Painful adjustment for spendthrifts

ROSS Garnaut has given a sharp warning to the Rudd government by arguing that the global financial crisis legacy for Australia is more serious than has been assumed and that the community has "barely begun" to grasp what lies ahead.

Garnaut told a Lowy Institute audience on Monday night that Australia should expect a contraction in living standards. His concern was that "the Australian community has not focused at all on the difficulty of the task".

This reinforces the alarm siren in his book The Great Crash of 2008 where Garnaut says of Australia: "There are hard times ahead. Sustainable full employment will require reductions of average incomes and living standards below those to which Australians became accustomed before the crash. The Australian government, community and business leadership has barely begun to contemplate the adjustment that is required. There is a danger that the lack of awareness of the hard realities will lead to poor management of the difficult days of economic policy."

This should make for another interesting book launch when Kevin Rudd launches Garnaut's book at Parliament House tomorrow at 10.30am.

One of the sub-themes of Garnaut's work is that Australia, despite the soundness of its banks, misjudges the extent to which the crisis will demand serious economic and social adjustments. This is tied to another concern, that public policy in Western democracies will deteriorate post-crisis because of the interaction of government intervention and interest group political lobbying.

Keen to expose the unreality of our present debate, Garnaut highlighted at the Lowy Institute the Coalition's demands for more assistance for business, industry and electricity generators to cope with the emissions trading scheme. It followed his argument last week on ABC1's The 7.30 Report that the ETS "has been one of the worst examples of policy-making we have seen on major issues in Australia", a manifest dig at Rudd.

For Garnaut, this is part of a deeper problem that may yet define Australian politics.

He does not believe Rudd can deliver on "current community expectations about continuations of increases in defence expenditure, health expenditure, big payments in free permits for climate change compensation". That is, the present political dynamics conflict with coming economic reality.

Garnaut's book is devoid of any Australian triumphalism about its performance during the global crisis. Indeed, he offers a different story. For Garnaut, a nation's recovery from the crisis will depend on three factors: how much its banks failed, how serious was its current account deficit before the crisis and how much its terms of trade have deteriorated.

Judging these three tests, he finds Australia has two strikes against it. He argues the high current account deficit and terms of trade deterioration mean that "Australia will have to reduce average consumption levels more than most countries if it is to restore full employment on a sustainable basis".

One of the contentious aspects of Garnaut's book is his criticism of the Reserve Bank of Australia and Treasury as well as past economic policy under the Coalition.

He believes Treasury was too complacent for too long about Australia's current account deficit.

"Nowhere was the complacency about external payments deficits more pronounced than in Australia," he said. "There is no comfort in a deficit having its origins in excessive private debt. In a crisis private obligations become public liabilities in an afternoon. The Australian Treasury before the crash had become a voluble defender of the view that current account imbalances are irrelevant to macro-economic policy."

Given that huge external payments imbalances underpinned the global origins of the crisis, Garnaut predicts post-crash a far more prudent view about current account deficits.

Garnaut has long believed the Howard government spent too much of the pre-crash national income from the commodities boom. He brands Australia as "the spendthrifts of the early Platinum Age". He says that nations where government and private spending expanded too much because of high commodity prices will face "dreadful problems when it becomes necessary to adjust to lower living standards as prices fall to more normal levels".

This realisation is about to become "most vivid" to Australians because we were spending beyond our means before the crisis.

This point is consistent with Treasury's warning last May that the Australian budget was deteriorating from 2002-03 and moved into a structural deficit in 2006-07. Former treasurer Peter Costello says such an analysis was not provided to the former government. Indeed, it seems at the time Treasury was satisfied with Howard-Costello budget surpluses.

Garnaut's sense of urgency about Australia's structural adjustment drove his comments that because the economy is recovering faster than expected the correct response is "to pull back the stimulus at a faster rate". Understand this issue is not just about the stimulus but about the severity of the adjustment Australia faces.

The book offers a lethal indictment of the global financial system, whose benchmarks are set in the US. Its failure was comprehensive: intellectual, regulatory, political and moral. In the end the system "distorted, disguised, hid and forgot risks that were as real as bricks and mortar". This interpretation is fully consistent with Rudd's analysis in The Monthly.

But Garnaut issues another series of warnings about the so-called solutions. He fears the flaws in the financial system may not be addressed because of Wall Street lobbying. He is alarmed that bailouts with public money mean the guilty are being saved and expect to be saved again, creating "moral hazard on a scale the world has never seen before".

He fears the real problem, which is proper regulation of the financial system, may not be implemented. Yet an alternative phony problem may be addressed instead, that governments will justify intervention in other parts of the market economy that are working effectively.

This penetrates to the intellectual inheritance from the crisis. Garnaut sounds his alarm with these words: "The lightly regulated market economy has always been tolerated rather than embraced in the late 20th and early 21st centuries. Following the crash, it is now under fundamental challenge everywhere. The tolerance was warmest in the Anglosphere and there it will be most severely tested by the longstanding fiscal hangover from bailing out finance. It would be a mistake, one with fateful consequences, to expand the role of government in the economy in general."

At this point, however, an expanded role for the state seems the sure consequence of last year's crash, butwatch for the stance Rudd adoptswhen he grapples with Garnaut's conundrums.