Crikey

As the government puts the finishing touches to its budget, the biggest questions are how long the current recession will last and what form the recovery will take. In recent weeks, there has been something of an upsurge of optimism, reflected in widespread use of the phrase “green shoots”, first used in this context by Ben Bernanke on 15 March. Bernanke has a gift for the telling, if not always accurate phrase. He popularised the term “Great Moderation” used to describe the claim, widespread until 2008, that financial deregulation and improved monetary policy had permanently reduced macroeconomic volatility.

On most standard measures of US and global macroeconomic performance, it is hard to discern Bernanke’s green shoots. Unemployment is still rising (male unemployment in the US is now nearly 10 per cent), output is falling, and the markets at the core of the crisis, US housing and construction markets, are still falling.

Nevertheless, the situation has improved perceptibly since the beginning of the year. In particular, financial markets have been stabilised to the point where the risk of a complete collapse, comparable to the Great Depression, appears to have been averted. Risk measures such as the LIBOR spread have returned to normal levels, and, for firms and households with strong balance sheets and a desire to invest (both groups much smaller now than a year ago), credit is available.

That doesn’t mean that the banking system is out of the woods and, in this context, the ‘stress tests’ of US banks recently released by the US Treasury, represent an optimistic scenario, the product of bargaining between the government and the banks. Still, even if the actual outcome is substantially worse, it seems likely that the government has the resources to keep the system afloat.

More importantly, the end of the banking crisis does not resolve the imbalances that ultimately generated the financial crisis. Unsustainable patterns of borrowing and consumption, at the household and national level, need to be reversed and the adjustment process will inevitably be painful. This is true of Australia, where household debt has exploded, as well as of the US, though the stronger position of the public sector here gives us some big advantages.

In the real economy, there is a similar feeling that the risk of total collapse has been averted. The vast stockpiles of cars and other goods that piled up on wharves in the early months of this year are being whittled away, and more normal patterns of international trade are being restored, though total volumes of imports and exports are still declining.

The end of the “cliff-diving” period in which measures of economic activity dropped precipitously does not, unfortunately, imply that recovery will begin soon. The decline in activity will slow down, and probably level out for some time before being reversed. Hopefully, the implementation, in the second half of the year, of spending initiatives that have already been announced will improve things. Still, it is hard to foresee a general upturn in global economic activity before 2010, and it will be some time after that before pre-recession levels of output and employment are regained.

Thus far, Australia has escaped remarkably lightly from the global crisis, and tomorrow’s budget projections will presumably reflect this. It is possible that some kind of recovery will emerge later in the year, and that unemployment rates can be held below 8 per cent, a rate that has already been surpassed in the EU and US.

On the other hand, there are some serious vulnerabilities yet to be faced. Thanks to long-term contracts, the full impact of the crash in demand for commodities has not yet made itself felt. Even more seriously, Australia experienced a house price bubble as big as any in the world, but has so far experienced only a modest correction. A bursting of the bubble, as in the US, Ireland and Spain could be very painful.

The problem for the government in framing a fiscal policy response is that it needs to provide both a credible stimulus to the economy and a credible commitment to return to surplus and then to pay down the accumulated debt that will arise from the recession. Given that depressed conditions are likely to persist for some time, any savings that can be made in public expenditure (including favoured Treasury targets such as tax expenditures and “middle class welfare”) will be more than offset by increased demands in other areas.

The government’s only possible route to solvency is a substantial increase in the tax revenue share of GDP. An important first step is the cancellation or indefinite postponement of the second and third stages tax cuts promised in 2007. This would of course, entail breaking an election promise. Under normal circumstances, the need to restore trust in public processes would outweigh economic considerations. But these are not normal circumstances and the government has already acknowledged that not all promises can be delivered.