Hamish McRae: Growth – if Germans take it seriously, so should we

Economic View: Germany is being forced to take on more and more contingent liabilities for the weaker eurozone countries

Today we get the European Central Bank's (ECB) plans to try to support the weaker eurozone countries by buying their sovereign debt. If the leaks are correct this should buy the eurozone's high command more time.

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It looks as though there will be purchases of bonds of up to three years' maturity, with no formal limit on the amount but with the purchases offset in some sort of way so that the additional funds do not feed through into higher inflation. There are also suggestions that before the ECB buys these bonds the country concerned will have to show it is carrying out appropriate economic policies – that ugly word "conditionality" – and there may be some sort of threat that the ECB might start selling the bonds should a country go back on its promises.

This looks like being one of those initiatives where the devil is in the detail so let's wait until we know that detail. Quite how the ECB can buy sovereign debt when it is prohibited from doing so under its statutes is something that will have to be figured out. I suppose if the German and French leaders support the plan that will happen. Gradually, Germany is being forced to take on more and more contingent liabilities for the weaker eurozone countries.

But meanwhile a working assumption would be that this will turn out to be rather similar in its effect to the €1trn (£792bn) of cheap funds lent to European commercial banks last autumn under its so-called long-term refinancing operation (LTRO). Banks borrowed the money then stuck it into higher-yielding sovereign debt. That boosted their profits but also had the effect of cutting the interest rate on the debt. It also enabled foreign holders to bunk out of dodgy debt at a better rate than they would otherwise have been able to do. None of this was quite what was supposed to happen – the aim had been to increase bank lending to businesses – but the action steadied things for a bit. Expect the same again.

What neither the LTRO nor this programme of "monetary outright transactions" as it will apparently be called (I hope this sounds better in the German) will do is alter the willingness of countries to follow reform programmes that might increase growth. It is a question that is very relevant here, with the deterioration in public finances and the real possibility that this financial year will see the deficit going up, not down. You can see from the rhetoric associated with the reshuffle that the Government is desperately worried about this, as it should be. So what on earth can governments do to increase growth?

I have been looking at a paper by three civil servants in the German Ministry of Finance, Norbert Hoekstra, Ludger Schuknecht and Holger Zemanek, called Going for Growth – the best course for sustained recovery and published by Politeia. Dr Schuknecht was in London this week to launch it.

The paper reflects the authors' personal views but given the relative success of German financial policy in recent years, it deserves to be taken seriously as a German blueprint that might be applied by the weaker eurozone countries.

The authors first of all make the general observation that growth is beneficial for a number of reasons. It helps cut the relative size of deficits and debts; it helps countries that have lived beyond their means make the necessary adjustments; and it helps offset the effect of other aspects common in industrialised countries such as a shrinking labour force and the need to devote more resources to counter environmental concerns.

They look at the turnarounds achieved in a number of countries, including Ireland (before things went wrong), New Zealand, Sweden, Chile and Brazil – and, interestingly, East Germany, for we tend to forget that Germany has its own direct experience of converting a command economy to a market one. That was a much more radical downsizing of the state than anything any other Western democracy has had to contemplate.

At any rate, in these rather different economies there were certain common characteristics. Growth accelerated, unemployment fell, and these benefits continued after the initial reform phase.

Public deficits also fell, and in some countries moved into surplus. And the fiscal and structural reforms changed the perceptions of the role of the state, with increased economic freedom in both emerging and developed economies.

The authors draw a number of lessons for the so-called advanced economies. They feel we have to tackle the issue of big government, noting that the increase in the public spending ratio "is perhaps the worst legacy of the financial crisis and the preceding economic boom period… If left untackled this situation seriously puts at risk the prospects for confidence and growth in advanced economies more broadly".

This leads into several areas of debate. One is whether the large deficits in countries such as the US and UK, far from boosting growth are actually are damaging it by undermining business confidence. Another is a debate about the appropriate size of the state more generally. How big should the government be?

Here there seems to be what might be called a "Goldilocks band", not too big and not to small, with the state spending somewhere between 35 per cent and 40 per cent of GDP

That area, which was identified in earlier work by Dr Schuknecht and Vito Tanzi, is high enough to enable a state to provide the services expected of it, but not so high that it can crowd out the activities of the private sector.

You can see a selection of countries rated by average size of public spending and average growth for the decade between 2001 and 2011 in the graph. It is quite a wide scatter of results, but there does seem to be a definite relationship between faster growth and a smaller state.

While it is, of course, mathematically easier to reduce the size of the state if you have rapid growth, the experience of the reform countries which are studied in the paper needs to be taken seriously.

If the Germans take it seriously, surely we should too.