By Rob Taylor
CANBERRA, Jan 30 (Reuters) - Deficits may be in vogue for governments battling the global downturn, but for Australia's first Labor government in almost 12 years, dipping into the red for economic medicine is a risky political strategy.
After a dream first year, Prime Minister Kevin Rudd is under pressure to sell the pluses of a deficit expected to hit A$40 billion ($26.8 billion) at elections due by late 2010.
Resource-rich Australia rode an export boom and enjoyed surpluses for nine of the last 10 years. Rudd's conservative predecessor John Howard associated deficits with bad governance.
"If Rudd can't explain to the public the benefits of deficit spending and can't explain to them that the alternatives are perhaps long-term losses and more people out of work, then he might not be prime minister," political analyst Michael McKinley told Reuters.
Rudd, who has enjoyed high approval ratings in his first year in office, is set to unveil a second stimulus package as soon as next week as the once stellar economy continues to sour.
Treasurer Wayne Swan said on Thursday "overwhelming force" was needed to combat the fiscal crisis. Swan then ventured into no-man's land with a warning that the centre-left government would "entertain a temporary deficit" in the May national budget.
Former diplomat and bureaucrat Rudd came to power in November 2007, winning by a landslide, and promptly carried through on popular promises to withdraw combat troops from Iraq, boost reconciliation with Aborigines and ratify the Kyoto climate pact.
But the mood in Australia has changed.
Australia has been slower to feel the brunt of the global financial crisis than other big economies but slowing demand from its main resource exports has started to bite.
As a result, the government is likely to have to borrow far more than anyone thought in the next few years to stimulate the economy by spending money on big projects.
"It's now a question of what you do with your deficit spending. If it goes to finance consumption, that's quite stupid. But if it goes to infrastructure, it will give you employment and long-term benefit," said McKinley, an Australian National University academic.
BANANA REPUBLIC REVISITED?
Former Labor prime minister Paul Keating stunned the country in 1986 with a warning that prosperous Australia risked becoming a "banana republic" due to excessive foreign borrowing. Keating was kicked from office in 1996 with a budget heavily in the red.
Howard promised to restore the books with a commitment to surpluses. Australia dodged the 2001 world recession and the 2001-02 budget was the country's last in deficit.
Rudd ended near 12 years of conservative rule by promising voters to govern as an "economic conservative", while knocking the hard edges from Howard's education and workplace policies.
"I think the clear philosophical position this government has had since opposition and since becoming government is this: that we believe in maintaining a government budget surplus over the economic cycle," Rudd told reporters last year in Peru.
That was before the global credit crunch unfolded, bringing the worst financial blow to hit the country in a generation. Many economists now expect Australia to sink into its first recession since 1991, joining other major economies.
DEFICIT ABSOLUTION
Opinion polls that consistently placed Rudd's popularity at near-record levels have begun to slip to more mortal dimensions. The closely watched Newspoll this month showed conservative rivals making ground on Labor, sitting at 46 points behind the government on 54. Moreover, satisfaction with Rudd's handling of economic woes and other issues plummeted seven points to 63.
For months last year, Swan and Rudd avoided even using the word deficit or mentioning recession as economic headwinds gathered force, threatening a 17-year expansion.
"The Howard years enshrined the virtue of the budget surplus. The public associates the budget surplus with sound management," veteran political commentator Paul Kelly wrote in the Australian newspaper, highlighting the risks for Rudd of borrowing.
But as unemployment began to creep up last year and Australia's Reserve Bank lopped three percentage points off benchmark cash rates to 4.25 percent, both Rudd and Swan acknowledged the dream surplus run could end in 2009. Since October, the government has pledged stimulatory spending worth more than A$36 billion ($24 billion), including A$10 billion in cash for families, pensioners and homebuyers to encourage retail consumption and construction.
A second round, possibly including a combination of accelerated tax cuts for low income earners, more employment help and extra training opportunities, looks likely next week, after Rudd digests the impact on the world economy of a $819 billion stimulus plan passed by the U.S. House of Representatives.
Analysts see Australian government debt doubling over the next two years as Labor funds the deficit and meets its commitment to modernise ageing port, road, rail and internet links to lift flagging national productivity.
Polls show Rudd and Labor's popularity slipping but still high. The slowing economy and the coming May budget will be critical for the government as the China-led resource export boom slows even further, cutting into state revenues.
McKinley says embracing deficits means Australia is recovering from "an idiot form of economics" under the conservatives, which allowed infrastructure to deteriorate at the cost of maintaining surplus budgets and the political high-ground over Labor.
"The global financial crisis has provided the government with a sort of deficit absolution, there's no doubt about that," McKinley said.
No Australian government has lost power after only one term since 1932, when the Labor government of James Scullin was thrown out just two weeks before the U.S. stock market crash.
($1=1.491 Australian Dollar)
(Editing by Jeremy Laurence)