feelings of loss aversion that people imagine would accompany a reduction in their private consumption levels should taxes be increased. Because loss aversion exaggerates the sense of loss, the benefits of a lower rate of unemployment, lower greenhouse gas emissions and better support for old people are swamped by the exaggerated sense of loss from a small reduction in private consumption.

marginal, or piecemeal, changes. 11 A recurring theme in the monthly statements by the Reserve Bank of Australia justifying their decisions on interest rates is commentary about current and prospective trends in house prices.

15 Feelings that the tax system is unfair may also encourage tax resistance. Ross Guest (2016) discussed the increasing demand for government services in an article on The Conversation entitled entitled “Put your hand up if you would like to pay more tax”. A good proportion of the commentators on Guest’s article said they would be happy to pay more tax as long as it was fair.12

In as far as loss aversion induces people to resist increases in taxation that would address economic problems in a cost-effective way, it is reasonable to say that people are acting irrationally.

This irrationality may stem partly from the difficulty of making an independent subjective assessment of your living standard. Unless you are very poor, this assessment is very difficult. Wants are less pressing than needs. They embody more psychological construction and so are more malleable.

Because of the difficulty of making an independent subjective evaluation of one's living standards, people resort to comparisons. As prospect theory suggests. The earnings of your colleagues become the basis of your judgement of whether your own post-tax income is "satisfactory".

Furthermore, post-tax income is one of a number of contributors to well-being. The happiness literature shows that for most people, that is except for the very poor, post-tax income makes a very small contribution to well-being as measured by surveys of happiness. The narrow frame of individual post-tax income distorts people's evaluations of the benefits to them of paying higher taxes to finance improved economic outcomes. A resurrection of the social wage, a concept of the Accord, may help to broaden people's framing as perhaps it did in the 1980s.

Well-being could be improved if people were "tutored" to make better assessments of their well-being. Indeed the advertising campaigns urging people to drive more carefully and not to take drugs are examples of attempts to tutor people’s judgement of the determination of their well-being. The Accord tutored people to ignore or at least suspend their exaggerated feelings of loss aversion with respect to wage restraint. Perhaps similar policies could tutor people to reject their feelings of loss aversion with respect to tax resistance?

Packaging the policies

Now consider who loses from a failure to address these three major economic problems. The tax concessions on housing create unemployment insofar as they induce the RBA to run a tighter monetary policy than it otherwise would. Unemployment is particularly harmful for young people. However, tax-free capital gains on housing are particularly beneficial for older people. Furthermore, high house prices are a barrier to home ownership for young people. Similarly, failing to price carbon is a bigger problem for young people than for old people, the latter having shorter remaining life-times. On the other hand, a failure to maintain taxpayer support for the old would seem to harm old people and benefit young people. This is not necessarily true because today's young will become tomorrow's old but let us assume so for what follows.

Given that the three major economic problems identified here have a spread of losses and

12 Other factors in addition to loss aversion may also encourage tax resistance. People may think that all government activity is wasteful. They may follow Ronald Reagan (1981) in thinking that "government is the problem". These are ideological positions rather than propositions supported by empirical knowledge.

16 gains that varies across people by age, perhaps a package that addresses all three problems would generate support. Packaging the three policy solutions would generalise the costs and benefits of the solutions over a broad part of the population. This might increase the support for reform not just because there would be more people swayed by the selfish argument that I will benefit but also because it might encourage people to take a broader conception of the benefits. A package that benefits a broad swathe of the population may appeal to notions of fairness.

Behavioural economics suggests another possible advantage of packaging policies. Richard Thaler (1999) deduced from his concept of mental accounting the idea that to deal with loss aversion one could package small losses with larger gains. For example to package a loss of five dollars with a gain of six dollars leads to a net gain of one dollar and this would wipe out loss aversion. If by packaging the three policy solutions, individuals see a net benefit then loss aversion due to the tax increases would be wiped out and thus tax resistance would be reduced.13

Efficiency in government

While the proposition “all government expenditure is wasteful” is ideological, obviously waste in government expenditure should be avoided. This is all the more important if one wishes to persuade people to temper their resistance to tax increases. Thus the usual economic criteria should be used to evaluate government expenditure. Costs should be covered by benefits. Social contracts should be violated only with caution. Distributional objectives should be applied.

Conclusion: Are Accord-type policies relevant today?

This paper has argued that during the large fall in the terms of trade in the 1980s, the Accord induced employed workers to make sacrifices by accepting wage restraint for the benefit of the unemployed and for those who might have been unemployed. Given that econometric estimation of the prospect theory approach to the inflation-unemployment relation shows that during this period wages were determined by reference wages and that the Accord had a significant downward effect on real wages, it follows that the Accord was able to counter the intense feeling of loss aversion. To do this the Accord involved peak bodies, especially the ACTU, in decision-making. It publicised concepts, especially the social wage, to persuade workers to broaden their view beyond post-tax wages to include the benefits to them and those on lower incomes of government services. This broader view involved packaging benefits from economic activity, thereby being perhaps an example of mental accounting. Charismatic 14 leadership by Bob Hawke, Paul Keating and Bill Kelty was important.

The Accord can be seen as an example of a narrative, as discussed by Akerlof and Snower (2016). A narrative is an interpretation of experience. The Accord presented an interpretation of experience that changed worker's preferences by inducing them to overrule their conception of the reference wage.At the current time a major problem for the Australian economy is tax resistance. Tax resistance stymies attempts to reduce the fear of instability in house prices, thereby imposing a tighter monetary policy and thus a higher rate of unemployment on the

13 Milkman, Mazza, Shu, Tsay and Brazerman (2012) discuss how packaging policies may overcome loss aversion. 14 Charismatic leaders are beneficial if they take us in the right direction. But suppose they get us to invade Russia? More prosaically but still harmful to well-being, they might get us to maximise economic growth, cap the share in GDP of taxation or minimise regulation. Economics should be about well-being but all too often it seems that the well-being of the population in general is overshadowed by these other misleading targets.

17 community, to reduce greenhouse gas emissions and to maintain the relative living standards of old people as the population ages. Perhaps now is the time for an Accord-type policy to counter the intense but malleable feeling of loss aversion that drives tax resistance and thereby deliver the increases in taxation that will address Australia’s current economic problems?

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Minerva Access is the Institutional Repository of The University of Melbourne

Author/s: McDonald, IM

Title: ‘We Will End Up Being a Third Rate Economy … A Banana Republic’: How Behavioural Economics Can Improve Macroeconomic Outcomes

Date: 2017-06-01

Citation: McDonald, I. M. (2017). ‘We Will End Up Being a Third Rate Economy … A Banana Republic’: How Behavioural Economics Can Improve Macroeconomic Outcomes. The Australian Economic Review, 50 (2), pp.137-151. https://doi.org/10.1111/1467-8462.12199.

Persistent Link: http://hdl.handle.net/11343/173327

File Description: Accepted version