Hamish McRae: Europe needs a rise in production to create a healthier, stronger future

Economic View

'C Day" – cuts day – is Wednesday. The cuts will be greeted with a wall of sound: a raft of concern and anger, but mixed I expect with some relief.

The relief will not be so much from the chunks of the economy that will be unaffected but more from a feeling that at last we are confronting our problems, rather than pretending they are less serious than they are. Perhaps I should add that we should particularly beware adverse comments from people associated with the policies of the previous government. We have to move on.

But how? How do we move on beyond austerity? Ultimately what will determine whether the UK and indeed any developed economy can have a successful decade will be the extent to which it can generate real growth. We have to do this against the headwinds not only of these debts but also of adverse demography. And here it is, I suggest, time for some cautious optimism, certainly for the UK, but also more generally for other European nations, assuming that is that we, and they, have sound policies over the next few years.

Start with European public debts. The chart shows two things. On the left-hand side is the estimated government deficit this year, where as you can see, the UK leads the way. According to these OECD numbers, only Ireland has a larger deficit as a proportion of GDP – though I think those estimates for Greece look a trifle optimistic. On the right side is the stock of debt back in 2007 (blue bit) and this year (with the addition of the yellow bit). Every country has added to its debt but because we started with a relatively low burden, even now our own total debt is still middle-of-the-pack. The debt will go higher of course but assuming the structural deficit is indeed eliminated in the life of this parliament, then we will still be only towards the top end of the scale, roughly comparable with France, by 2015.

There are two other reasons to be modestly confident. One is that the maturity of UK public debt is relatively long: we don't have a huge pile to roll over next year, unlike the US. The other is that by European standards our society is ageing relatively slowly. We still have a growing workforce. So while we have a pension "black hole", it is not as yawning a chasm as most other European nations.

But we still need growth to fix these fiscal problems. Indeed the more growth we get the easier it is to earn our way out and the more chance we will have to have enough financial firepower to offset some future downturn, as and when it comes. How can we get that growth? I have been looking at a study by the McKinsey Global Institute to be published tomorrow Beyond austerity: A path to economic growth and renewal in Europe.

It is an encouraging title and it follows excellent work done by McKinsey earlier this year on the debt burden in the major economies. The basic thrust of the earlier paper was that the developed world has a huge problem; the basic thrust of this is that with wise policies, Europe can fix it.

The benchmark for this study is the US. Why is it that the EU has had so much poorer a productivity performance? Until the mid 1990s Europe (that is the 15 members prior to enlargement) was narrowing the gap with the US. Since then it has widened. The bad news is that McKinsey calculates that Europe has to increase its growth by some 30 per cent over past performance to grow at all. The good news is that there is plenty of scope for improvement. So how?

Practice varies across Europe and part of the McKinsey argument is that the region needs to adopt the best practice achieved in some of its parts. One big area for advance is labour market practice. Thus Scandinavia and the Netherlands have been good at keeping older workers in employment. Denmark and the UK have been good at cutting structural unemployment. A number of countries have been good at creating part-time jobs and hence helping people make the choice to balance work with leisure.

Another area is improving productivity in service industries. The biggest differences between productivity in the US and Europe are not so much in the relatively small manufacturing sector but in the much bigger services one. The paper argues that service productivity is held back by high levels of regulation, by lack of competition and by a fragmented service industry structure.

And a third area is the lack of support for growth in public policy: for example the lack of R&D support from governments, the poor connections between universities and business, and the failure to support an entrepreneurial mindset.

How does the UK stack up when compared with the rest of Europe? The short answer is not too badly but not top of the class. We have pulled up our productivity since the early 1990s but we were some way behind and overall productivity now is only about the EU average. We do have more older workers and more women in the workforce than the average and we do work longer hours than most of Europe, though shorter than the US. Crucially, we also have less adverse demography. But this is very much a case of "could try harder".

I would add a further point. There must be opportunities for increasing productivity in the public sector. We know that productivity has been either flat or falling in government services: that the huge increase in public spending has resulted in disappointingly small improvements in output. We know from comparative international studies that the UK government sector is below average in the developed world in terms of efficiency: not dreadful but not very good either. And of course we have lots of anecdotal evidence of government waste, especially from those working within it.

So let's see this exercise not just as an essential macro-economic move to get spending back to a level that is sustainable. Let's also see it as a way of improving productivity in an important part of the economy. For lifting productivity is the only way we, or indeed any country, can improve the living standards of its people.

As US prepares to launch QE2, China will be forced to make currency decisions

The other big policy story in the next week or so will be the announcement of another bout of quantitative easing by the US, the so-called QE2. Formal approval will be given at the November meeting of the Federal Reserve board but already we are starting to see its effect. Expectation is leading to market movements: a downward nudge of the dollar, an upward nudge in US equities, some new peaks last week in the gold price and so on.

What should we make of all this? The first point is the US will do what it feels it has to do to pump up demand. This is an exceptionally weak recovery compared with past cycles. Fiscal policy cannot be eased any further; indeed given that the US has a huge stock of maturing government debt this year, policy has to be tightened, as President Obama acknowledges. So it has to be monetary policy, and since interest rates cannot be cut any further, this is the only option.

One effect of this is that countries with a peg to the dollar will experience monetary easing too. Whereas countries with floating rates, will almost certainly see their currencies rise. What happens then depends on their monetary authorities but the immediate effect will be for policy to tighten. Worldwide – because at least some of the "floaters" will offset the rise in their currencies – the net effect will be an easing of monetary policy worldwide. So global demand will increase.

At some stage, however, this policy has to be reversed. You cannot go on printing money for ever and expect people to accept it. China has already signalled its disapproval of US policy, but what will it do about it?

My guess is that though the currency and interest rate effects of QE2 are already evident, when it is announced the dollar will further down. Then the Chinese will have to take some tough decisions – decisions they have so far avoided.