Next year's poll agenda unfolds

THE recession that Australia never had is the beautiful gift and the looming curse that dominates Kevin Rudd's first term, branding Labor as bold on Keynesian job-saving expansion yet needing to prove its toughness on managing the recovery.

This is documented in the story of jobs and interest rates. The dramatic effect of Australia's defiance of doom is the revision of the unemployment peak from 8.5 per cent in the May budget to 6.75 per cent in Wayne Swan's November mid-year outlook. While the jobless rate will keep rising, Australia will dodge a deep recession.

Yet the flipside is yesterday's second interest rate rise of 0.25 percentage points to take the cash rate to 3.5 per cent en route to above 5 per cent next year. Understand the big picture: Rudd and Swan infinitely prefer the shallow downturn with interest rates now moving towards normality to the alternative of a serious recession that would have threatened their government.

The irony of Swan's mid-year review is its significant change in the economic outlook with little change in policy settings. It is a deliberate choice. Rudd and Swan have nailed their judgment to the wall: despite higher growth they refuse to surgically reduce the fiscal stimulus. The stimulus is a sanctified political gift for the 2010 election year, proof of Labor's ability to save Australia's economy. Labor will never concede that because the downturn was less than predicted its stimulus should also become less than predicted. This is reinforced by Swan's cautious instinct to ensure he is not trapped by any setback in global recovery.

The shallow downturn weakens the Coalition's deficit and debt attack. For 2010-11 the projected budget deficit has fallen from 4.7 per cent to 3.6 per cent of gross domestic product (and will probably finish lower). The net debt figure is estimated to peak at 10 per cent of GDP, a figure most nations would kill to own and $50billion below the May budget expectation. As Swan said, the mid-year outlook shows lower unemployment, higher growth, lower deficits and lower debt compared with earlier predictions.

But it also tells another story. It gives an insight into the inevitable policy and political struggle that is going to shape the next long stage of Rudd's government. This is the battle between a disciplined recovery strategy and the vast political expectations unleashed by Labor that span health, climate change, households and defence.

Reserve Bank of Australia governor Glenn Stevens said yesterday that "growth is likely to be close to trend over the year ahead and inflation close to target". His message: policy must be geared towards managing the return to growth, not pretending huge interventions are essential to save the furniture. Through time Rudd must move fiscal policy to support monetary policy.

Swan and the Treasury are refining their instruments to impose discipline. Buried on page 32 of the outlook is the declaration that "real spending is expected to fall in 2010-11 for the first time in more than two decades". The estimate is for a real spending reduction of 1.3 per cent, an ambitious target (but helped by the withdrawal of the fiscal stimulus). Yes, this will be the first year of the second term. It highlights the strange ambivalence that will become Rudd's 2010 election manifesto: he will campaign as the Keynesian who saved the nation yet promise to reappear as the fiscal conservative who won in 2007 and always believed in sound money. How will this dual message play out?

The outlook highlights what will become the Swan mantra: the medium-term fiscal rules. Rule one is that all new non-stimulus spending should be offset by savings. Swan says this has applied since the May budget and he told this column yesterday that "it is the bridge" that lasts until rule two is triggered. Rule two is that once trend growth is resumed real spending will be limited to 2 per cent in real terms. Rule three is that upward revisions to tax receipts will be banked and go to reducing the deficit.

Swan and Finance Minister Lindsay Tanner are building their fortifications for the coming internal struggle. It will be critical to the government's future economic credentials.

They may be helped by conservative forecasts in this document. It has hefty upward revisions to growth yet little immediate effect on the budget deficits. For example, while growth in 2009-10 is now forecast at 1.5 per cent compared with a 0.5 per cent contraction forecast at budget time, the deficit forecast stays the same at just below $58bn.

Access Economics principal Chris Richardson argues the budget bottom line will be significantly stronger for both 2009-10 and 2010-11 than the Treasury indicates.

The explanation from Swan and Treasury is that while growth is stronger the gains only flow to tax receipts with a distinct lag. Swan said the revenue "gold bars" of company tax and capital gains were not expected to recover quickly. Despite the stronger growth, Treasury still estimates the total revenue collapse at $170bn compared with $210bn at budget time. Yet any error is likely to be an under-estimate of revenue strength, suggesting a stronger budget bottom line.

The pivotal struggle, however, will occur on the spending side in the next several years. In this sense the critical table (3.12 on page 54) offers two conflicting omens about a hybrid government. First, policy decisions since the budget have reduced spending by $2.1bn over the forward estimates. So it's cheers for a tough-minded government geared to spending restraint.

Yet there's a second story. It concerns "parameter and other variations" showing an increase in expenses of $1.9bn in 2009-10 and $9.7bn across the forward estimates. This contains some hefty messages; when interest rates rise then public debt costs more and many Rudd government programs are a function of take-up rates (such as the home insulation program and education funding) where extra spending is recorded under parameter rather than policy changes.

It leaves the deep suspicion that Labor's commitment to spending restraint lacks the willpower that Swan and Rudd will need to enforce.

In relation to climate change, the outlook is sobering. It opens a new door on the fiscal uncertainty surrounding the Rudd government's Carbon Pollution Reduction Scheme that was estimated in the budget to be broadly revenue-neutral. Now it is estimated to impose a net cost of $1.2bn over the forward estimates caused mainly by the higher dollar and fewer permits available for issue. Warning about the reliability of CPRS fiscal estimates, the Treasury says they depend on a range of variables such as emissions growth, future exchange rates and terms of trade fluctuations. It delivers a warning pertinent to Labor and the Coalition on "the need for caution in designing assistance measures", a mild version of warning issued by Ross Garnaut.

In the short term the Rudd government must use these estimates in negotiations with the Coalition to argue that more assistance under the CPRS is untenable. The new fiscal factor makes agreement more difficult. In the long run, however, this is really a warning to the Australian government to exercise prudence in designing its scheme to avoid damaging fiscal consequences. The outlook, overall, presages the outlines of the second-term struggle over spending restraint and raises questions about Rudd's 2010 election messages.