PM solving the wrong problem

KEVIN Rudd's recovery plan of a decade of public-sector led nation building suggests he will not use the recession to reform.

AUSTRALIA'S experience during the global financial crisis has been different in its economics and politics from that of most of the world, but our benign recession conceals unusual political, policy and intellectual traps for the Rudd government.

Australia's success, so far, has been stunning. There are two main reasons for this: the performance of the Howard government before the crisis and the response of the Rudd government to the crisis.

The Howard government left Australia, alone among industrialised nations, without public debt and without toxic loans in the banking system. This was a position of unique strength bequeathed to Kevin Rudd, despite his rhetorical distortions trying to prove the opposite.

The Rudd government earns almost full marks for its immediate response, a decisive fiscal stimulus backed by the Reserve Bank of Australia's interest rate cuts. The leadership from Treasury secretary Ken Henry and Reserve Bank governor Glenn Stevens has been conspicuous. The absence of any domestic banking crisis and the huge government-led fiscal stimulus in Beijing has helped to fuel Australia's momentum.

Nearly a year into the crisis the politics are remarkable. This event has defined the Rudd government and kept Rudd high in the polls with a bigger projected majority than his 2007 historic victory. Before the crisis Rudd struggled to find any convincing narrative, but since the crisis his storytelling has been sharp, politically effective and intellectually shoddy.

Recessions change nations and Australia will be changed by this downturn. The question is: In what direction? The answer will be provided by Rudd's government but nobody, at this point, can be sure of that answer.

The key to understanding the crisis is that this was an external event imposed on Australia. This is the difference from past recessions of the 1970s, 80s and 90s, when global downturns were accentuated by domestic failures, the main culprits, at various times, being excessive spending, wage breakouts, high inflation and monetary miscalculations.

The beauty of politics is that when failures arise they demand solutions. Much of Australia's economic reform agenda over the past generation was about correcting for such recessionary blunders: witness the emphasis on surplus budgets, an independent central bank, the ALP-ACTU accord followed by labour market deregulation and exposing Australia to global competitive pressure by opening its economy.

What is the lesson for Australia from the present crisis?

Rudd has written two essays on this subject. In the first he attributed the crisis to unrestrained free markets and neo-liberalism and called for a new epoch based on social democratic capitalism. This is a popular Labor Party position.

Its problem is that there was no such era of neo-liberalism in Australia. Rudd's economic advisers know this. Treasury deputy secretary David Gruen was honest enough in his recent Sydney Institute speech to say: "Certainly I cannot recall any time over the past several years when an Australian policy-maker has extolled the virtues of leaving the financial system largely to regulate itself." Not one. Yet this was Rudd's precise definition of neo-liberalism.

There are a number of critiques of Peter Costello as treasurer. Thinking he was a neo-liberal on financial policy is not among them. Costello believed in financial regulation: he created the Australian Prudential Regulation Authority, kept the four pillars policy to limit unrestrained bank competition and repudiated business lobbying that had any let-it-rip mentality. At the same time the Reserve Bank ran a tight money stance to contain asset price pressures.

Rudd's neo-liberal critique is a handy device to attack his political opponents. The bigger question, however, concerns the policy consequences of Rudd's conclusion. The point is obvious: if Rudd makes the wrong diagnosis about Australia then the wrong policy remedy will follow.

In Rudd's second essay last weekend he focused on the recovery and offered the paradigm of "the building decade" as the overarching political theme. Again, the appeal of such an old-fashioned pitch is obvious. But can Rudd be serious in arguing that nation building is the main policy lesson from this event? Rudd boosts this idea from schools to national broadband but the ongoing financial foundations for such nation building will be limited and must be tied to financial rates of return to avoid large-scale rorts.

It is the conflict in Rudd's messages between policy and politics that generates constant doubts about his real priorities.

In his second essay, Rudd rightly focuses on the need to withdraw the stimulus over time, retire debt and look to productivity. Keen to manage expectations, he warns that a benign recession will be followed by a tough recovery. Unemployment will be rising, revived growth will provoke higher interest rates, more demand and commodity price rises will drive inflation; the return-to-surplus pledge dictates what Rudd calls "unpopular decisions" as federal spending is kept to 2 per cent in real terms for many years.

Last week Access Economics described the task in these terms: "The 2 per cent rule doesn't sound scary and hasn't lost any votes so far, yet it implies a tight straitjacket on federal spending in coming years. You may be surprised to know that, after 4 1/2 years, the cumulative impact of the 2 per cent real rule will be devastating. It would, for example, be the equivalent cost savings from abolishing the Defence Department, or it would be the equivalent of the savings the government would make from lifting the age pension not to 67 but to 107."

This is a far cry from the present surrealism. "Most strikingly of all, the average Australian family is spending 6per cent more at shopping malls than they were when this crisis first hit last September," Access Economics says. "No other comparable nation can claim the same. We have spent our way through the most dangerous spell in the global economy in 60 years."

This will come to an end. The global downturn is still chasing Australia; Treasury estimates that falling commodity prices will remove about 3 per cent from national income over the coming year at the same time the cash splash fades. Rudd knows the economy will get much worse before it gets better. This is the immediate trap he must manage.

The bigger issue is the recovery strategy. Political leaders typically use recessions to alter the political climate in favour of new reformist agendas that were previously unobtainable. Not Rudd. This is not his style. He feels it is not necessary. Indeed, he feels that he had it right anyway.

His recovery policies outlined in his second essay are mainly his pre-crisis agenda of regulatory reform, more infrastructure, a national broadband network, the skills and education revolution and a broad-based tax reform.

This raises the question: How much has the crisis changed Rudd's underlying thinking? This has been a global crisis but, so far, there is no Australian crisis. Rudd's response is marked by a dramatic short-term stimulus backed by a remarkably unaltered long-run policy framework.

Rudd is sticking by his pre-crisis agenda for change and believes the crisis gives this a new validity.

The doubts are whether his social democratic capitalism and nation building are the right lessons to draw from the crisis.