Two cheers for Rudd

THE beloved claim that Australia has spent a decade Americanising its values and institutions and indulging in free market neo-liberalism has been exposed as the ultimate absurdity. The nadir of George W. Bush came this week when the President put a loaded political gun to the head of Congress and said unless his bailout plan was passed the nation faced a "financial panic". This is how the Bush debacle is ending. It constitutes a warning only made more extraordinary because it contains strong elements of truth.

The difference between the Australian and American systems of capitalism has rarely been so stark. Kevin Rudd in New York at this time of crisis - a fortuitous accident - deserves two cheers for his response.

Rudd is right to stress the strength of Australia's financial system. He is right in his UN speech to talk up initiatives to restructure global financial rules. But he has failed to exploit the worst financial crisis for half a century to wind back dangerously high expectations in Australia about budget handouts for welfare and corporate interests. Rudd needs to shift Australia's political debate and culture from the 2007 campaign to the 2008 global crisis.

With US banks in crisis, Reserve Bank governor Glenn Stevens issued the Financial Stability Review this week. It says: "The Australian financial system is well placed to weather the current difficulties in the global financial system.

In contrast to many banking sectors across the world, the Australian banking sector continues to be highly profitable. The system is soundly capitalised and the banks have high credit ratings and relatively little exposure to the US sub-prime related assets or to market risk from trading activity." Rudd is a lucky PM, having this inheritance. Our governments, regulatory agencies and banks declined to follow the American model.

Bush's speech depicted a wasteland that beckoned without congressional approval of the $US700 billion rescue plan. "Our entire economy is in danger," Bush said in an address to the nation. "More banks could fail, including some in your community. The stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet. Foreclosures would rise dramatically. If you own a business or a farm, you would find it harder and more expensive to get credit. More businesses would close their doors and millions of Americans could lose their jobs."

Even for a chief executive keen to intimidate Congress, it is an abject list of his own failures and those of the key US agencies, including the Federal Reserve. Australia, by contrast, was largely successful in supervising its private credit and eliminating its public debt. But the shadow of downturn and recession now engulfs much of the developed world: America, Europe, Japan and New Zealand. This is likely to be the making or the breaking of the Rudd Government. Rudd's policy responses so far have been sound but his political strategy needs to be refined.

While the gravity of the crisis cannot be predicted, Rudd realises the broad impact on Australia. He said from New York that the crisis was global, that it would reduce world economic growth and that it would have a dampening effect on Australia's economy.

In reality, it will intensify pressure on corporate balance sheets, profits and investments. Sharemarket confidence has taken a big hit. Superannuation accounts for Australians will be punished. Net household wealth will be reduced. The Government's ambitious infrastructure plans will need to be adjusted because less private sector borrowing will be available and more public sector borrowing will be needed. The global credit crunch follows the six-year-long monetary policy tightening by the Reserve Bank to squeeze inflation from the economy, a squeeze that has changed the behaviour and outlook of many Australians.

The Reserve Bank says housing credit - the bulk of household borrowing - is at about its slowest pace since the mid-1980s. Stevens raises the prospect of deeper social and economic change that may define the Rudd era: a reversal of the great debt binge by Australian households. Stevens says there is a "good chance that households will for some time seek to contain and consolidate their debt, growing their consumption spending at a pace closer to income than in the recent past", ending the big financial story of the past 15 years.

The logic in this context is for Rudd to reduce expectations within Australian society for handouts, whether for welfare or business subsidies. Australia may not be the US, but pretending that Bush's message belongs to another planet entirely would be a mistake.

ANZ Bank chief economist Saul Eslake says: "The most likely scenario for Australia as we head towards the next election is that unemployment will be a bit higher and interest rates will be lower. One of the consequences of the global credit crisis is that inflation will fall and thus create more scope for the Reserve Bank to lower interest rates."

This suggests that for Australia the present crisis has positives as well as negatives. If Australia's downturn is more serious, the Rudd Government (unlike the Bush administration) has a big surplus from which to stimulate the economy while the Reserve Bank has Australia's high interest rates, which it can unwind.

But the crisis is destined to create an issue between Rudd and the banks. The Achilles heel of the Australian economy is the current account deficit. Australia has the world's fourth largest current account in dollar terms after the US, Spain and Britain. Eslake argues this is the "lone gap in our defences".

He says: "Our banks are reliant on wholesale funding to raise short or long-term debt and this is our principal means of financing the current account deficit. The situation, as the Reserve Bank points out, is that our banks are still able to finance this debt but they have to pay more to do so. The premium they have to pay for short-term wholesale funds has risen over the past fortnight to about 80-100 basis points, from about 35 basis points before the latest blow-up and less than 10 basis points before the crisis started last July.

"The difficulty this creates for the Government is that if these funding costs persist and the Reserve Bank cuts the cash rate by, say, 50basis points, it will be extremely difficult for the banks pass on the full amount."

The real message is that Rudd needs to get the balance right. He must reassure Australians but not pretend Australia is immune, explain that an externally located crisis will still have a negative impact on Australia and argue that while Australia is well placed to avert recession, its growth will slow and its expectations should be reduced. The sooner Rudd does this the better. He should prepare a statement along these lines after his return.

The crisis will become a test of the Rudd Government's judgment.

It suggests the Government got the May budget correct in its balance between anti-inflation and maintaining activity. But Rudd must further adjust policy and political settings, with the prize, if he gets it right, being the mantle of economic credibility.