Hamish McRae: Sometimes governments get it right

The question now is how to choreograph the recovery and get the balance right

Government policies do sometimes work. The six months since the Group of 20 economic summit in London in April have been a considerable success story. The world economy has pulled out of recession; the financial markets have recovered; the fears of a 1930s-style meltdown now seem quite unwarranted. In fair measure that turnabout has been the result of government action: propping up the banks, cutting interest rates and using fiscal policy to boost demand.

True, those measures were taken by individual governments, mostly last autumn, and the G20 merely pulled together what was already being done. But the meeting brought home to the world the fire-power that governments can direct at an economic problem and helped end the sense of uncertainty, even fear, that had lingered on through the winter.

So what happens next? This week's G20 meeting in Pittsburgh will have a different tone – and in a way a harder task. It is no longer a question of selling the rescue operation to the world's financial and business communities. That bit is done. It is one of explaining how governments will get back to normality. The world cannot continue with near-zero interest rates or with huge fiscal deficits and most governments certainly don't want to continue supporting banks. So there has to be an "exit strategy", horrid expression but you can see what's meant. That will be part of the debate in Pittsburgh.

It will be different for different countries. Some, such as Germany, have a strong fiscal position and will be able to cut taxes to sustain demand. We are in the opposite camp and, even on this government's plans, have to start tightening policy next year. In all probability the squeeze will have to be harsher than is at present proposed whoever wins the forthcoming election.

So the G20 cannot co-ordinate exit strategies because they will all be different, but that need not matter too much. What really does matter is that the next phase of growth should be put on a more sustainable basis than the previous one. Both governments and private sector made big mistakes during the last boom and the aim now has to be to make fewer ones from now on.

Of course this isn't a matter for a single meeting. That would be absurd. In any case these are sovereign governments that won't react well to being told what to do by others. What these successive G20 meetings ideally might do is to create a forum in which peer pressure can create a set of checks and balances over governments' policies so that really damaging actions are checked in the bud.

Step back a bit. A couple of years ago when the boom was in full swing there was a lot of talk about there being a single global financial system but no single political system. Governments were national, economics was international. The implication was that governments were the problem. Well, in a sense they were, because we can now see that lax monetary and fiscal policies in many countries puffed up both overall demand and asset prices into an unsustainable bubble. The banks, or at least many of them, were complicit with those policies.

But we can now see that governments have also been the solution, while finance has been a large part of the problem. So the question now is how to choreograph the recovery and get the balance right. Governments have to be sufficiently internationally- minded to give freedom to the private sector to generate growth but also not to allow it get out of hand and jeopardise the entire economic system.

Is it unreasonable to hope that the G20 leaders might, over the next decade or so, get this balance right?

There are several grounds for pessimism but one shining reason to be optimistic. Start with the former. There will be lots of talk about the need for "balanced growth" – there is some of that in the communiqué which, as always, has been written well ahead of the meeting.

What matters, however, is not what leaders say in meetings; what matters is they have sustainable policies. For a while it seemed as though they were succeeding, for the scale of the swings in the world economic cycle seemed to be coming down. Then they blew it. Sure, the rescues seem to have worked, but at costs that will hobble the recovery.

That is a second reason for pessimism. Government debts have increased everywhere – we just have a particularly serious bout of a global infection. They have increased more rapidly than at any period in peacetime, have coincided with the demands of ageing populations, and they will be a drag on growth for a generation.

There is a third reason. It will be harder for everyone – companies, home-buyers and consumers alike – to get credit from banks. New regulations will force them to be more risk-averse, so they won't lend money to people and companies that are not rock solid. People will have to save more and companies will have to finance more of their investment from retained profits. It is an inevitable and, to some extent, necessary shift, but it means growth in countries that have relied heavily on credit will be slower than it otherwise would have been.

Put all this together and you can see that we will have several years of policies that are consistent with slow economic growth, at least in the developed world. Living standards will rise more slowly and may even fall. Employment will recover more slowly. The only possible beneficiary will be the environment as, in the short term, fewer resources will be consumed, but I am not even sure of that in the long term, for there will be less money to invest in technology and research.

Fortunately there is one profoundly important reason for optimism, exemplified by the fact that this is G20 meeting, not a G7 one. This is not just a rich world club. All the most important emerging economies, not just China and India, are there too. Their governments are less constrained by debt. Their banking systems are less highly-geared. Most have better growth records, in some cases astoundingly so, and they will continue to drive the world economy forward. As they do, their ideas on how to run an economy will come to influence ours – and I can tell you, you can't get a 125 per cent mortgage in China.

h.mcrae@independent.co.uk