Memo Coalition: Why our bond yields are falling

LAST week, while our attention was diverted, something amazing happened. In effect, global investors paid the German government to borrow their money and return it in 10 years' time.

Sure, there was a catch. The investors bought inflation-indexed bonds, which means the money they get back in 2022 will have grown to match inflation in the meantime. If inflation in Germany in the next decade is the same as in the previous one, that means if they invest ?10 million ($A12.8 million), they'll get back ?11.675 million. But in 2022, that will buy them only what ?10 million buys them now.

And to park their money like this, investors paid the German government 0.24 per cent of the amount they invested: ?24,000 for every ?10 million. Imagine if the Commonwealth Bank or NAB were to pay us to borrow money from them, and then we eventually pay them back just the amount they lent, plus inflation. Any volunteers?

It shows you how fear has taken over among global investors. They are pulling out of stock markets because they sense they are more likely to lose money there than make it. And they are putting that money in low-risk bonds regardless of how little they pay.

It was not the only coup Germany pulled off last week. It also offered a two-year note, on which it promised to pay no interest at all. Give us ?10 million now, and we'll pay you back ?10 million in 2014; that's the deal. To get investors into this one, the Germans did have to pay a small yield, but just 0.07 per cent. That's value!

Rabobank International strategist Richard McGuire summed it up neatly: "It reflects the now-familiar crisis-induced trend of investors favouring the return of their money over a return on their money."

When confidence is high, investors buy shares or other ventures offering good returns, accepting risk. But in a crisis, as in Europe now, they sell shares and retreat to the safety of the bond market. And there, they lend to governments they know will repay them, not to those offering high returns.

In Europe, pre-crisis bond yields differed little from one country to another. Now the gaps are huge. At last count, 10-year bond yields were 1.37 per cent for Germany and 2.5 per cent for France. But for Italy, they were 5.79 per cent, in Spain 6.32 per cent, Ireland 7.46 per cent, Portugal 12.37 per cent and Greece 29.68 per cent. Countries regarded as safe are issuing debt more cheaply than ever before. Countries in trouble are finding debt either expensive or impossible to issue.

Australia is one of the winners. The Australian Office of Financial Management, which manages the government's debt, has won Risk magazine's global award as sovereign risk manager of the year twice in the past four years. Yields have plunged for Australia's Treasury bonds, inflation-indexed bonds and notes which in turn set benchmarks for yields on bonds issued by Australian companies.

Since 1998, our bond yields have usually ranged between 5 and 6 per cent. But in recent days, the Office of Financial Management issued a new 10-year bond at a yield of just 3.15 per cent, a five-year bond at 2.65 per cent, and a three-year bond at just 2.52 per cent. Yields have fallen by half in a year.

Why? Because global investors have flocked in to buy Australian government debt. Their concern is not that we have too much debt, but too little. IMF figures show that of the 34 advanced economies, Australia has the third smallest ratio of gross debt to GDP: including state and municipal debt, it's just 24 per cent of GDP. By comparison, Germany has a debt-to-GDP ratio of 79 per cent, the United States 110 per cent, and Japan 241 per cent.

The Coalition and its allies are like a broken record warning that Australia is swimming in debt and putting itself in danger. That is simply untrue. Ask yourself: if Labor's borrowing has put us in danger, why is Australia one of only eight countries rated AAA by all three global ratings agencies? Sure, ratings agencies make mistakes, as we all do, but are they that incompetent?

The surge in demand for Australian bonds that has driven yields down has come from overseas buyers. Are these investors incompetent in seeing Australia as a safe bet? No. Rather, the Coalition is using rhetoric to make a dangerous case that doesn't stand up. Australia's debt levels remain very low by world standards. Net debt is expected to peak at less than 10 per cent of GDP here; in Greece, it's about to hit 160 per cent. That's some difference.

The question we should ask is: why aren't our debt yields even lower? Other AAA-rated countries pay far less to borrow than we do. Even the US and Japan, on lower ratings and with critical long-term debt problems, are paying only half to a quarter as much.

The reasons are not clear, but there are several suspects. Because Australia has so little debt, it is less easy to trade, which imposes a premium. Our inflation rate is still a bit higher than in Europe, Japan or the US, which puts a floor under the yield. We are far from the bond traders, and less well known.

And foreign investors are wary of a nation where house prices are so high relative to income, where for 30 years the current account on average has been in deficit by 4 to 5 per cent of GDP, and where banks have a lot of short-term foreign debt, and far fewer foreign assets.

That is what a Coalition government would inherit. It should be thinking about it now.

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NZ budget: toned down

THEY'RE like us, but different. New Zealand's 2012-13 budget cracks down on tax breaks for "baches", axes tax breaks for childcare and frozen subsidies, and hikes repayment rates for student loans to stick to its target to get the budget back in surplus by 2014-15.

In a budget criticised by commentators as dull and contractionary, Finance Minister Bill English also promises New Zealand its own Future Fund, financed by the sale of minority stakes in Air New Zealand and four electricity generators.

The budget is mostly normal. It raises more than $A1 billion from tax and revenue rises, and $A1.75 billion of spending cuts, and spends it in health and education, fixing the country's rail freight lines, and rebuilding Christchurch after the earthquake.

The bottom line ends up where it started, with net new spending of just $A20 million over four years, and a deficit edging down from $NZ8.4 billion ($A6.5 million) this year to a tiny surplus of $NZ197 million by 2014-15 all going well.

Last year's ambitious forecasts have been slashed to predict growth averaging 3 per cent over the next four years. Net debt is forecast to peak at 28.7 per cent of GDP in 2013-14, compared with a peak of 9 per cent forecast in Australia.

Next year's deficit is forecast as $NZ7.9 billion, with more than $NZ2 billion, 1 per cent of the country's GDP, being spent to rebuild Christchurch and other earthquake-damaged towns.

The tax rises primarily hit smokers and tax avoiders. Excise duties on cigarettes will rise 10 per cent above inflation for each of the next four years. And as in Australia, the government will be hiring more tax investigators to stamp down on avoiders.

But the budget also took on some sacred totems. New Zealanders renting out their holiday homes (or baches) will no longer be able to write off the full cost against tax. Tax credits for childcare, housekeepers and low-income earners will all be scrapped; Revenue Minister Peter Dunne said the threshold for the low-income-earner credit is so low that no full-time workers now qualify. And with the government under far less pressure than in Australia, the budget could tackle some long-term issues above all, Prime Minister John Key's crusade to tackle inherited welfare dependency, particularly high among Maori and Pacific Islanders.

The budget freezes subsidies for childcare centres in most of New Zealand and invests the money saved to set up new centres in disadvantaged areas, put $NZ1 million aside to provide "long-acting reversible contraception" to young women at risk, and pump more money into youth services and welfare-to-work.

The initiatives come out of two reports Mr Key commissioned into why New Zealand has the OECD's highest rate of youth suicide, and so much inherited welfare dependency. Both reports told him that early intervention to keep young people out of trouble is far more successful and cost-effective than anything you try to do once they're in it.

You can't imagine Julia Gillard or Tony Abbott giving these issues priority over those that chime with focus groups. But Mr Key who grew up on a welfare housing estate in Christchurch before making millions as a foreign exchange trader set himself three targets to meet:

98 per cent of young Kiwis to be in early childhood education by 2018 (up from 94.7 per cent now).

85 per cent to successfully complete school by 2017 (up from 68 per cent now).

Reduce the proportion of prisoners reoffending by 25 per cent by 2017.

"We firmly believe that people who can work, should work," Mr Key said.

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We're importing skilled workers, but not into mining towns

Most skilled workers brought into Australia under section 457 visas are settling in Melbourne and Sydney, not in mining towns facing skills shortages, research reveals.

Demographers from the centre for population and urban research at Monash University say data on skilled migrants in 2010-11 suggests most of them are not in jobs related to mining, even though that is the rationale for Australia's open-door policy.

They say the record quota for skilled visas assumes "that there are nation-wide shortages of skilled workers, and that employers everywhere should be allowed to sponsor 457s and permanent migrants in any skilled occupation, industry or location.

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OECD wants growth rather than austerity

THE Organisation for Economic Co-operation and Development has urged Europe to shift its economic tack by adopting a growth compact , including interest rate cuts, infrastructure investment, and ultimately, the issuance of eurobonds.

In its half-yearly Economic Outlook, released overnight, the OECD cautiously throws its weight behind the snowballing demands for the European Union to reweight its economic policies to give more priority to growth rather than austerity and low inflation.

Its economic forecasts are heavily qualified, as they rest on the assumption that policy actions will be sufficient to prevent destabilising euro developments, that there will be no major disturbances affecting oil prices, and that disruptive US fiscal consolidation will be avoided .

If those assumptions are right, the OECD estimates GDP growth in 2012 will be 3.1 per cent in Australia, 2.4 per cent in the US, 2 per cent in Japan, 1.6 per cent in the rich world as a whole and -0.1 per cent in the eurozone, ranging from 1.2 per cent in Germany to -5.3 per cent in Greece.

The OECD does not challenge the EU s fiscal compact, which requires EU members to slash their bloated budget deficits to below 3 per cent of GDP by next year, other than to urge that if growth slumps, countries should abandon the targets rather than try to meet them at all costs.

But while noting that prospects for the global economy are somewhat brighter than six months ago , when markets were paralysed with fear of government debt defaults and bank failures, it warns that the risks facing the world are extensive, and primarily on the downside .

The OECD warns that the eurozone crisis is the biggest risk to the global economy and urges the EU to try radical new measures to restore confidence and growth.

In particular, it urges new issues of jointly guaranteed government bonds to refinance Europe s troubled banks, and allow them to write off bad loans. It suggests this could be a step towards the future issuance of eurobonds, which would allow Greece, Ireland, Spain, Italy and other troubled countries to borrow from global markets without prohibitive costs.

France s new President, Francois Hollande, will propose eurobonds tonight at an informal summit of EU leaders called to debate Europe s recession and the crisis of confidence surrounding its banks and government debt.

German Chancellor Angela Merkel firmly opposes any move to centralise debt issuance. Germany s 10-year bond yields have fallen to record lows, just below 1.5 per cent, with widening spreads to other EU members. Yields for French bonds are almost 3 per cent, Italy and Spain close to 6 per cent, and Greece in the 20s. For Germany, a move to eurobonds could be expensive.

An economic think tank based in Paris and financed by its 35 rich and middle-income member governments, including Australia, the OECD is a fringe player in the policy contest now being fought out all over Europe, from national leaders at summit meetings to the voters at the polling booths.

But its endorsement counts for something when new economic policies are in the wind.

Its new report does that, in suggesting that the EU s proposed growth compact includes increased mutualisation of risk by:

Issuing jointly guaranteed government bonds to help recapitalise Europe s banks and encourage them to write off bad loans.

Increasing the resources of the European Investment Bank so it can step up financing new projects in transport, energy and communications infrastructure.

Growth-friendly structural reforms, agreed jointly by a range of countries, to liberalise labour markets and product markets, particularly opening new opportunities for service industries.

An easing of monetary policy by the European Central Bank, in view of the minimal risk of an inflation breakout.

The risk of disruptive policy changes has probably increased, the OECD observes. Against the backdrop of fiscal consolidation, increased inequality, and high and rising unemployment, a sense may be spreading that the burden of the crisis has not been shared fairly.

This risks giving rise to policy upheavals with adverse long-term, and possibly near-term, effects on growth prospects.

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We watch as Europe struggles in quicksand

THE immediate future of the global economy, including Australia, now depends on Europe, and whether it can restore confidence to markets. If European leaders can resolve their tangle of problems, growth is ahead of us. If they can't, all bets are off.

Pessimism comes more naturally than optimism. It is now five years since we first heard the phrase "the sub-prime crisis", which rang the end of a golden era of debt-financed growth. Since then, we've had years of recurring crises, summits and resolutions that promised to solve the problems, but haven't.

Australia escaped the damage through a combination of luck, circumstances and good policy. Our banks did not go broke, because the Australian Prudential Regulation Authority did a great job as watchdog, our real estate boom gave banks ample opportunity for growth and, when the crisis hit, the government guaranteed their debts so they could keep borrowing.

The government did not go broke, either. Two decades of asset sales and bipartisan fiscal discipline have made it a net creditor, so it could deliver quick, decisive and well-targeted stimulus measures while maintaining a AAA credit rating. And even bigger stimulus in China saw demand for our exports keep growing in 2009 as the world's exports shrank.

In Europe it was different. To understand where it is now, it's worth taking a look at how it got there.

The euro was born in the '90s as part of the grand vision to create a European government and identity alongside those of the nation states. It promised economic gains: reducing transaction costs, giving business a bigger and more stable market, and creating a currency too big for the speculators to take on. And it has delivered those gains.

But it also brought new problems. Interest rates could no longer be set to fit each country's needs. Countries in trouble would no longer see their competitiveness restored by a falling currency and falling interest rates. And that meant fiscal policy government spending and tax cuts had to do all the work when things went wrong.

Europe's leaders saw that this would require tighter fiscal discipline. As a first step, they agreed to limit their deficits to 3 per cent of GDP, except in exceptional circumstances, and their gross debt to 60 per cent of GDP. Some governments took these goals seriously. Others, including Germany, Britain, France and Italy, did not.

In 1992, when that deal was agreed, the future eurozone had an average government debt of 56 per cent of GDP, and Australia 28 per cent. By 1993 the eurozone's debt crossed its self-imposed 60 per cent threshold, never to return. This year, even with all the austerity, its gross debt will average 90 per cent of GDP, and Australia (including the states) 24 per cent.

Lack of fiscal discipline was one cause of Europe's problems, although only Greece was seriously delinquent. Some countries also resisted reforms. That partly reflects the social conservatism of tribes with a long history low rates of workforce participation by women and older workers in Greece and Italy; shops closed at weekends; pensions at 60 but also shows a lack of political courage to tackle reforms. Even in per capita terms, Europe has grown more slowly than the US or Australia, and tolerated higher unemployment.

But this crisis was caused by Europe's banks. They were big, gullible investors in US sub-prime loans. In many countries, above all Spain and Ireland, they financed real estate bubbles so large they were bound to burst, with devastating fallout. Ireland's banks collapsed, and were bailed out at great expense by Irish taxpayers. In Spain, where one in four home owners now owes more than their property is worth, the banks kept refusing to admit their losses and have lost the trust of investors.

The problems are different in each country. In Greece, government debt is the problem. In Spain, it is the banks. In Ireland, it has become both. And all of them have massive unemployment: 5.5 million people in Spain, almost 3 million in France, 1 million in Greece, 300,000 even in little Ireland. And with their economies going backwards, voters are demanding not more austerity, but growth.

Under the EU's fiscal pact, however, austerity is what they're getting. The pact requires governments to cut their deficits below 3 per cent of GDP by next year. Last year 17 of its 27 members were above that threshold, many of them hugely so Ireland had a budget deficit of 13.1 per cent of GDP, Greece 9.1 per cent, Spain 8.5, Britain 8.3. But they also have very high unemployment and shrinking economies. More austerity will mean far more pain ahead.

The austerity push is driven by Europe's most successful economy, Germany, which is booming due to its state-of-the-art manufacturing industries, especially in machinery. Germany is prepared to add a "growth package" to the austerity pact, which would focus on infrastructure investment and be financed by the EU. There is debate over what more should be done to safeguard the banks. Should the European Central Bank, for example, became a lender of last resort if banks face a run by depositors? Should it invest in the banks when governments lack the capacity to do so and private investors lack the trust?

But on one key question, the EU has not budged. EU President Jose Manuel Barroso has drawn the line at renegotiating the fiscal pact itself, even though its economic (and political) consequences look increasingly dangerous. With all the austerity imposed in Greece, for example, it is running a bigger budget deficit now than when it started, because its economy has shrunk 20 per cent. It's like a dog chasing its tail. You can't generate growth through austerity.

Perhaps the real options will emerge after the Greek election on June 17. The EU and Germany want Greek voters to make it a referendum on whether or not they should stay in the eurozone. But if last week's market plunge continues, or the run on the banks in Greece and Spain gathers strength, time may not be on the EU's side. And it is hard to see where a real solution lies.

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Global crisis as shares crash

GLOBAL financial markets have slid into a crisis of confidence, with depositors reportedly pulling their money out of banks in Greece and Spain, and Australia's share prices crashing yesterday in their biggest fall of the year.

More than $110 billion has been wiped off the value of Australian stocks in May, with $35 billion stripped from share values yesterday alone. The ASX/S&P 200 index fell 2.7 per cent or 131 points to close at 4026.5, its lowest level for six months.

The Australian dollar fell briefly below US98? before closing local trade at US98.18?, also a six-month low. It has fallen 9.25 per cent since the start of March, amid growing concerns about recession in Europe and a slowdown in China.

Gloomy data from China sent markets down further yesterday afternoon. Official figures showed home prices falling in 46 out of 70 cities surveyed and stockpiles of unsold cars rising sharply. Goldman Sachs lowered its June quarter growth forecast from 8.6 to 8.1 per cent, while economists from the China's State Information Centre forecast growth to fall to 7.5 per cent.

Federal Treasurer Wayne Swan last night issued a reassurance that prospects for Australia and the region remained healthy. But Mr Swan spent much of the afternoon and night on the phone with other finance ministers, debating what steps could be taken to restore confidence.

Australia is seen by global markets as a fair-weather investment. Money piles in here when times are good, and moves out when times are bad.

The plunge so far bears no comparison to the panic of September 2008, but with no light showing in Europe's tunnel, the future is uncertain.

Financial markets believe the Reserve Bank board will deliver another interest rate cut to restore confidence when it meets on June 5. It remains to be seen whether the banks will pass on all the cut to customers.

ANZ bank chief Mike Smith said Australian banks were still able to raise finance on global markets. ''European funding markets are essentially closed at the moment because of the uncertainty in Europe, however Asian and US markets remain open'', he said. ''Australian banks are well placed right now''.

Mr Swan said Australia's fundamentals remained solid.

''We have rock-solid public finances, one of the strongest financial systems in the world, low unemployment, solid growth, a massive pipeline of investment over long-term horizons, a reaffirmed AAA credit rating from all three global ratings agencies, world-class regulators, and a proven track record of dealing with global instability,'' he said.

Yesterday's market plunge was part of a global slump, after a report that nervous investors in Spain withdrew more than ?1 billion on Thursday from the troubled Bankia group.

The Spanish government, which has taken over the bank, denied the report, but shares in Bankia slumped 30 per cent.

Earlier, the head of Greece's central bank said depositors had taken ?700 million (about $A900 million) out of Greek banks after the May 6 election left the country without an elected government.

A run on the banks would create a serious risk that the European crisis could spiral out of control. The Greek crisis has left no one in charge, just a caretaker government that has no ability to borrow the funds its banks might need to survive.

Overnight in Europe, Moody's cut the ratings of 16 Spanish banks, citing the country's deepening recession and increasing losses on real estate loans. Fitch Ratings dumped Greek government bonds into a C-class rating, saying the Greek election results showed a lack of public and political support for the austerity pact the previous Greek government had negotiated with European authorities.

Investors are retreating from sharemarkets to park their money in safe places, such as government bonds, where their capital will remain intact even if the yield is low.

On Wednesday, the Australian government sold a new tranche of 10-year bonds at a record low yield of just 3.36 per cent, compared with 5.48 per cent a year ago. But yesterday the demand for bond futures was so intense that the implied yield sank to 3.035 per cent.

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Why BHP wants to be free of unions

BHP Billiton has one key goal in demanding reform of industrial relations law: it wants its managers to be free to manage the business as they see fit.

The issue is not primarily about wages, or productivity, but power. BHP wants to get the unions out of its decision making.

In the wake of BHP chairman Jac Nasser's broadside on Wednesday against the Fair Work Act, the mining tax and Australia's high-cost economy, Employment Minister Bill Shorten hit back, blaming BHP itself for its problems.

"If a company is struggling to persuade its long-standing workforce of the case for change, then perhaps the problem isn't just the law, maybe it's the way the case is being put, and the engagement of the workforce," Mr Shorten said.

The ACTU Congress condemned "BHP's pursuit of safety deregulation, that would transfer vital safety roles from qualified workers on the job to management". It declared support for the 3500 coalmine workers in Queensland's Bowen Basin in their 18-month campaign of industrial action against the BHP Billiton Mitsubishi Alliance (BMA).

BHP sees it differently. The list of complaints in its submission to the review of the Fair Work Act is mind-numbing in detail. Most relate to just one of its five key principles of industrial relations: "management's retention of the ultimate responsibility and right to run the business with employee consultation not elevated to a right of veto over operational decision making".

"BHP Billiton contends that the legitimate sphere of enterprise agreements is entitlements for employees in respect of their wages and conditions of employment," it says. The Fair Work Act, it argues, goes beyond that, to allow "interference with managerial decision making".

The submission was lodged in February, two months before BMA took the drastic step of closing its Norwich Park coalmine, in part due to industrial action led by the Construction, Forestry and Mining Employees Union over a proposed enterprise bargaining agreement.

The agreement, which would cover the mines operated by the BMA in central Queensland, offers annual wage rises of 5 per cent for the next three years, plus a production bonus of $15,000 a year. It was rejected overwhelmingly by workers at meetings last October. But a postal ballot approved by Fair Work Australia is now under way to seek a second opinion from workers.

In its submission, BHP lists 18 union claims in the dispute that it calls "beyond what is reasonable or necessary for the protection of employees".

They include union demands that:

Delegates be paid for time off to deal with member issues, attend union meetings, including preparation time for meeting conveners.

Delegates be able to use mobile phones at all times, regardless of safety rules.

Employees not be suspended during investigations into their conduct, or disciplined for breaching BHP's code of conduct.

Contractors and labour hire workers now most of BHP's workforce be paid the same as the minority of employees.

The submission goes well beyond that. BHP wants to be free to conclude individual agreements with high-income employees (such as miners). It wants to tighten the rules on pattern bargaining, union officials' right of entry, union representation and a dozen other issues.

The review, headed by Reserve Bank board member John Edwards who 20 years ago was point man for then prime minister Paul Keating in the reforms to introduce enterprise bargaining will hand its report to Mr Shorten by May 31.

Its terms of reference, however, aim to limit it to reporting whether the act is working as intended.

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Markets rocked by euro chaos

INVESTORS nervous about Europe and the slowing global economy have wiped $27 billion from the value of Australian shares - as the chairman of BHP Billiton warned that the nation's mining boom was winding down.

Sharemarkets around the world quaked amid growing speculation that Greece would be forced out of the euro bloc, triggering a new bout of global financial instability. In Australia, investors pulled their money out of shares, sending the market on its biggest fall of the year.

By the end of yesterday, the benchmark ASX/S&P200 index had plunged by 101 points to 4165.50. The Australian dollar sank below 99 US cents for the first time this year.

More than $75 billion has now been stripped from the value of Australian shares this month - mostly over Europe concerns, but also because growth in China and India has slowed, easing demand for our mineral exports.

Trade figures released last week imply that imports of capital equipment shrank in the March quarter, and have barely grown in the past six months. This suggests growth in business (mostly mining) investment is slowing sharply.

Yesterday's fall began as soon as markets opened in the wake of more bad news from Greece. Negotiations to form a new government failed again, forcing a second national election.

New data showed Greece's GDP shrank by 6.2 per cent in the year to March, amid reports that European and German leaders want Greece out of the eurozone, and are ready to risk a market meltdown.

There was a brief rally when new data showed Australian wages growth remains subdued - except in Western Australia, and in mining - but the market started falling again after BHP chairman Jac Nasser said the resources cycle had turned, and that BHP would shelve some of its planned projects.

''The tailwind of high commodity prices has contributed to record growth in the sector and the country,'' Mr Nasser said in Sydney. ''Now we have a period where those tailwinds are moderating, and we expect further easing over time.

''The resources business has always been, and will always be, a cyclical business.''

Asked if BHP still planned to invest $80 billion over the next five years, he responded: ''No.''

In a politically charged speech, Mr Nasser, the Melbourne engineer who became Ford's global chief, called for a new wave of industrial relations reform, saying that in 2011 BHP faced 3200 cases of industrial action in its Queensland coal business alone.

He warned that Australia had become ''one of the higher cost countries of the world''. Its industrial relations environment was deteriorating, governments had hiked mining taxes and royalties, and investors had lost confidence in the future of the global economy.

''Those decisions have repercussions,'' Mr Nasser said. ''At BHP, our choices include in which product ? and in which country we choose to invest.

''Stable tax and appropriate industrial relations frameworks ? we will make progress if we focus on getting these two issues right.''

He censured Treasurer Wayne Swan for his attacks on mining billionaires, and urged him to create ''a stable, predictable and competitive tax framework''.

''I cannot overstate how the level of uncertainty about Australia's tax system is generating negative investor reaction,'' Mr Nasser said. ''I don't think it is good for Australia when global investors question openly whether Australia really wants a globally competitive resources industry.''

But the slide in the dollar is giving relief to thousands of Australian businesses, as it was mostly the dollar's rise that made them (and BHP) high-cost.

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Europe's economic nightmare should worry us

FOR Australia to achieve the government's 3.25 per cent growth forecast, and hence a budget surplus, the global economy will have to remain benign. That really depends on what happens in Europe and, week by week, it looks more unlikely.

Europe is far away, and unless you watch the SBS news it has an unfamiliar cast of characters and issues. But this year it will become more and more important in our lives, so it's worth watching and its scene is changing rapidly. Deficits and debt are one half of Europe's problem. Recession and unemployment are the other. The issue is: which should you tackle first?

German Chancellor Angela Merkel, outgoing French President Nicolas Sarkozy and the European Commission insisted that governments must get their fiscal house in order first, whatever the cost to jobs and growth. And so Europe's governments have locked themselves into a pact to bring their deficits below 3 per cent of GDP by 2013.

But as economists such as Martin Wolf of the Financial Times and Paul Krugman of The New York Times forecast, those austerity measures have led Europe back into recession. So deficit targets have not been met, which requires further austerity measures, which leads to still deeper recession, which . . . well, you get the hang of it.

At the centre of this dilemma is Greece. Through reckless fiscal mismanagement over decades, Greece now has gross government debt of 160 per cent of its GDP (as against 24 per cent in Australia), and an annual interest bill equivalent to almost $100 billion here.

But it is also in an economic depression: its output has fallen by almost 20 per cent, 22 per cent of its workers are unemployed, and an appalling 54 per cent of its young jobseekers.

Which should it tackle first: getting its fiscal house in order, or trying to stimulate growth to provide jobs for its people?

That is what last Sunday's Greek election was about. But in a key complication, no bank will lend to Greece any more. Its only loan sources are the European Union, the European Central Bank and the International Monetary Fund, and (against the IMF's better judgment) they have insisted Greece meet the 2013 fiscal target. Given its economic free fall, that requires it to make another ?11 billion ($A14.2 billion) of spending cuts or revenue hikes: 5 per cent of GDP.

Greece's two main parties had joined forces to try to negotiate a better deal, but failed. The elections saw their combined vote plunge from 77 per cent at the previous election to 32 per cent this time, as voters flocked to parties to the left and right who reject the deal, yet have no realistic alternative. At this stage the elections seem to have left Greece at an impasse, with no viable government, and any new election likely to end in a similar impasse.

But the story has just taken a new twist. Merkel became the most powerful person in Europe, largely because the German public supported austerity, and the opposition Social Democrats had not opposed it until now. But on Sunday, in the Ruhr valley state of North Rhine Westphalia, Germany's biggest, her Christian Democrats were hammered in a state election fought on the issue of austerity, their vote falling to just 26 per cent.

Germany has not suffered the austerity seen in Greece, Spain or Ireland. But German voters objected to council swimming pools being closed as an economy measure. The west is weary of paying endless subsidies to east Germany. And Social Democrat Premier Hannelore Kraft won a personal vote that makes her a potential challenger to Merkel at 2013's federal election.

The trend in German state elections is startling. Since the last federal election, 10 of the 16 German states have gone to the polls: the Christian Democrats have won just two states while being dumped from office in four. They and their partner, the Free Democrats, have shrunk from 515 seats to 399, compared with 590 seats won by the Social Democrats and the Greens.

The crisis in Europe has now seen governments fall in 19 of the 27 EU members, including Britain, France, Italy, Spain and the Netherlands. Tonight Francois Hollande takes office as president of France, then flies to Berlin for dinner with Merkel. Hollande has been ambivalent about whether he wants to rewrite the EU fiscal pact, or just add a growth package to it, by increasing investment. Whatever his goal, he might find Merkel more receptive now.

But even if Hollande can reconcile the contradictions of his campaign promises to meet the deficit reduction targets while increasing spending, there is no good way out for Greece. No Greek government is likely to carry out the spending cuts the European Union requires. Too bad, says European Commission President Jose Manuel Barroso, we won't change the rules for you. And if the EU keeps its hard line, there will be a new financial crisis.

Greece would run out of money to pay public servants. It would have to exit the euro, default on its debts, and bring back a cheap drachma. Markets would speculate on defaults by other countries in strife: Spain, Portugal, Ireland. IMF chief Christine Lagarde warns that this could see a slump worse than the panic of 2008.

A crisis in Europe would convulse trade and financial markets. Australia's banks could face a crisis in rolling over loans. Our dollar would sink. Investments would be put on hold. All bets would be off.

Keep your eye on Europe.

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The jobs growth figures are wrong - here's why

The official jobs figures published by the Bureau of Statistics have significantly underestimated recent job growth, due to forecasting errors that first overstated, then understated, the growth in the adult population.

The errors, which have serious implications for economic policy, began when the number of foreign students living in Australia fell rapidly after immigration laws were tightened in late 2009.

The unforeseen fall at first led Bureau forecasters to greatly overstate population growth — and When it realised the error, rather than correct it by revising the previous jobs figures the Bureau decided to understate population growth in future forecasts, depressing the labour force figures. These then reported a net loss of 900 jobs in 2011.

On one estimate, once the figures are adjusted for the erroneous forecasts, at least 100,000 of the jobs supposedly created in 2010 in fact arrived in 2011.

The errors are not in the official estimates of population growth, which are issued six months after the period to which they apply. They are in the estimates — in effect, forecasts — of the adult civilian population used in the labour force figures.

Usually the two series move together. But in the year to September 2010, population growth (including children) shrank rapidly, from 433,000 to 325,000, whereas the forecasts for the labour force estimated that adult population growth would remain steady at 394,000.

In the year to September 2011, that suddenly reversed. Actual population growth was little changed at 320,000, but the Bureau slashed the forecasts used in the labour force figures from 394,000 to 224,000.

Since most people interviewed in the labour force survey are employed, the effect of understating population growth was to understate employment growth.

The Bureau defended itself yesterday in an article published with the labour force figures, arguing that its main focus is on getting a correct reading of the unemployment rate and workforce participation rate — which come straight from the survey data.

But its approach seriously misled readers, commentators and ultimately the public, about the size of the slowdown in the jobs market — and hence, the true state of the economy.
One prominent commentator seized on the reported fall in jobs to describe the labour market as being in its worst shape since 1992.

The Australian Statistician, Brian Pink, yesterday stood by the Bureau’s figures. “We do not believe that the employment growth that we have shown has been biased in some way by the method - that’s our view,” he said.

Senior economic officials are aware that the data is flawed, but have refrained from making any public statement, so as not to reduce confidence in the Bureau.

But tax data released with the Victorian and Federal budgets confirm that the jobs markets in 2011-12 has been stronger than the official figures show.

The Bureau estimates that jobs in Victoria fell by almost 20,000 in the first nine months of 2011-12, with 38,000 full-time jobs lost. Yet the state’s payroll tax revenue rose 7.7 per cent in that time, with no fall in jobs.

Tuesday’s Federal budget showed PAYE income tax revenues up 9.7 per cent in 2011-12, faster than the 9.4 per cent growth in 2010-11. While officials believe job growth has weakened in recent months, the tax take is strong evidence that the Bureau’s estimates are wrong.

Westpac senior economist Justin Smirk said the bank’s economics team is uncomfortable with the way the Bureau has tackled its problem.

‘‘It does raise concerns about the accuracy of the data, and we still have questions about the actual employment levels and their growth path’’, he said.

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Government bond issues to plummet

NEW issues of Australian government securities will shrink sharply in the new financial year, with net new issues falling from $44 billion this year to just $9 billion in 2012-13.

The announcement by the Australian Office of Financial Management could put further downward pressure on Australian bond yields, which have fallen to record lows as investors flee the stockmarket and Europe.

Tumbling bond yields have already slashed $600 million off the government's estimated interest bill for 2012-13, and $2.4 billion off the forecast bills for the next two years.

It came as the opposition attacked the government's decision to raise Australia's debt ceiling by a further $50 billion.

The increased debt limit was not mentioned by Treasurer Wayne Swan in his budget speech.

But an appropriations bill, introduced on Tuesday night after the budget, would increase the nation's credit limit from $250 billion to $300 billion.

The opposition seized on this yesterday as its main attack on the budget. Opposition Leader Tony Abbott called it "really extraordinary", saying it "gives the lie to Wayne Swan's talk about a surplus".

Shadow treasurer Joe Hockey asked why the Commonwealth needed to raise its credit card limit.

"If they really are delivering a surplus and that surplus is meant to pay down debt, why did they need to increase the allowable borrowings of the Commonwealth government to $300 billion?" he asked.

But Mr Swan said the government was acting on the advice of the AOFM, the Treasury agency that runs Australia's debt finance. He said the AOFM wanted the rise to give it a "buffer" against a temporary financing challenge.

"What tends to happen is that government revenues come in big lumps towards the end of the year but government expenditure goes out evenly across the year. Secondly, we also have to retire bond lines as we bring new ones on," Mr Swan said.

The government has yet to decide on or publish a report by senior Treasury, Reserve Bank and AOFM officials urging that after the budget returns to surplus, gross government debt should be kept at 12 to 14 per cent of GDP about $200 billion now to maintain a liquid market for trade in bonds.

Yesterday the AOFM announced that gross issuance of new Treasury bonds would shrink from $58 billion this financial year to $35 billion in 2012-13.

They will include a new line of bonds maturing in 2024, to be launched early next year, and a new 15-year bond to be launched a bit later. A further $2 billion of Treasury indexed bonds will also be issued, and short-term Treasury Notes as required.

The AOFM also floats the possibility that some Aussie Infrastructure Bonds used to finance NBN Co's investments might be raised in the same process.

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More cuts may be necessary: Swan

AUSTRALIA could face further spending cuts and/or revenue rises this year and in 2013 after Treasurer Wayne Swan pledged to make more budget savings if weaker-than-expected economic growth imperils his promise of a budget surplus.

As the ratings agencies warned that the budget's economic forecasts are ambitious and might not be reached, Mr Swan told the National Press Club that Labor would cut further if the budget looked like failing to reach its target of $1.5 billion.

His decision, announced as a curt one-word answer "Yes" to questions on the issue, sets Australia at odds with the International Monetary Fund, which is advising governments in such situations to let their fiscal position take the hit rather than weaken the economy.

"Countries need to keep a steady hand on the wheel," IMF managing director Christine Lagarde said in Zurich on Monday. "If growth is worse than expected, they should stick to announced fiscal measures, rather than announced fiscal targets.

"In other words, they should not fight any fall in tax revenues or rise in spending caused solely because the economy weakens."

Ratings agencies gave the budget the thumbs-up, declaring it consistent with Australia retaining its AAA rating. But they issued caveats on the economic targets, implying Mr Swan's resolve may be put to the test.

Standard & Poor's credit analyst Kyran Curry said the forecast return to surplus "will provide flexibility to respond to large economic and financial shocks, and the forecast peak level of Australia's debt was "well below that of most peers".

"However, this strategy relies on an accommodative economic outlook that remains highly uncertain, and the support of coalition partners for the minority government's austerity measures," Mr Curry said.

Moodys vice-president Steven Hess said that while Australia's low debt gave it "considerable flexibility in the timing of a return to surplus", its economy was a heavy borrower from global capital markets and it was important to see "a substantial positive move in the government's fiscal position".

But he warned that "the fiscal correction of about 3 percentage points of GDP in 2012-13 will be a drag on economic growth", and raised doubts about "whether the targeted budget surplus is ultimately achieved".

Fitch Ratings put a similar view, calling the government's plans "positive", but adding they "could be challenging, particularly if the economic outlook weakens further."

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It's a political budget, a fake budget

THERE comes a point in the lives of governments when they cross a line that is indistinct yet crucial. The ideals and policy goals that they wanted to promote in power start to matter less to them than the desire to just stay in power, whatever it takes.

The Gillard government is now past that point. Yesterday's budget is not about economics, but politics. It sets out to turn a deficit of $44.4 billion into a surplus of $1.5 billion. At face value, that's equivalent to taking 3 per cent of the Australian economy out of circulation. You don't do that for economic reasons particularly when most of the economy is struggling against the effects of a dollar at record highs and interest rates appropriate to boom times. You do it because, in better times, you once promised it and having lost half a million votes through breaking one promise, you don't want to break another. It's all politics.

The measure that best sums up this budget is its biggest one: the $4.75 billion promised to business over four years as a company tax cut will now be taken away, and given to parents. Why? Employers don't vote for Labor. Parents might.

The government had trumpeted the company tax cut as a way to spread around the wealth created by the resources boom. Now it's gone, and this budget offers nothing else to tackle our biggest economic problem: the slump of growth in jobs and output in most of the economy, above all in the south-east, where most Australians live.

The budget's only initiative for Victoria is to take away the money promised to duplicate the Western Highway beyond Ballarat, and spend it instead on a freight terminal in western Sydney. Perhaps Western Sydney has more Labor seats than the Western District.

At first sight, it's hard to see how this budget makes the numbers fit. It seems to be splashing money around, yet it estimates that spending will actually shrink by $7 billion something that last happened when World War II ended. From 25.1 per cent of GDP, on these figures, spending would plunge to 23.5 per cent in 2012-13, and more or less stay there in future. That's on a par with the cuts of Keating and Walsh in the 1980s, and Howard and Costello in the 1990s.

Yet revenue is forecast to increase from 22.3 per cent of GDP to 23.8 per cent. That would be the steepest tax/revenue rise since the double-digit inflation and bracket creep of the Whitlam years. Put them together and the bottom line would go from a deficit of 3 per cent of GDP to a surplus of 0.1 per cent. The last time we saw anything like that was 60 years ago in the original "horror budget", which was designed specifically to slow down an overheated economy.

Where's the austerity? Mostly tucked away in places where it will cost few votes. The four main savings are to cut defence spending ($5.4 billion over four years), scrap the company tax cut ($4.75 billion), slow the expansion of foreign aid ($2.9 billion) and reduce superannuation tax breaks for the super-rich and over-50s ($2.4 billion).

There are some good moves to raise revenue: phasing out the pointless tax break for mature-aged workers, capping tax breaks for medical expenses, and starting to inject some sense into superannuation tax breaks. But there are other savings to regret, backward steps such as scrapping the standard tax deduction proposed by the Henry review, which is the key to freeing ordinary taxpayers from the complexity of tax returns, as well as scrapping the proposed tax break on interest income. Business and investors do badly in this budget.

But in general, this budget is less austere than the dramatic bottom line suggests. That's largely because, as the Coalition points out, many of the "savings" are fiddles, which shift spending out of 2012-13 into 2011-12. We already had lots of them locked in such as carbon tax compensation delivered in May or June when the carbon tax starts in July and this budget has added two more: the first July payment of the Schoolkids Bonus will come in June, as will the 2012-13 grants to local government. As much as $9 billion of spending has been transferred from 2012-13 to 2011-12 to create this budget surplus.

This is important. First, it means the surplus, if it happens, would be a fake, created simply by shuffling payments. But second, it means the budget cuts are less severe than they seem. If the shift is really from a deficit of $35.5 billion to one of $7.5 billion, and if some of it will be replaced by us saving less to spend more, then the real impact on the economy is more like taking out $20 billion.

But that is still a big hit to a weak economy. It makes the budget forecast of 3.25 per cent growth in 2012-13 implausible. And if the economy stays becalmed, even a fake budget surplus will remain out of reach.

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Swan's song to be in the key of austerity

ON SUNDAY, the Greeks had their say on austerity budgets. In 2009, 78 per cent voted for Pasok (Labor) or New Democracy (Liberals). Now the two are in coalition, and on Sunday, their combined vote fell to 33 per cent. Some swing: 45 per cent.

But austerity there will be: we will find out some of that tonight, some in the days and weeks ahead. And if Labor is not already in enough electoral strife, tonight's budget is a big gamble, with the potential to put it in even deeper strife.

To put it simply, this budget aims to turn a deficit of $40 billion or so this financial year into a surplus of $1 billion or so next year at a time when, other than mining, the economy is going either sideways or down.

The government has been releasing good news before the budget, to make sure it gets noticed. But the bottom line is that in 2012-13, the government will pull more than $40 billion out of Australia's economy, either by spending less, taxing more, or both.

It doesn't have to do that. There is no pressure from markets or voters for Australia to run a budget surplus. Money is flooding in to buy government bonds. And an Essential Research poll found just 12 per cent of us want to get the budget into surplus in 2012-13.

But the government had promised before the 2010 election that the budget would be in surplus in 2012-13. At the time it thought the economy would be growing at 4 per cent by now and adding 250,000 jobs a year.

Sadly, that was another forecast that went wrong. But after Julia Gillard has taken so much flak for breaking her promise on the carbon tax, Labor decided the budget had to go into a surplus in 2012-13, whatever the economic cost.

The outgoing Greek government made a similar choice, under duress from its European partners. Greece has 24 per cent unemployment and an economy that has shrunk 20 per cent in four years. Yet the budget deal imposed by the EU requires Greece in 2013 to run a sizeable "primary" surplus that is, a surplus of revenue over all spending except interest bills.

That will require huge budget cuts. So two-thirds of Greeks voted for parties to the left and right of the big two, in protest. Since the far left and far right can't agree, the centre will probably keep governing but will demand changes to the deal.

So will France, where Socialist Francois Hollande dethroned President Nicolas Sarkozy, after campaigning to replace deficit reduction with growth as Europe's central goal. "Europe is watching us," he said. "Austerity isn't inevitable. My mission now is to give European construction a growth dimension."

It was a similar story even in Germany, Europe's success story. In the northern state of Schleswig-Holstein, Chancellor Angela Merkel's coalition was swept from power in a swing of 7.5 per cent: the third state it has lost in a year or so.

In Europe, austerity is going out. In Australia, it's coming in.

Don't worry, the Treasurer tells us: the budget forecasts that even with $40 billion taken out of the economy, we'll still grow by 3.25 per cent. Yes, but the last accurate budget forecast was in 2007. And the last time he forecast growth of 3.25 per cent, we got just 2 per cent. If that happens this time, it will mean boom in outback mines offset by recession in the south-east. That is the risk tonight.

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Prepare. Swan's budget nightmare.

IN THIS year of uncertainty, my favourite quote is from fund manager Matt Williams, head of equities with Perpetual Investments. Asked how the global economy would go in 2012, he demurred: ''There are too many moving parts to forecast it all with accuracy.''

On the eve of next week's federal budget, Treasurer Wayne Swan will nod his head. Two years ago, when he pledged to deliver a budget surplus in 2012-13, Treasury's growth forecasts made it seem easy and appropriate.

But those forecasts proved wrong: too many moving parts didn't move as forecast. Now Swan has to deliver a surplus that will be both difficult and inappropriate.

Reserve Bank governor Glenn Stevens, too, might nod his head. The Reserve also got it wrong during 2010 and 2011 by misreading the speed of the economy's various moving parts. Now the RBA is undoing the interest rate rises it so confidently inflicted on us - and waiting to see how much of the intended stimulus gets past the banks to small businesses and households.

Ted Baillieu and Kim Wells might well nod their heads. In short time, Victoria has gone from economic standout to being close to recession. This week's state budget was sound, but not stimulatory. It assumes that Victoria's economy will trough in 2012, then recover during 2013. But for that, those moving parts will have to click together.

And the moving parts that matter most to us might be on the other side of the world.

Tomorrow, there will be two elections in Europe that could make it switch priorities from deficit reduction to growth. At best, this could revive the global economy; at worst it could unleash a new wave of instability that would jeopardise what the International Monetary Fund calls its ''fragile recovery'', and even send the world into a double-dip recession.

One is the French presidential election. If the polls are right, President Nicolas Sarkozy will be defeated by socialist challenger Francois Hollande. If so, that would mean that since the market rout of September-October 2008, 19 of the 27 European Union leaders then in power have been tossed out, along with their counterparts in Japan, Australia, New Zealand, Israel, etc. In that time, only five EU leaders have won re-election.

Sarkozy has been a disappointment to those who hoped he would reinvigorate France, but Hollande's policies are seriously retro. They include undoing Sarkozy's reforms (Hollande wants to lower the pension age from 62 to 60), lifting France's already high minimum wage, lifting state spending (already 56 per cent of GDP, compared with 36 per cent here), putting a 75 per cent tax on incomes over ?1 million ($A1.28 million) - and demanding a renegotiation of the EU fiscal pact to shift priority from reducing deficits to boosting growth.

In Paris, the markets believe that as president, Hollande would quietly shelve some of those policies to focus on renegotiating the European pact. Sarkozy has been the junior partner of German Chancellor Angela Merkel in steering Europe down the path of austerity. The electoral tide is now swinging Europe the other way. In the short term we will see more crises, more negotiations, more summits, and more instability in global markets.

What could be even more important, however, is the result of tomorrow's Greek election. After years of bitter polemic and two changes of government, the traditional rivals PASOK (left) and New Democracy (right) briefly united last year to negotiate Greece's austerity pact with the EU and the International Monetary Fund. That will require even more tough measures to force the Greek budget back into surplus, at a time when the country is in a deep depression.

Greece's GDP fell by 7.5 per cent over 2011, and by 17 per cent since the crisis began. Unemployment has climbed past 21 per cent; among young Greeks, it is 51 per cent. Not surprisingly, Greeks are rebelling; the polls show that new or previously obscure parties opposing the deal could win most seats in the new Parliament. There is no obvious way out; an unravelling of the Greek agreement risks unleashing a market panic like that of 2008.

This is a year of uncertainty. Australia was well-insulated from the 2008 crisis because its banks had lent wisely, the Rudd government moved boldly to shore up household finances and bank liquidity, and China's demand drove coal and iron ore prices sky-high. We remain relatively well-insulated now.

Despite the Coalition's rhetoric, Australia's government debt is very low. Even gross debt is just 24 per cent of GDP, the third lowest in the affluent world. Foreign investors see Australia as a haven, snapping up a net $110 billion of government bonds in the past two years, and driving bond yields to record lows. Almost 80 per cent of Australian government bonds are now held overseas. Yes, that makes us vulnerable to changes in global sentiment. But look around: whatever we do, Australia is not a country the world is likely to worry about.

Our problems are different from Europe's. The one fact that sums them up is that in 2011, in real dollars, mining investment increased by more than GDP. Mining investment is booming, but the rest of the economy is sluggish. The high dollar has flattened much of it. High interest rates and consumer caution have flattened other parts. And the trickle-down from the mining sector is too much of a trickle to kick-start activity.

The dollar is the biggest problem. It raises the cost of doing anything in Australia rather than in the rest of the world. A KPMG study in March found Australia is now the second most expensive business location in the world, behind only Japan. That happens when your currency rises 50 per cent above its long-term level, as Australia's has since 2005. If you're buying anything overseas - holidays, goods on the internet, machinery - it's a blessing. If you're trying to do anything here that competes with anything done overseas, it's a disaster. And the dollar will remain high as long as the world sees us as a haven.

Even BHP and Rio Tinto are now considering shelving big mining projects here, in part because the high dollar has inflated their cost in global comparison. Mineral processing has boomed, but the output of the rest of Australian manufacturing has slumped 7.5 per cent since the GFC, costing more than 100,000 jobs. Those who tell you manufacturing is doing well are seriously uninformed.

The growth pace of the economy in the second half of 2011 was just 2.5 per cent. There are signs that the slowdown might have bottomed. We are told that next week's budget will forecast growth to accelerate to 3.25 per cent in 2012-13. Indeed, Swan is talking as if the mere forecast is already an achieved fact. Not so - and the risk that it will not be achieved could become his nightmare over the year ahead.

Why? Because the budget usually forecasts growth to be 3.25 per cent or thereabouts. That doesn't mean that's what we get. Two years ago, the budget forecast growth of 3.25 per cent, but we ended up with just 2 per cent.

The budget forecasts were good in the good years, but in the past four years, they have been way out. In 2008-09, 2010-11 and 2011-12 they forecast far more growth than we got, while in 2009-10 they did the reverse. Too many moving parts!

There's a big risk that this forecast will again prove too optimistic. Mining investment could fall well short of the $120 billion forecast. The budget itself will slow activity: even with all the fiddles, you can't take $40 billion out of this economy without it putting a brake on growth, particularly where it is already weak. With the world recovery fragile, state governments also cutting spending, business and consumer confidence subdued, and the banks passing on only about half the Reserve Bank's rate cuts, it's difficult to see where that growth will come from.

If growth falls short, then the budget too will fall short of its target. Swan could be forced to play catch-up, tightening spending again and again in a low-growth economy to ensure that his political target of a budget surplus is met. Those moving parts are unpredictable.

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Budget 2012-13: Why Baillieu had to cut.

THE Baillieu government's budget has got us talking. Is the government really so hard up that it has to break its promise not to sack public servants?

Is it taking us back to the Kennett era? Or is it, as Kim Wells claims, actually Labor's fault? Let's check some of that against the facts.

1. Does the government's pledge to cut 4200 jobs take us back to the Kennett era?

Not if you remember the Kennett era. By this stage of its life, the Kennett government had sacked 45,000 public servants, teachers, nurses and police. By its end, 81,000 state and local government jobs had gone: one in four!

The Baillieu government plans to cut its workforce by 4200 over two years. Treasurer Kim Wells hopes to do so by voluntary redundancies, targeting back-office jobs where there is duplication between departments and agencies, or between federal and state programs. People will be sacked only if those numbers fall short.

The state public service now has 37,000 people, up from 23,000 in 1999. Even if all 4200 job cuts come in that core, it would still have 33,000 left. It's not even Kennett Lite.

2. But do we really need it? Has state revenue collapsed?

Sure has. When the government took office, Treasury estimated that Victoria in 2012-13 would have revenues of $49.7 billion to spend. Within 18 months, on unchanged policies, that had shrunk by almost $2 billion, to $47.75 billion.

The government's revenue hikes on WorkCover, water authorities, vehicle rego, car taxes, stamp duties, tax compliance and fines have added $600 million to lift that to $48.35 billion. But it still leaves a gap of $1.35 billion that would have sent the budget into deficit, were it not for spending cuts.

Most of the revenue collapse has come from the GST. The retail slump and the Grants Commission's decision to cut our share of GST money has cost Victoria $1 in every $8 it had expected from its biggest tax. The slump in house prices and sales has created an equally sharp fall in its stamp duty. And the state has few tax options.

So it had to cut spending. It says it's lopped off $1.15 billion in savings. But in net terms, spending will be down just $650 million, or 1.3 per cent, from the forecast Treasury issued in 2010. That's frugal housekeeping, not liposuction surgery.

3. Why do we need a surplus, anyway?

Victoria's budget surplus is not like the Commonwealth surplus. It just means that revenue pays for recurrent spending the cost of running schools, hospitals, public transport, police, and so on, and a bit over.

The bit over is then spent on infrastructure. In 2012-13 the state plans to invest a record $5.8 billion in infrastructure, roughly half from its own funds and half from borrowing. The surplus is not being banked, but invested.

Second, Victoria has own-source revenues of $26 billion, a fraction of the Commonwealth's $375 billion. It has far less ability to rebound from deficits to sustain a balance over the cycle. The target to run surpluses of $100 million is a modest one.

4. Was it all the Labor government's fault, as Wells claims? Did Steve Bracks and John Brumby put Victoria on an unsustainable fiscal course?

No, that claim is phoney. The "unsustainable course" it refers to is the sudden spike in spending during the GFC, when the federal government paid the states to build school halls and the rest.

But that was never going to be sustained. When Brumby lost office, state spending was growing at only 2 per cent.

The truth is that B&B had a splurge in their first budget in 2000-01, then settled down to steady, AAA-rated fiscal responsibility.

Between 2001 and 2008, revenue grew on average by 6.7 per cent a year, and spending by 6.8 per cent. Big deal!

What is unsustainable is raiding the funds of state agencies, as Baillieu and Wells did to produce this surplus. Pots should not call kettles black.

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Victoria: Good housekeepers dust the corners

THIS is a low-key budget from a low-key government. It has few highlights and few lowlights. It will not lead ratings agencies to question Victoria's AAA credit rating, nor to demonstrators outside Parliament House.

It is not really leading Victoria anywhere. It is just good housekeeping: coping with hard times by a nip here, a tuck there, maybe lots of nips and tucks and endless restraint, resisting the temptation to buy new things, so that the state ends up saving a little rather than spending more than it earns.

This time, frugality was not enough to keep the budget in the black. So Ted Baillieu and Kim Wells pulled out a few more tricks to get it over the line. They took $300 million over four years off funding for TAFE courses they see as low priority. They pinched another $420 million from the water authorities.

As a last resort, they scrapped the state's well-targeted first home buyers bonus. That saved just enough $165 million a year to create a respectable surplus in 2012-13, and something more thereafter.

Ratings agencies Moody's and Standard & Poor's gave it a tick of approval. Many Victorians will do the same. It opened no big issues for Labor to attack.

But nor was there anything resembling a jobs plan, or anything aiming to get the economy to fire on all cylinders again.

And there was nothing to answer the question Victorians are asking: why does Ted Baillieu want to be Premier? Where does he want to take us?

At some point, his government is going to have to tell us what it stands for. The budget was a missed chance to do that.

There are good things here. The $311 million of initiatives to protect vulnerable children is welcome. The $2.7 billion of new infrastructure projects will relieve a battered construction industry. Some will welcome the $670 million to build new prisons; others will ask why the state would rather fund prisons than TAFE courses.

The odd thing about this budget is that it is so normal, given that the times we are going through are anything but.

Victoria's economy is struggling under the double burden of the high dollar and high interest rates. Unemployment has climbed to 5.5 per cent. Spending by foreign students fell $1 billion last year.

Home building, retail sales, house prices, manufacturing output, they're all down. And business confidence has sunk with them.

Yesterday's welcome interest rate cut will help, but the budget won't. Since December's budget update, the state has cut $1 billion from this year's infrastructure spending. It plans a rebound to record levels in 2012-13, but over the forward estimates, state infrastructure spending is forecast to decline from 2 per cent of gross state product (GSP) in 2010-11 to just 1 per cent by 2015-16. That's only a projection, of course. And it will have to rise if the three big projects on the budget's planning list the Melbourne Metro rail project, the East West road link, and the container port at Hastings are built any time soon.

The infrastructure needs are endless. This budget commits to remove three of the 175 level crossings that shut roads down. Wells says that on average, Springvale Road is closed for 50 minutes of the two hours of peak traffic, and Mitcham Road for 54 minutes. Who can seriously argue against spending the money needed to fix problems like that?

It's by cutting infrastructure spending that the Baillieu government plans to start reducing the budget sector's net debt by 2015-16, after it peaks at $24 billion, just 6 per cent of GSP. The debate we need is whether we want the infrastructure we desire, or a AAA rating. We can't have both.

In the budget papers, Treasury argues that Victoria's economic state is challenging, but not critical. It says that employment is flat, but not falling, as the statistics report. It believes Victoria is heading for growth of just 1.5 per cent in 2011-12 and 1.75 per cent in 2012-13, not a recession. And it forecasts a recovery to begin early next year, and a positive long-term future based on exports to rapidly growing Asia.

You hope it's right.

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