Crisis a defining test of leadership for Kevin Rudd

THE global financial crisis should become the making of the Rudd Government, just as the Asian financial crisis in 1998 injected a surge of confidence into the Howard government.

This assumes one factor: that Kevin Rudd and Wayne Swan reveal the judgment and policy the crisis demands. So far their performance has been impressive, apart from Rudd's rhetorical nonsense last Friday.

The Reserve Bank has just made its most important decision since the era of independence began in 1996. Its one full percentage point cut in the cash rate (double that of any other single move in the past 12 years) signals the most material change to global conditions in many years.

It is a financial and political gift to the Rudd Government. The trajectory of lower interest rates translates into electoral clout. Its deeper meaning, however, is the bank's alarm about the global economy.

Governor Glenn Stevens made clear the bank had a dual motive. With bank collapses across the world, it wants to promote liquidity, maintain lending and buttress the immediate stability of Australia's financial system. Beyond this, it seeks to avert an Australian recession in line with the unfolding global recession.

The Reserve Bank sees a weakening in the Asian economies, a decline in Australia's record terms of trade during the coming year, a softening in commodity prices and a retreat in global inflation. It expects Australia's inflation to run at 5 per cent for the year to September but judges the coming fall in inflation will be faster because of the crisis. Within a short period the threat has changed from inflation to recession.

Crisis always defines political leadership. It makes and breaks leaders: witness US president Franklin Roosevelt in the Depression and Indonesia's president Suharto in the Asian crisis. John Howard was a successful PM because he became an excellent crisis manager. History suggests Rudd and Swan have the chance to enhance their authority and credentials by their handling of this crisis.

It will not be easy. It involves negotiating Australia's path through the financial crisis and the coming global growth crunch. How far Australia's economy will slow defies prediction. But Rudd and Swan, so far, have made some sound calls.

They softened their May budget late in the day to accommodate US financial woes while still bringing down a stronger surplus. They have stuck closely to the official advisers in the Treasury, the Reserve Bank and the Australian Prudential Regulation Authority. They have offered sustained assurance about the integrity of Australia's banking system to combat the risk of panic as important overseas banks collapsed. Rudd argued strongly for the US bailout package, despite its defects, aware that swift passage was in Australia's best interest.

The Rudd-Swan message in the prelude to yesterday's interest rate cut was to give the banks flexibility to absorb some of this reduction. Once again, the priority is financial system stability and having enough funds to maintain lending. This was the sensible call.

Let's get some perspective here: a month ago there was no prospect of an interest rate cut this week, let alone one percentage point. Borrowers are distinctly better off for getting a slice of a reduction they would not otherwise have got.

No country is immune from the crisis and no financial expert can gauge its full import. Australia, however, is fortunate in the quality of its economic governance and commercial bank management. Having been told by intellectuals for the past decade that our governing institutions were in shocking decline, Australia's economic governance is now shown to be second to none in the industrialised world and its banks among the most prudent in loan policy.

Australia has had three great strengths: the Reserve Bank, by lifting interest rates from 2002, choked off excessive cheap money, unlike the US Federal Reserve; our prudential supervision, while not perfect, has been superior to overseas jurisdictions; and our banks kept their exposure to sub-prime loans to a minimum, declining to purchase securities based on risky US mortgages.

But no nation is invulnerable. Australia's potential weakness, as identified by ANZ chief economist, Saul Eslake, is its current account deficit, the fourth highest in the world after the US, Britain and Spain.

This deficit is financed almost exclusively through the overseas borrowings of the banks. Their ability to continue this financing is essential to Australia's economic position. And the lesson from the crisis is that the banks are forced to pay a higher premium for short-term wholesale funds for such financing.

The crisis, contrary to Rudd's Friday homily, is about governance, not greed. Announcing that rampant greed has been on the prowl tells us everything and nothing. Greed has been on the prowl since the Garden of Eden. Rudd would have been equally helpful to tell us the problem was Original Sin.

The problem, in fact, flows from a comprehensive failure of governance in the US that has been compounded through many years. The activities that ignited this crisis were legal. The failure of governance lies in the executive arm, the Congress and in the financial and regulatory oversight. It is a special failure of the US system.

Nor is Rudd correct to say the problem is the work of "extreme free market ideologues" who think "any regulation of private business is wrong". On the contrary, the problem is a combination of lack of regulation and poor government regulation. The latter has been overlooked, yet it is striking: witness the US Fed's poor monetary policy and the tolerance the US regulatory authorities displayed towards commercial banks and other institutions under their ambit that purchased the toxic mortgage packages.

Writing in The Washington Post, financial analyst Sebastian Mallaby said: "The appetite for toxic mortgages was fuelled by Fannie Mae and Freddie Mac, the super-regulated housing finance companies" that are estimated to have bought one-third of the bubble's junk bonds and, in addition, were encouraged because "heavy government oversight obliged them to push money towards marginal home purchasers".

In short, the crisis arose from too little regulation and too much bad regulation. Rudd's speech means one of two things: either he does not understand the crisis despite his trip to the US and multiple briefings or he cannot restrain himself from resort to populist spin. The moral for Rudd is unmistakable. He is best when he addresses policy on merit and invites trouble when he indulges his "brutopia" philosophy.