Our heads remain above water

1108120 Gillard Smith

WITH the eurozone facing a sovereign debt crisis and the US threatened by another downturn, the Gillard government is confronting a new external shock that will weaken Australia's confidence and challenge its economic conditions.

It is trite to say that Julia Gillard's political strategy, based on electoral revival over 2012, looks even more remote because of global events during the past fortnight. At the precise time Labor wanted to pivot the agenda more to economic management the world economy has taken another hit with the bears roaming free.

In this climate of rising uncertainty, Australia remains the best placed of virtually any industrialised nation. Despite this truism, the omens are alarming.

The corner-store retail slump tells a story not just about your own neighbourhood but of something much bigger as the pillars of Western glory - the European Union and the US economy - reveal structural cracks that spread into global markets.

The West is in crisis. There will be no quick fix in Europe or the US. The road back will be protracted, volatile and unpredictable. Treasurer Wayne Swan, desperate to kindle confidence, concedes the core truth: "The US and many European countries are confronting a long and painful road ahead to reduce their debt burdens and get their budgets back on a sustainable footing."

He warns the present instability "is going to be with us for some time". It is surely a calculated underestimate. Under threat is Labor's sacred pledge to return to surplus by 2012-13, long seen as the ultimate proof of its economic credentials.

The sad reflection is that the 2008 global financial crisis revealed a debt problem in the West that remains unfixed and transferred to the public sector with democracies unable to produce the required policy solutions.

Economic guru Nouriel Roubini, predictor of the global financial crisis, says "most advanced economies are on the brink of a double-dip recession" and that multiple problems have created a "massive increase in risk aversion" as policy-makers run out of options with interest rates near zero and fiscal stimulus shots fired.

US Nobel laureate economist Michael Spence, visiting Australia, warns the world is facing a "pretty tough decade" with the future of the eurozone undecided, US politics in "gridlock and disconnectedness" and China sure to be affected if Europe and the US both slump.

Harvard University's Kenneth Rogoff says policy-makers misjudged in assuming a return to strong growth after the GFC and that the European and US economies "never fully exited the downturn".

World Bank chief Bob Zoellick, also visiting Australia, says the world has entered a "dangerous phase", with Europe's situation more serious than America's.

The heart of Europe's crisis is a lethal loss of confidence in government bonds of indebted nations. The heart of the US crisis is different - as explained by Standard & Poor's in its downgrade of the US credit rating: "The political brinkmanship of recent months highlights what we see as America's governance and policy-making becoming less stable, less effective and less predictable than what we previously believed." Such brinkmanship in the US congress has been unforgiveable: the willingness of some Republicans to flirt with default is the action of legislators without honour or responsibility.

Australia is trapped in two different responses: sheer relief that we do not share the debt crisis of the North Atlantic economies, yet growing awareness that we are not immune and face a series of exacting challenges.

The backdrop is Australia's transition to the Asian economic zone. The US-led North Atlantic economies dominate our share market but the China-led Asian story now dominates our economic growth. The panic in global markets hurts Australia's confidence but the China investment surge underwrites our strong output.

"For the first time in our history we are located in the right part of the world at the right time," Swan told parliament. Our exports to China and India are nearly double those to US and Europe. Swan's message is that Australia is tied into the coming Asian century. Indeed, never in Australia's history has its divorce from the rest of the West been so pronounced. Australia, unlike Europe, has no sovereign debt crisis. As Swan said, the US has a net public debt of more than 70 per cent of GDP and rising while Australia's is just over 7 per cent of GDP and set to fall. Despite Gillard's minority government, Australia is devoid of the political gridlock that has brought the once mighty US to its knees.

What is evident, however, are symptoms of what can be called the New Australian Stress. It has many manifestations and it is likely to be long-run. It was on display this week from boardrooms to the protest convoys. Australia is burdened by a truly bizarre and chaotic array of forces - a terms of trade boom, a painful two-speed economy, imposition of an unpopular carbon pricing policy, weak productivity, soft domestic demand, a government of declining authority, an opposition agitating for an election and a community polarised between political insiders and outsiders.

This week saw Qantas announce job cuts and new Asian ventures in what is billed as a survival strategy. Manufacturing and finance affirmed the new cost and job pressures with statements from OneSteel and Westpac. Small business is bleeding, with the Australian Chamber of Commerce and Industry August 2011 survey showing conditions at their lowest in more than two years with falling sales, falling demand and rising costs.

The protest rallies outside Parliament House revealed an anti-Labor grassroots movement based on an assembly of grievances: rejection of the carbon tax, agitation at rising costs, opposition to same-sex marriage. Above all, this is a movement against Labor's perceived values and its network of trade union and green supporter groups. This mood is only likely to intensify.

The problem for Gillard and Swan is the phenomenon of "stress amid prosperity" that is now Australia's fate. The outlook for the nation remains strong, yet wide sections of the workforce and industry are under the gun. Gillard's ability to stage a political recovery in this climate seems highly improbable.

First, the good news. As Swan said, 2011 is not a repeat of 2008. Australia has a triple-A credit rating, its banking system is strong, its growth outlook remains buoyant. The Reserve Bank still forecasts growth at 3.25 per cent for 2011. Mining investment is booming and business conditions are about the average of the past two decades.

The bad news is that the inflation threat remains with the risk of higher interest rates. The new higher Australian dollar imposes relentless cost pressures on much of the non-resources sector with the viability of manufacturing, retail and tourism enterprises now in question over the long run. Does Labor have a strategy to manage this transfer of income, jobs and wealth? Frankly, there is little sign of it. It is one thing for Treasury and the Reserve Bank to advise the market will adjust, but another for a Labor government to preside passively over such unfolding pain. A dangerous debate about the future of manufacturing is guaranteed. Note, this structural change is what being part of the Asian century means.

The Reserve Bank August board meeting minutes are a daunting read: our productivity growth during the past five to 10 years has been weak; higher incomes were driven by higher commodity prices but these prices will ease; as a consequence, income growth in Australia cannot be sustained without a productivity revival. Its prospects? Not good.

The Rudd government was proud of its ability to avoid recession during the 2008-09 GFC, but Labor must feel a touch of battered party syndrome with the return of these North Atlantic dilemmas. Swan made clear this week Labor remains determined to meet its 2012-13 "return to surplus" pledge. But the global shakeout makes this more difficult. This pledge originates in Labor's determination to prove its economic prowess and its meaning is political, symbolic and psychological. Labor cannot tolerate any impression it is abandoning this surplus pledge because of weakness or lack of grit. This week Labor was trying to buy itself some flexibility, uphold the pledge and confront the reality that significant spending cuts will be required to meet the target.

Access Economics director Chris Richardson told The Australian: "This commitment was really a political target and I wouldn't die in a ditch for it. The point is you shouldn't defend a surplus for the sake of a surplus. Having said that, I am not at all convinced the surplus is a dead duck." But Richardson warns that if the surplus is under pressure because of weaker than expected growth, then cutting the public sector becomes counter-productive. Labor must avoid the trap of "trying to defend its economic credibility by resort to dumb economics".

Tony Abbott and Joe Hockey won't grant Labor any immunity. Their message is obvious: this is a weak government about to prove its weakness. Having declared Labor would never deliver a surplus, Hockey would score a huge propaganda victory if the budget slips. It would be tied to the carbon tax as another broken promise. In this sense the politics of missing the surplus could be savage.

Swan says Australia's reform agenda cannot wait for the uncertainties in Europe and the US to play out. He's right.

But Labor's political capital is near empty. Its ability to respond with authority will be tested to the limit as it collides with the New Australian Stress.