Europe's collective response to the 2008 credit crunch ranks with the treaty of Versailles and German reparations among the great follies of history. While the peoples of Greece, Spain, Italy and France wrestle with counter-productive austerity policies, Britain's rulers have no more idea of what to do next. On Tuesday David Cameron and Nick Clegg renewed the coalition marriage vow of two years ago, but there were no smiles of rapture in a Downing Street garden, just gritted teeth in an Essex factory. Cocks of the walk had become headless chickens.

Those who warned at the time that the coalition risked double-dip recession by over-suppressing demand have been proved right. The chancellor, George Osborne, raised VAT to 20%, tightened benefits and allowed banks to restrict credit (while saying the opposite). He declared that private sector growth would more than compensate for public sector contraction. He meant well, but he was wrong.

He was also wrong to dismiss the desire of Gus O'Donnell, then cabinet secretary, for a plan B. It was clear 18 months ago that demand was collapsing. A government obsession with rescuing banks took the cabinet's eye off the ball and had nothing to do with the case. The longer course correction was delayed, the more demand drained from the economy, until the gangrene of double-dip set in. Britain is now having one of the worst recessions in the OECD.

From Cumbria to Corinth it has been left to ordinary voters, to the great Babel of democracy, to bring reality to bear on those who manage economies. Enough austerity, they have cried, try something that works. As Andrés Velasco, the former Chilean finance minister, has written, it is "insane" to envisage countries locked in a common currency slashing their deficits while trying to promote growth: it is a contradiction in terms. This appears at last to have been grasped by an improbable coalition of the White House, IMF, Greek electorate and new French government – and even the ageing British one. They all want "growth", though few seem to know how to get it.

In Britain the only growth the Treasury has recognised so far has been to turn to the banks. It is like asking the mafia to promote honesty in local government. Ministers pleaded with bankers to lend more to real people, and even printed the money for them to lend. The banks simply carted the loot from the mint and used it to pay off their gambling debts. There is no evidence that one penny of the hundreds of billions of pounds made available "leaked" into the productive economy.

I witnessed government growth policy at work last week on the road north out of Manchester towards Rochdale. The scene is one of utter devastation. Not just individual shops but entire parades have gone out of business and are boarded up. Mile upon mile of factories, garages, supermarkets and warehouses lie empty and for sale. Recession has delivered the coup de grace to a quarter century of manufacturing decline. Manchester is by no means the worst hit of English cities, but its northern suburbs are Detroit UK.

The British economy needs three things: demand, demand, demand. It needs cash in pockets and cash in tills. It does not need richer banks or easier credit lines or looser regulation. It needs that old Keynesian salve, money in circulation. If money can be showered short term on banks, it can be showered short term on consumers, whether through benefit handouts, vouchers, tax holidays or scrappage schemes. Osborne declares quantitative easing to be off his debit sheet. He can do the same for temporary boosts to the money supply.

The chancellor can take credit for winning a reputation for responsibility. Now is the time to draw on that credit. To the claim that boosting demand is inflationary, the answer is that this is the least serious threat to Britain at present. Look at youth unemployment, shop prices or interest rates. Visit the outskirts of any British city. Britain is bursting with unused capacity. Inflation is for another day, not now.

The cabinet's current response to the cry for growth is to dip into the old goody bag. Osborne is already spending or planning billions of pounds for new railways, tunnels under London, wind turbines and aircraft carriers. There are murmurs of power stations, toll roads and ecotowns. The portfolio of ideas flowing through Whitehall reflects the interests of those whom Whitehall meets – government contractors, land-owners, estate developers and the bankers who finance them. It comes from government departments lobbying for airports, colleges, roads and hospitals.

The reason why the Treasury likes such projects is that they make headlines for ministers and can be controlled from the centre. Also, few involve big spending now. They are slow growth, lobbyists' growth, dumb growth. They can be farmed out to private finance and are more likely to fuel the next boom than ease the present slump.

It would be better by far to import the US concept of "smart growth". This does not channel counter-recessionary spending through grand projects. It directs it to the renewal of existing communities and infrastructure, to where there are already roads, transport, schools and hospitals. It restores, infills and stimulates activity where the social and physical framework is in place. It is productive and "sustainable".

Smart growth revives the private sector through blood transfusion to the high street, rather than through the colossal public contracts favoured by Osborne and the industry secretary, Vince Cable. It makes cities denser, rather than depopulating them. It lets the market rather than the state allocate the extra cash. All this may lack ministerial glamour and earn little for consultants, but if politicians are serious about growth, smart sure beats dumb.

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