T he global financial crisis has brought the state roaring back, with large stimulus packages and overhaul of regulatory systems. It is to be welcomed – but only up to a point. Today, we need a smarter, more active state, not necessarily a bigger one.

In the decade before the crisis, the role of government was under attack almost everywhere. Alan Greenspan, the former chairman of the US Federal Reserve, expected the markets to self-regulate in their own interests. International institutions pushed for open capital accounts. Privatisation was promoted as the answer to the problems of the developing world.

The assault came after almost a century of expansion. On the eve of the first world war, the average size of the state in the developed world was around 10 per cent of gross domestic product. By 1920, it had risen to 18 per cent. With the Great Depression it expanded again to 22 per cent of GDP, hitting 28 per cent by the end of the second world war.

The golden period came with the expansion of the welfare state between 1960 and 1980, when government spending in the developed world rose to around 43 per cent of GDP. Public debt also rose sharply. In 2007, just before the crisis, it averaged 70 per cent of GDP in the Organisation for Economic Co-operation and Development. Huge stimulus packages and output losses will push this above 100 per cent by 2011, raising concerns over a sovereign debt default, especially in southern Europe.

In the post-colonial world, likewise, state-led development had became the accepted model. But the post-1980 period saw a reversal. Total government expenditure as a percentage of GDP declined in 43 developing countries – from 19.3 per cent in 1980 to 16.3 per cent in 1998. Asia experienced the most rapid decline – from 19.1 per cent in 1980 to 15.2 per cent in 1998. In spite of this, Asian countries succeeded in lifting millions out of poverty. Even in east Asia, crony capitalism, and not open capital accounts, was seen as the cause of the 1997-98 Asian financial crisis. This led to further cutbacks in public investment and social expenditure programmes.

So what is the appropriate role of the state after the financial crisis? In the developed world, a permanent expansion is impossible, especially as ageing populations put further pressure on public finances. With almost half of GDP in state hands, it is not surprising that large stimulus packages helped stop the markets going over the edge. But with public debt in the developed world exceeding GDP, there is less scope for fiscal activism. If economies sink back into recession, further fiscal expansion could unnerve markets. In the long run, debt sustainability may require a fundamental review of the welfare state.

It is too early to predict the demise of the nation state. The state remains the ultimate protector of people’s interests as markets overreach, on both the upswings and the downswings of capitalism. Self-regulation – à la 16th-century Scottish bankers – or a light-touch regulatory system cannot be the solution for the modern financial world. A co-ordinated, activist and sceptical regulatory system is needed. The Group of 20 and more broadly the UN can play a bigger role.

Asian-style state-led capitalism has performed well during the crisis. With low public debt at around 40 per cent of GDP, Asia has shown the world that future capitalist development depends on an activist state, but not necessarily a large one. Unburdened by expensive welfare provision, developing countries in Asia and elsewhere must now build social protection systems but with “workfare” rather than European-style “welfare”.

With global warming – the mother of all market failures – looming, the role of the state becomes more critical. Investment in green technologies and public infrastructure must be the priority.

In terms of size, the state has reached its limits in the developed world. But there is a case for increasing its role in sectors such as banking and finance, as well as in addressing climate change. In the developing world, government needs to play a bigger role in social protection, basic services and rural infrastructure. Addressing corruption and ensuring delivery will be key to its legitimacy.

What will matter is what the state does, not how big it is. A smarter, more active state is the way forward.

The writer is UN assistant secretary-general, UNDP assistant administrator and director of the Regional Bureau for Asia and the Pacific