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

• Published date: 01 June 2017
• Author: Ian M. McDonald
• Date: 01 June 2017
• DOI: http://doi.org/10.1111/1467-8462.12199

‘We Will End Up Being a Third Rate Economy ... A Banana

Republic’: How Behavioural Economics Can Improve

Macroeconomic Outcomes

Ian M. McDonald*

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 broad-

ening people’s perspective beyond their post-

tax incomes to the broader spread of benef‌its

for them and others.

1. Introduction

Thirty 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 on 14 May 1986

that Australia faced the prospect of becoming a

‘banana republic’.

1

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 perfor-

mance. 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 article, 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 faceAustralia 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).

2. The Context

As shown in Figure 1, Keating’s banana

republic comment followed a dramatic drop in

the terms of trade to a historicallylow level. As

shown in Figures 3–7, this was in a situation

where,in March 1986, unemployment was high,

the wage share, having fallen from its peak

* Department of Economics, The University of

Melbourne, Victoria 3010 Australia; email <i.mcdonald@

unimelb.edu.au>.Thisarticleisbasedonaninvitedlecture

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.

The Australian Economic Review, vol. 50, no. 2, pp. 137–51

°

C2017 The University of Melbourne, Melbourne Institute of Applied Economic and Social Research

Published by John Wiley & Sons Australia, Ltd