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1 21/10/2016 “We Will End up Being a Third Rate Economy …A Banana Republic”: How Behavioural Economics Can Improve Macroec

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1 21/10/2016 “We Will End up Being a Third Rate Economy …A Banana Republic”: How Behavioural Economics Can Improve Macroec 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 Melbourne Abstract To address the economic problems facing Australia 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? 2 “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, Paul Keating, 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 Bob Hawke, Prime Minister, Bill Kelty, Secretary of the Australian Council of Trade Unions (ACTU), Peter Walsh, Minister for Finance, and Simon Crean, 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 style 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.
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