Wayne Swan hedges against disaster

Wayne Swan and Julia Gillard

AS the world stares into an economic abyss Wayne Swan has hedged his bets - he has sensibly kept Labor on an official path to budget surplus but recognises his mid-year forecasts may be swept away.

Australia is hostage to forces beyond its control. Just as China's demand made our resources boom, Europe's financial crisis now points towards a deeper global downturn.

The ALP national conference preoccupation with same-sex marriage reveals an Australian surrealism disconnected from the economic fractures only guaranteed to reach this country.

The economic mission facing Labor now hangs in the balance. Will it become to stimulate the economy and save activity in the teeth of a violent European recession or, if the world escapes the worst, will it become to bank our high terms of trade by delivering the 2012-13 surplus as promised?

Marking time as the clock approaches midnight for Europe, Swan has taken a nakedly political decision to bring down a mid-year budget review that tells financial markets Australia remains on track for surplus.

This is the correct decision. There is insufficient economic argument to ditch the surplus at this point. Such a retreat would have been economic and political folly inviting ridicule given Labor's declarations enshrining the virtue of the surplus.

Note that Julia Gillard recently told the Business Council of Australia that Labor "will hold our fiscal discipline" and such discipline is "vital at a time of heightened global instability". That remains true - so far. Gillard made apparent that Labor's strategy is to look to monetary policy (interest rate cuts) in preference to fiscal policy as the key tool to maintain activity.

It is not hard to see Swan's calculation: if Labor's surplus goal is to be abandoned he wants that to be a "no-brainer" with a deeper global downturn providing justifiable cover. But Swan's surplus is paper-thin. So paper-thin it invites ridicule with a forecast surplus of 0.1 per cent of GDP next year, 0.1 per cent in 2013-14 and 0.2 per cent in 2014-15. The Treasurer admits the surplus is "modest" but insists it is achievable.

Unsurprisingly, the Coalition has gone for Labor's jugular. It has fixated on the current year 2011-12 deficit that has blown from its May budget forecast of $22.6 billion to the revised mid-year figure of $37.1bn. The strain on Labor's credibility is immense. This is not fiscal consolidation in action; it is current-year fiscal unravelling (despite the accounting trick of deliberately moving costs into the current year).

In short, to deliver next year's surplus Swan needs to shift the budget bottom line equivalent to 2.5 per cent of GDP, a herculean job. There has rarely been such a transition in Australia.

Opposition treasury spokesman Joe Hockey says Labor cannot deliver the surplus. It is "beyond the realm of possibility". Opposition finance spokesman Andrew Robb says the claim is a "hoax". The Coalition is lining up to brand Labor as the party that forever pledges a surplus but only delivers deficits. It will become Tony Abbott's mantra.

Swan calls his strategy a "middle course" between competing scenarios. With a "sails for growth" camp urging Labor to accept a deficit now because of global threats and a "fiscal discipline" camp calling for a firmer trajectory towards surplus, Swan has hedged his bets.

"Everything we've done here is to strike the right balance," Swan says between government support for jobs and growth on the one hand and keeping financial market confidence in Australia's financial discipline and budget position on the other.

This is the key to strategy. Swan has positioned for both. It is a juggling act that reflects deep economic uncertainty. Swan and Gillard are fixated on being agents of surplus discipline (Australia's asset compared with the rest of the rich world) but they are equally fixated on creating jobs and keeping unemployment low, with Gillard telling the national conference yesterday that "we govern for jobs - by governing for growth".

Will this surplus be achieved? The figures suggest it is highly doubtful. Many economists dismiss the goal as unrealistic. The point, however, is that if the growth forecasts are delivered then Labor, if it has the political will, can deliver the surplus that Gillard, Swan and Penny Wong have long seen as pivotal to Labor's 2013 re-election campaign. And the forecasts are consistent with private-sector analysis.

Labor, as usual, oversold its budget savings in this mid-year review to compensate for Treasury's reduced growth forecast to 3.25 per cent for this year and next, down on its more optimistic budget-time forecasts. This signalled a loss of more than $20bn revenue across the forward estimates.

When the book was opened Labor's net save this week was only $6.8bn across four years. That's modest. The saves come from the baby bonus, university funding, public service restraints, business allowances and various fiddles that move spending from next year to this year to achieve the 2012-13 surplus.

For Labor, there is no voting exodus in these measures. They don't damage the economy. They don't confront the structural deficit. They are not sufficient to warrant the Reserve Bank cutting interest rates. If the bank cuts rates it will reflect the eurozone crisis. They constitute, in fact, a holding operation.

The entire key to Australia's position is the extent of its fiscal and monetary flexibility to respond to another global shock. This week Fitch rating agency said Australia's relatively low debt, now forecast to reach 8.9 per cent of GDP or about a 10th of other rich economies, provided the space to "weather adverse shocks".

True. But the declared view of Labor and Coalition is to look first to the Reserve Bank in any crisis where interest rate settings are neutral, meaning it has plenty of ammunition.

The further truth is that an optimal fiscal policy means you wouldn't start from here - you would start with a tighter fiscal policy reflecting earlier tough decisions that had left more fiscal policy ammunition. Labor could have done far more, far earlier, to rationalise both spending and tax breaks.

The defining feature of Labor under Kevin Rudd and Gillard has been its determination to proceed with its declared policy agenda regardless of global turbulence. Witness its carbon pricing scheme when such schemes are in retreat elsewhere, its expensive National Broadband Network, its re-regulation of the labour market and its pension and welfare increases. The central question for the making or breaking of Gillard Labor is whether this strategy is financially and politically viable.

Last week Paul Keating warned of the eurozone troubles that "this is the worst crisis of my lifetime". Australia's budget outcomes will be more determined by global events than future Labor decisions. Hence, the hostage theme.

Labor will take its cue from the competing global scenarios - modest downturn or full-blown catastrophe.

Swan unveiled his review by saying: "It's pretty clear that storm clouds are gathering and this time the darkest clouds are cast over Europe." He mentioned OECD downside forecasts as showing what can happen "if things were to take a turn for the worst".

The OECD has cut its 2012 forecast for its 34 member economies from 2.8 per cent growth to 1.6 per cent. It finds the eurozone in "mild recession" and forecasts growth at 0.2 per cent. Yet a far deeper recession threatens. Its chief economist, Pier Carlo Padoan, said: "Everyone should be clear that the euro is at stake."

Eurozone unemployment is 10.3 per cent and rising. In Britain, outside the euro, the Institute for Fiscal Studies says average families will fail to regain their 2002 income levels even by 2015.

The OECD warns political leaders "must be prepared to face the worst". Its worst-case scenario, while unlikely, is spelled out: "If everything came to a head, with governments and banking systems under extreme pressure in some or all of the vulnerable countries, the political fallout would be drastic and pressures for euro-area exit could be intense. The establishment and likely large exchange rate changes of the new national currencies could imply large losses for debt and asset holders including banks that could become insolvent. Such turbulence in Europe with the massive wealth destruction, bankruptcies and a collapse in confidence in European integration and co-operation, would most likely result in a deep depression in both the exiting and remaining euro-area countries as well as in the world economy."

It is intended to frighten policymakers and let's hope it succeeds.

In an article that flashed around the world this week, Wolfgang Munchau of the Financial Times said "the eurozone has 10 days at most" to sort its problems. One way or another, world economic history is being made.

It is no surprise that Treasury in its review says the risks "remain firmly on the downside". It says European events "have shaken confidence" and "pose a significant risk that the global economic outlook could deteriorate quickly". If this happens Australia's terms of trade could "decline more sharply than currently forecast".

Another revenue collapse would demand policy re-setting with serious electoral risk for the Gillard government.

The economic judgment on Gillard Labor is coming. It is whether Labor has had sufficient policy strength to handle the dangerous global environment during its time in office.

Given the difference in outlooks between Europe and Australia, the further test is whether Labor has made the most of Australia's opportunities.

Abbott's charge is that Labor has misread the times and misjudged its priorities. Swan's hedging strategy this week seeks to prove him wrong.