The chief task that John Maynard Keynes set himself in writing his General Theory of Employment, Interest, and Money was to uncover the deep axioms underlying the economic orthodoxy of his day, which assumed away the possibility of persistent mass unemployment. The question he asked of his opponents was: “What must they believe in order to claim that persistent mass unemployment is impossible, so that government ‘stimulus’ to raise the employment level could do no good?” In answering this question, Keynes reconstructed the orthodox theory – and then proceeded to demolish it.

Today, despite the Keynesian revolution, the same question demands an answer. What do people who demand rapid “fiscal consolidation” amid heavy unemployment need to believe about the economy to make their policy coherent?

This question is not trivial, because the fiscal hair shirt has become the favored article of policy clothing among those who now dictate economic affairs. Prestigious bodies like the G-20, the IMF, and the OECD join the “markets” and economic columnists in demanding that governments liquidate their deficits. Any other course, they say, spells disaster; balancing budgets as soon as possible is the only way back to prosperity.

A few Keynesian economists stand against this stampede to retrenchment – Paul Krugman, Joseph Stiglitz, and Brad DeLong in the United States; Martin Wolf, Samuel Brittan, Danny Blanchflower, and I in the UK; and Paul de Grauwe and Jean-Paul Fitoussi in continental Europe. But we are a small minority.

Indeed, all Western governments, with the exception of the Obama administration, are committed to retrenchment – and Obama cannot get a new stimulus package through Congress. The question is: what must the cutters and slashers believe to justify their policies?

When I ask this question, I never get a coherent answer; so let me retrace Keynes’s steps.

The first of the implicit assumptions of orthodox theory that Keynes identified was Say’s Law, the doctrine that “supply creates its own demand.” This means that all money earned is bound to be spent, and therefore that at no point in time could there be a “general glut” of commodities.

Keynes pointed out the fallacy here: while the income derived from production is, by definition, equal to the value of production, it does not follow that all this income will be spent. Some part of it may be “hoarded,” in which case demand may fall short of supply. Specifically, Keynes denied that saving is simply deferred spending. In a well-known passage, he wrote: “An act of saving means…a decision not to have dinner today. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence…Thus it depresses the business of preparing today’s dinner without stimulating the business of making ready for some future act of consumption.”

“Getting to that realization,” says Krugman, “was an awesome intellectual achievement.” Yet Say’s Law is alive and well among new classical macroeconomists like John Cochrane and Eugene Fama. It amounts to claiming that the factors of production will always be fully employed, and that, in Cochrane’s words, “if the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment.”

The second classical postulate Keynes identified was that the “real wage is equal to the marginal disutility of labor.” This means that, in a competitive labor market, real wages will always be instantly adjusted to changes in conditions of demand. In other words, there can never be involuntary, or unwanted, unemployment.

Keynes denied that real wages are set in the labor market. Workers bargain for money wages, and a reduction in their money incomes might leave total demand too low to employ all those willing to work. Yet today most economists model unemployment as “voluntary” – a rational preference for leisure rather than work. This reinforces the idea that “stimulus” cannot do any good, since workers have as much employment as they want.

Keynes thought that the chief implicit assumption underlying the classical theory of the economy was that of perfect knowledge. “Risks,” he wrote, “were supposed to be capable of an exact actuarial computation. The calculus of probability…was supposed to be capable of reducing uncertainty to the same calculable status as certainty itself…”

For Keynes, this is untenable: “Actually…we have as a rule only the vaguest idea of any but the most direct consequences of our acts.” This made investment, which is always a bet on the future, dependent on fluctuating states of confidence. Financial markets, through which investment is made, were always liable to collapse when something happened to disturb business confidence. Therefore, market economies were inherently unstable.

Today’s “efficient market theory” restored to economics the assumption of perfect knowledge by claiming that all risks are correctly priced. This means that the “underpricing of risk worldwide,” which Alan Greenspan identified as the root cause of the banking collapse of 2007-08, is impossible. Yet it happened.

The classical view of the economy, which Keynes set out to demolish, is not only alive, but in recent years has been dominant, feeding the belief that competitive markets can be left to regulate themselves, will always provide as much employment as is wanted, and are immune to large-scale collapse. This also fuels opposition to government intervention, and to “stimulus” policies, which are supposedly redundant, if not harmful, since the events that require them cannot happen (but do).

Unless we start discussing economics in a Keynesian framework, we are doomed to a succession of crises and recessions. If we don’t, the next one will come sooner than we think.

Copyright Project Syndicate

It may have been fear of communism that agitated governments when Karl Marx penned the opening line of his famous manifesto in 1848, but today it is the dread that market sentiment will turn against them and drive up the spreads on their government’s bonds. Governments all over are being forced into premature fiscal retrenchment, even though unemployment remains very high and private demand shows few signs of life. Many are driven to undertake structural reforms that they don’t really believe in – just because it would look bad to markets to do otherwise.

The terror spawned by market sentiment was once the bane of poor nations alone. During the Latin American debt crisis of the 1980’s or the Asian financial crisis of 1997, for example, heavily indebted developing countries believed they had few options but to swallow bitter medicine – or face a stampede of capital outflows. Apparently, now it’s the turn of Spain, France, Britain, Germany, and, many analysts argue, even the United States.

If you want to keep borrowing money, you need to convince your lender that you can repay. That much is clear. But in times of crisis, market confidence takes on a life of its own. It becomes an ethereal concept devoid of much real economic content. It turns into what philosophers call a “social construction” – something that is real only because we believe it to be.

For, if economic logic were clear-cut, governments wouldn’t have to justify what they do on the basis of market confidence. It would be evident which policies work and which do not, and pursuing the “right” policies would be the surest way to restore confidence. The pursuit of market confidence would be superfluous.

So, if market confidence has a meaning, it must be something that is not pinned down simply by economic fundamentals. But what is it?

In his Communist Manifesto, Marx went on to say that it is “high time that Communists should openly, in the face of the whole world, publish their views, their aims, their tendencies, and meet this nursery tale of the specter of Communism with a Manifesto of the party itself.” Similarly, it would be nice if markets would clarify what they mean by “confidence” so that we would all know what we are really dealing with.

Of course, “markets” are unlikely to do any such thing. This is not just because markets comprise a multitude of investors and speculators who are unlikely ever to get together to publish a “party program,” but more fundamentally because markets have little clue themselves.

A government’s capacity and willingness to service its debt depend on an almost infinite number of present and future contingencies. They depend not just on its tax and spending plans but also on the state of the economy, the external conjuncture, and the political context. All of these are highly uncertain, and require many assumptions to reach some form of judgment about creditworthiness.

Today, markets seem to think that large fiscal deficits are the greatest threat to government solvency. Tomorrow they may think the real problem is low growth, and rue the tight fiscal policies that helped produce it.

Today, they worry about spineless governments unable to take the tough actions needed to deal with the crisis. Perhaps tomorrow they will lose sleep over the mass demonstrations and social conflicts that tough economic policies have spawned.

Few can predict which way market sentiment will move, least of all market participants themselves. Even with hindsight, it is sometimes not clear why markets go one way and not the other. Similar policies will produce different market reactions depending on the prevailing story, or fad of the moment. That is why steering the economy by the dictates of market confidence is a fool’s errand.

The silver lining in all this is that, unlike economists and politicians, markets have no ideology. As long as they make money they do not care if they have to eat their words. They simply want whatever “works”—whatever will produce a stable, healthy economic environment conducive to debt repayment. When circumstances become dire enough, they will even condone debt restructuring—if the alternative is chaos and the prospect of a greater loss.

This opens up some room for governments to maneuver. It permits self-confident political leaders to take charge of their own future. It allows them to shape the narrative that underpins market confidence, rather than play catch-up.

But to make good use of this maneuvering room, policymakers need to articulate a coherent, consistent, and credible account of what they are doing, based on both good economics and good politics. They have to say: “we are doing this not because the markets demand it, but because it is good for us and here is why.”

Their storyline needs to convince their electorates as well as the markets. If they succeed, they can pursue their own priorities and maintain market confidence at the same time.

This is where European governments (along with their economist advisors) have kept missing the boat. Rather than face up to the challenge, leaders first procrastinated and then buckled under pressure. They ended by fetishizing the pronouncements of market analysts. In doing so, they have denied themselves economically desirable policies that have greater chance of garnering popular support.

If the present crisis gets worse, it will be political leaders that bear primary responsibility – not because they ignored markets, but because they took them too seriously.

Copyright Project Syndicate

The project of seriously re-regulating the financial sector requires a great deal more leadership than we have seen so far from any of the large nations. In many ways, the Obama government has been the most disappointing. To the extent that the governments of Britain, France or Germany have ventured slightly bolder proposals, they have been discouraged by the government of the United States.

To appreciate the degree of reform that we need, it is helpful to review the function of the banking system. At bottom, the role of the financial sector is to channel credit and capital to the real part of the economy, to make assessments of risk, and to price the cost of credit accordingly. Until the 1970s, the financial sector in most of our countries was well regulated and well behaved. The financial sector itself was fairly small – under 6 percent of GDP in the US. It existed to serve the rest of the economy. With deregulation, more and more of what financial intermediaries did became pure speculation, aided by extreme degrees of leverage and pyramiding. The enlargement of the financial sector became an end in itself.

One can divide the financial system into three broad functions:

• extending credit to businesses and households;

• connecting investors to entrepreneurs;

• pure trading and speculating.

The first two functions add value to the economy. But since the 1970s, more and more of the financial system and an increasing share of its profits have been based on the third function. As many critics have observed, all of the banks want to be hedge funds. But pure speculation and trading adds nothing to net economic welfare. At best, it is a zero-sum game. At worst, as in the recent crisis, it simply allows middlemen to take immense risks with other people’s money. If their bets pay off, they can become extremely rich. If their bets fail and they are large enough or interconnected enough, governments often make up the losses.

The historic task of government in this era is not just to discourage or prohibit risky practices, but to fundamentally alter the business models of major financial institutions, so that no institution that makes most of its profits from speculation or from trading is in a position to menace the entire system or to require bailouts from taxpayers. Speculation, to the extent that it is permitted at all, should be a purely private activity, and it should be discouraged.

The Obama Administration has shown little interest in this degree of fundamental reform. On the contrary, its strategy for resolving the banking crisis has been to prop up banks that are effectively insolvent such as Citigroup, and to disguise the degree of their insolvency. The consequence of this policy is that real reform is deferred, and the process of recovery is protracted because traumatized banks are rebuilding capital and setting overly strict lending standards rather than providing credit where it is needed. Though the Federal Reserve has reduced short term interest rates to barely above zero, the real economy suffers from a paradox of cheap money and tight credit.

Large money center banks continue to see speculative activities rather than ordinary commercial banking or stock underwriting as their main profit centers. This is a recipe for the next bubble economy.

The reform legislation recently approved by the U.S. House of Representatives is far too weak. It does not include serious controls on derivatives, or fundamental reform of credit-rating agencies. It leaves the most unregulated kinds of financial institutions such as hedge funds and private equity firms almost untouched. It preserves the doctrine of “too-big-to-fail”, and puts the Federal Reserve in the role of “systemic risk regulator” despite the Federal Reserve’s failure to adequately regulate sub-prime lenders or bank holding companies, both of which were its responsibility during the run-up to the crisis.

True reform would include the following:

• Capital reserve requirements for all classes of financial institutions. The larger the institution and the riskier the activity, the larger the reserve requirement.

• A strict separation of institutions that perform commercial banking from those that make their profits from trading.

• A strict separation of institutions that place orders for retail customers from those that trade for their own accounts.

• The same disclosure and reporting requirements for hedge funds and private equity firms as for publicly-traded and registered companies.

• A prohibition of the tax favoritism for borrowed money used to acquire companies.

• A prohibition of payment of special dividends to private equity owners of operating companies.

• Public ownership of credit-rating agencies.

• A requirement that all derivatives shall be traded on regulated exchanges, with capital requirements and limits on overall position.

• A provision that any firm that locates in a tax or regulatory haven shall not be permitted to do business or have financial transactions in an OECD country.

• A Tobin Tax on all financial transactions, graduated so that very short-term transactions pay the highest rate of tax.

• Corporate governance reform to ensure that shareholders and other stakeholders hold executives accountable for compensation formulas.

One disabling myth of recent years has been the premise that, because of globalization, national governments are relatively helpless to re-regulate finance; any nation that tries to regulate will simply drive business offshore. But the reality is that China and India largely escaped the consequences of the financial collapse because they simply did not permit their banks to traffic in exotic securities. India used punitively high reserve requirements to do the job. Chinese banks commit a variety of sins against free markets, including the use of artificially low interest rates for favored enterprises. But the Chinese government understands that their function is to supply capital to firms, and not to speculate. It would certainly be useful if the major nations could agree on a more effective Basel III with more consistent and adequate capital reserve requirements; or on a universal Tobin Tax. But that day will never come and reform should not be delayed in the meantime.

Much of what needs to be done can still be done by national governments. After the attacks of September 11, 2001, the Bush administration initiated a rigorous enforcement program to crack down on international money laundering to prevent movements of funds to finance terror. The same enforcement program could have been used to prevent regulatory or tax evasion – but that was explicitly prohibited.

Another disabling myth has been that any “innovation” should be welcomed as enhancing economic efficiency. But nearly all of the financial innovations of the past three decades have been aimed at evading regulation, enriching insiders, reducing transparency, increasing leverage, and passing off risks to others. The valuable innovations are those in the real economy. The proper role of the financial sector is to evaluate those risks and opportunities and make available financing.

To conclude:

• Banks need to return to their legitimate role of providing capital to households and enterprises.

• Investment banks and venture capital firms need to return to their legitimate role of financing new enterprises, expansions, and transfers of ownership.

• Private equity, as currently defined, is mostly parasitic and changes in tax policy should discourage the entire business model.

• Hedge funds exist only as pools of capital that evade regulation. They add nothing to the net economic well-being and should be discouraged as business forms.

• Derivatives, such as options and futures need to be limited to their legitimate role of providing hedges to commercial users against price fluctuations – and not be used as highly leveraged forms of gambling. Taxation can discourage very short-term trading.

• National governments, given the political will, can achieve most of this.

It should be obvious that virtually all of these proposals are far outside the current political discourse. It is our task to make them mainstream, even conventional.

This article is part of the book ‘After the crisis: towards a sustainable growth model‘, edited by Andrew Watt (ETUI) and Andreas Botsch (ETUI/ETUC) and published by the European Trade Union Institute (ETUI).

Last week, it suddenly looked as though Krugman’s worst fears were about to come true. Driven mainly by higher energy prices, annualised Consumer Price Index (CPI) inflation for April hit 3.7%, the highest for 17 months—nearly twice the target figure set by the Bank of England (BoE); April inflation measured by the Retail Price Index (RPI) was even higher. Despite barely perceptible growth of the UK economy in the first quarter, many City pundits forecast that the BoE would be forced to tighten monetary policy.¹ And of course, because higher energy prices are world-wide, a spike in the Eurozone might force the ECB to take similar action making a double dip recession in the EU a near certainty.

The price of petrol will not have escaped the attention of the man-in-the-forecourt. He knows that despite the recession and the lapse in world demand, petrol prices are higher than ever. Why? One reason in Britain could be Sterling’s weakness and the rising price of oil imports. But that can’t be the full answer since energy prices are rising everywhere.

According to a new study, the main reason is speculation: flows of hot money are swamping commodity markets and Exchange Traded Commodities (ETCs) have grown enormously. Traders are betting that energy prices will rise, and such is the herd instinct that the prophecy becomes self-fulfilling. In the case of oil, exchange-traded futures have gone from being twice the size of the market in 1995 to 12 times its size today. One of the analysts at Absolute Return Partners, a London based hedge fund, has found a near-perfect fit between the growth in these funds and the price of US benchmark crude oil. Starting in January 2007, the two sets of figures rise together until the peak in May 2008, then fall until the trough in January 2009, then rise again until the present.

?

Of course one can take issue with any statistical study, but the evidence in this case looks pretty solid. The basic lesson is that speculative activity is greatly amplifying the magnitude of the underlying fluctuations in the price of oil (and other commodities). Since oil lubricates the world economy, the larger fluctuations in oil prices mean bigger booms and busts, and higher oil prices – as we know from the 1970s – lead directly to economic tightening, stagnating incomes and unemployment.

In Hilton’s words:

It is not impossible to imagine a world in which speculators create inflation by pushing up the oil price and then, en masse, short the bonds of those countries whose inflation-fighting credentials they doubt.

I urge the reader to think about that for a moment. What does it have to do with the opening paragraph of this piece? Krugman in his book, The Conscience of a Liberal, argues that when the IMF urged Asian countries to balance the books during the 1997 financial crisis, they did so not because they believed it was the right medicine. The IMF forced its drastic medicine upon Thailand, Korea and Indonesia because it was what the international financial markets demanded.

Now fast forward to today’s financial crisis. World financial markets have an annual turnover of nearly one quadrillion dollars – one thousand trillion dollars, or about 20 times the size of world GDP. That’s a lot of clout – certainly enough to bet against Eurobonds and dictate that Greece or the other Club-Med countries should undergo serious economic surgery. That’s enough to speculate against Sterling in case Britain’s cuts are not timely and drastic enough. That’s enough to ensure that the cost of the financial crisis is borne not by the banks and hedge funds, but by you and me.

While the details are complex and controversial – and Goldman has rejected any suggestion of wrongdoing – the essence of the charge is simple: it knowingly sold securities that it had structured on behalf of one client who was betting on the underlying securities defaulting, and who indeed had selected them precisely with this in mind, to another client whom it left in the dark about their origin.

Whatever the details, and whether or not Goldman acted illegally in this case, what are the implications? Well, the media are buzzing with the prospect of an avalanche of legal claims from those who had suffered large losses in similar deals. Perhaps a former master of the universe or two may find himself mastering sewing mailbags in gaol. (I am not holding my breath, though.) More worryingly the uncertainty could disrupt the recovery of the real economy.

There is a broader point, however, one that the financial press and orthodox economists are almost certain to largely ignore. It is not entirely new but gains greater force from the recent scandal. The point relates to two fundamental questions of political economy and social ethics: Who gets what? And what are the most efficient social institutions? Let us start by recalling some basic economic theory, revisit some of the obsessions of mainstream economists and the media prior to the crisis, and then return to look at the Goldman story in that light.

A fundamental tenet of orthodox economics is that in an undistorted market economy people – conceived as economic ‘agents’ who sell certain ‘endowments’, such as labour and capital of different types and quantities, on the market – get what they deserve. Specifically, what people get out of the economy, proxied by their monetary income, is what they put in. Now there are a whole range of other problems with this view, to which I will return briefly, but I focus on the issue of distortions: ‘Undistorted’ is a short-cut for a range of technical assumptions that need to hold for this core belief of welfare economics to stand up. Now of course everyone knows that these assumed conditions do not hold in the real world. There are a whole range of institutional arrangements and real-world frictions and which are held to ‘distort’ market prices. Examples include welfare systems (which provide income to non-producers), regulations that restrict market entry (which enable firms to charge higher prices and make excess profits), the public sector (which takes service and goods production out of market competition) and trade unions (which, in the standard view, restrict labour supply and drive up wages for organised workers).

Now think back all those eons ago to before the great economic crisis (i.e. about two years). The story usually told about these distortions was typically framed as one of insiders against outsiders – and most commentators and academic researchers focused on the labour market. It went like this: On the one hand there were workers protected by trade unions, dismissal protection legislation and welfare states. These insiders exploited their market and political power, achieved through collusion, to wring resources out of the rest of the economy over and above their contribution. The outsiders were the unorganised workers, consumers and taxpayers, who were held to suffer, respectively, poor employment conditions, and higher prices or higher taxes for products and services that could have been produced more cheaply. Open almost any copy of The Economist prior to the crisis and read the familiar litany of the undeserving, privileged insiders: auto workers in the US, French farmers, German trade unionists generally, and teachers just about everywhere.

What is common to all these groups is that they are organised. This reflects the orthodox view that atomistic economic agents cannot – at least for long – be privileged insiders: competitive industries and (labour) markets mean that any advantage gained by one player would swiftly be bid away. Almost every standard policy recommendation (deregulate labour markets, downsize the public sector, reduce minimum wages, weaken trade unions, abolish agricultural policy) had its origin and justification in this belief: fight organised interests and make the real-world economy more like our model of the economy, based on atomistic competition, because that delivers efficient and fair outcomes (fair in the sense of ‘equivalent to input’: much of the political debate centred, in essence, on the extent to which that notion of fairness should be supplemented by a needs-based concept of justice).

At the same time the financial markets were portrayed in the financial media as being a jungle of no-holds-barred competition, while financial academia postulated and justified the efficient markets hypothesis of which financial markets were supposed to represent the apotheosis. Accordingly, the massive profits, wages and bonuses in the sector were routinely justified as reflecting finance’s hugely beneficial impact on the economy and/or the intellectual brilliance or downright hard work of its leading players. Criticism of the behaviour of investment banks, hedge funds, speculators or private equity companies were, accordingly, routinely shot down as economically illiterate.

The financial crisis has already shown that this was, at best, an almost comically naïve view, if not a downright fabrication. As is now well understood and generally accepted, the financial sector as a whole was living above its means because it was receiving an implicit and long-hidden subsidy from the state. To a considerable extent the profits being booked (and distributed) were fictitious. The financial sector built up and ruthlessly exerted raw political power and got its way with governments around the world, notably by moving to so-called light-touch regulation.

It is against this background that the revelations about Goldman Sachs – and I fully expect more to follow – should be understood. They underline once more who the real insiders are today. The real insiders are those that hold privileged access to information (that’s why I emphasised the words ‘knowingly’ and ‘in the dark’ in describing the charge earlier). The issue of the precise circumstances in which such action is technically legal or illegal is, of course, important with respect to these particular transactions (and this is certain to be the key issue for the media). But for the understanding of the political economy of financialisation, this is a second-order issue. Illegal fraud is the icing on the cake of financial insider power. What is key is that, in a financialised and globalised economy, those in asymmetric possession of information can easily convert it into staggering amounts of money for as long as it can be shielded from outsiders who want to grab a share of the goodies. Such shielding is possible for well-understood reasons such as economies of scale, first-mover advantage, branding etc. These ‘rents’ can then also be partially converted into political and ideological-discursive power (not least via the aforementioned financial press), which in turn buttresses the insiders’ position and ability to extract real resources at the expense of other sectors of the economy. Such insiders virtually have a license to print money. In the Goldman case the losers were, it may be argued, other financial institutions. But they did not belong to the core of insiders and, ultimately, most of these losses were in any case socialized; the tab was picked up by, for instance, German workers in the form of higher taxes after the rescue of IKB.

This brings us back to the pre-crisis insider-outsider debate. What can now be said about the real or supposed insiders amongst ordinary workers who, as we have seen, were the prime obsession of mainstream economists and the financial media? Even if the formidable organisational challenges involved can be overcome, the same processes of finacialisation and globalisation that increase the power of financial-sector insiders seriously limit via international competition on product and capital markets, the ability of nationally based workers’ organisations to extract real concessions in much of the economy. Similarly, national-level labour market regulations and welfare state systems are pitched into competition with one another. And this shift in the locus and determinants of insider power since the 1980s is no arcane theory: the results show up very clearly in the statistics, with unprecedented increases in wealth and income inequalities and in capital’s share of national income recorded in most advanced countries. The best that can be said about the media’s portrayal of insiders is that it might have had some relevance – in the 1970s!

In fact, there is a whole other line of argument that such institutions, and notably collective bargaining by trade unions, are welfare-maximising (and ‘efficient’ in the standard economic sense) given imperfections in labour and other markets – but that’s for another column. Let me merely recall Adam Smith’s comments in the Wealth of Nations that collusion by ‘masters’ was ubiquitous but hidden, that between workers difficult and obvious. What has belatedly become clear also to many mainstream observers is that the steady weakening of ‘countervailing power’ by workers has been a crucial factor behind key social trends in recent decades and, ultimately, the crisis itself.

If Goldman executives and others have acted illegally, they should – everyone can agree – be punished in law. But the legal question must not be allowed to obscure the more fundamental point about the insider power of the financial sector as a whole vis-à-vis the real economy and of powerful actors within it vis-à-vis financial-sector outsiders. The recent revelations and the likelihood of more to come are but one more good reason to continue the fight for re-regulation of the financial sector, in order to reduce at least the most egregious excesses, and for levies and taxes to recoup at least some of the resources needed by governments to clear up the mess. And we need to focus attention on the comparative irrelevance of much economic theorising and media commentary on the so-called distortions of social institutions and the focus on labour-market insiders. The broader challenge is to reorient the debate in these areas and prevent a return to orthodox business as usual in the face of high unemployment and fiscal deficits.

Apart from the rather strange title it was a lively discussion.

The German economy has contracted appreciably, by over 5 per cent – a situation as dramatic as any experienced since the Second World War. Even though there are some first signs of economic stabilisation and new growth in Germany, the fact of the matter is that further setbacks are entirely likely and there are very good reasons to question how sustainable this stabilisation really is.

The crisis-management phase is by no means over. And what has brought the world economy to the brink is precisely what, in recent years, has been touted as its main driving force: the increasingly close linkage between international capital markets and world trade, facilitated and supported by increasingly complex financial instruments that have led to soaring profits. It has now turned out, in the course of the crisis, that the global financial system was in no way able to contain the negative effects that resulted when the US real estate market bubble finally burst. Indeed, the international financial system itself has served to amplify, globally, the slump in the world economy.

When the crisis broke out, experts were relatively quick to agree that it would make no sense to simply seek to ‘muddle on’, at least as far as financial market regulation is concerned. A consensus soon emerged that the main cause of the turmoil besetting the global economy must be sought in the international financial markets. These, it was agreed, had, in connection with a protracted phase of underregulation, evolved into a kind of parallel world to the ‘normal’ economic system, in which even hard-boiled insiders were hard pressed to find their bearings. It was this failure of the world’s free and self-regulating financial markets that led to the initiative of the ‘systemically relevant countries’ (the G20) with regard to the regulation of the international financial markets. The G20 is now resolved to join forces in taking steps to bridle unregulated financial transactions and actors. The G20 agenda includes measures designed to ensure more transparency and accountability on the part of the financial sphere, at the global, regional and national levels.

When, in the winter of 2008/2009, it became clear that the financial crisis would have dramatic repercussions for the rest of the economy, a rethink took place at a number of levels, with the major industrialised countries and the most important emerging countries adopting massive stimulus and recovery packages and seeking to stabilise the real economy and the financial markets. In particular, the actions undertaken to rescue banks and major corporations reached proportions that had previously seemed inconceivable. All of a sudden, there was much talk of the ‘comeback of the state’, a return to a managed economic policy à la John Maynard Keynes – a return to state demand management in the economic space, an economist closely associated with the economic model that emerged in the post-War decades. Institutions such as the European Commission and the International Monetary Fund, which for decades had championed budget consolidation and improvements of supply-side conditions, were suddenly trying to outdo one another in their calls for bigger and bigger demand-side economic stimulus programmes. The discussions now centred not on whether state intervention was needed to support the economy, but on how such intervention might be effected as quickly, efficiently and cost-effectively as possible.

But the public debate has, since then, proceeded far beyond these technical issues. In political terms, we have experienced the impeachment of the market-radical vision of a ‘night watchman state’ in a system dominated (nationally and globally) by market structures. The population is showing a marked and growing aversion, not only to financial capitalism but also to the market as the one and only mechanism of economic governance. There is a growing impression that this model has failed to deliver on its promise of better living conditions for the broad mass of the population while, at the same time, generating huge incomes for individual managers and speculators. All of a sudden, calls for efforts to overcome this financial capitalism seem to be regaining political currency. But what would a new economic model look like? What shape would a ‘good capitalism’ take in a globalised world?

Correcting a multiplicity of capital aberrations

In this article, we develop a proposal for a ‘good capitalism’, one geared in fundamental ways to guaranteeing social justice and ecological sustainability at a high level of prosperity. This new model, however, should in no way be seen as a fundamental counterproject to the existing economic and social model of the kind embodied in the historical communist experiment of a socialist planned economy. While counterprojects may be intellectually stimulating, we are convinced that they have little to offer in the present situation. In the currently dominant economic model, which has evolved and taken hold just about everywhere, including Germany, since the 1970s, we see two major complexes of problems that need to be resolved – and can be resolved!

First, the reforms of the past 40 years have been based on a problematic faith in the market. The market was here understood as a self-regulating mechanism that leads, more or less on its own, to stability, including high rates of employment and a halfway acceptable distribution of income. When unleashed markets proved, as they generally did, unable to deliver the desired results, the invariable response of the political sphere was to administer to the economy another stiff dose of deregulation.

Second, starting in the 1970s, a growing imbalance emerged between the global market on the one side and the national level of regulation on the other. It is difficult to imagine any stable development of the world economy unless and until this asymmetry has been broken down.

When it comes to a new economic model, one central question that needs to be answered is what role the financial markets are to play in it. It is important here not to vilify the financial sector and its dynamism when it comes to creating and supplying credit. True, excessive lending is generally seen as the main factor behind the bubble in the US real estate market, and thus as responsible for the present crisis. But we must not forget that there is nothing wrong with credit and credit growth as such. Indeed, credit is the stuff that fuels innovation and growth. In our view, the financial sector has an important role to play in a social-ecological economy. In contrast to past years, in which financial sector transactions often ended up as the be-all and end-all, the financial sector needs once again to be the service provider for the rest of the economy. The financial markets need to supply the economy with the financial resources it needs to guarantee an optimal level of production and distribution of goods and services. They need to make available the risk capital required for innovations, above all in the ‘green economy’. But they also need to provide the ‘patient’ capital on which businesses rely to devise long-term strategies and to plan for the longer term. It is essential that the framework conditions for investment banks, fund management companies, commercial banks and other actors be formulated in such a way as to ensure that the financial sector as a whole is able to meet these challenges.

The financial sector will, of course, be able to play this role only as long as it does not see itself faced with excessive debt or debt crises in individual countries or sectors. Crises of this kind tend, regularly, to destroy the equity capital the financial sector needs to supply businesses with the credit they require for their productive investments. What this implies for a new, stable growth model is that constantly rising debt levels, on the part of the state or private households, will not be able to serve in it as a driver of growth.

The present crisis was preceded by gross global imbalances that found expression, in particular, in the huge US current account deficit. This clearly indicated that the United States was living far beyond its means – a state of affairs, however, from which the major exporting economies, above all China and Germany, were not at all disinclined to benefit. Inter-country imbalances of this kind may prove viable for a certain period, but once debt burdens have reached excessive levels, shaking confidence in the markets concerned, the result is inevitably capital flight, accompanied by economic stagnation.

One fundamental result of our new economic model is derived from just this insight: beyond financial market regulation, it is essential to set the economic framework conditions in such a way as to ensure that it is possible to create demand without unduly increasing debt levels.

Looked at in global terms, what this means is creation of demand via wages and salaries, a demand, however, that should rise, in the ideal case in all countries, in line with productivity and population growth. The central instrument needed to manage this demand is an active wage policy that provides for just wages and salaries for all. Any and every labour market policy, therefore, needs to give due consideration to the macroeconomic factors that feed into the creation of demand. Or, to put it differently, labour market reforms must not be allowed to endanger global economic stability – as they have until now.

The task of financial policy, in turn, is to prevent growing imbalances and to correct them whenever they occur. There is a simple economic reason for this: big earners consume, in relative terms, less than small earners. And this means that raising low incomes generates a larger demand effect than granting more and more tax breaks to millionaires (to say nothing about questions of equity).

Furthermore, major inter-country imbalances are an unmistakable sign of unhealthy debt trends, and they need to be prevented for this reason – this applies, it should be said, to deficits no less than to surpluses. Or, as Helmut Schmidt once put it: ‘No one should long be allowed to accumulate surpluses at the expense of all others, no one should be allowed to consume, in their own economy, the surpluses and the capital accumulated by others’. This is why the monetary policy run by a country or – in the case of Europe – a region needs to deploy new instruments, beyond the measure of key interest rate setting, to prevent and redress imbalances in both financial markets and in trade.

Two steps forward, without having to take one step back

The core issue underlying the question of a ‘good capitalism’ is finding the right balance between market, state and society. There are many places in which more state influence is needed to keep financial capitalism in check. This is not at all to say, however, that we need to return to the old ‘Model Germany’ of the 1970s. Nor does ‘more state’ imply any need to revoke measures undertaken to further liberalise society.

While the 1970s ‘Model Germany’ achieved one of its aims, namely broader scope for long-term thinking, on the basis of a close integration of the industrial and banking sectors (commonly referred to as ‘Deutschland AG’), European integration and the globalisation of production have deprived the model of the base on which it rested. Furthermore, the model served to entrench certain questionable power structures which, in fact, needed to be overcome. Some groups in society were excluded, de facto, from the labour market, or at least from certain positions. For women, for instance, finding reasonable employment in the 1970s was more difficult than it is today. A return to the 1970s model appears, for these reasons, neither desirable nor, indeed, even possible. Roughly the same can be said of attempts to copy the – foundering – Anglo-Saxon model, with its emphasis on short-term increases in shareholder value and its inclination to grant the financial sector exaggerated weight in the overall economy.

Coming up with a new economic model is quite an ambitious project. Many of its elements would necessarily elude implementation by one country going it alone – to say nothing of Germany, which, as an EU member state, is closely integrated with its neighbours in both economic and legal terms. What is more, for a considerable number of new ideas the supranational level is, for fundamental economic reasons, the appropriate level of governance and regulation. This applies, in particular, to financial markets and their actors. Capital is highly mobile and it invariably seeks an optimal location (optimal, that is, in terms of capital interests), one that is often found in an unregulated ‘offshore centre’ with no more than the most rudimentary of oversight structures. Quite apart from issues of equity, ‘regulatory arbitrage’ of this kind serves to undercut the very possibility of effective regulation. What is called for is, therefore, a globally coordinated regulation of financial markets. International coordination is essential when it comes to other points as well, including, for example, the need to redress global imbalances.

Be that as it may, in many areas the best place to embark on the path of conversion to a new economic model is at home. To take Germany as an example, efforts to reduce the country’s huge current account surplus could start out with a change of course in German wage policy and a tax policy geared to achieving greater redistribution effects at home. Neither of these elements would call for the coordination with other countries nor create conflicts with EU partners. And fewer imbalances in the world’s third- or fourth-largest economy would mean appreciably fewer imbalances worldwide.

‘Good capitalism’: A four-pillar model

The idea of capitalism as a self-regulating system which leads to stability and welfare for all has always been wrongheaded and will remain so. Markets need to be embedded in institutions and regulatory systems; otherwise, they tend to unleash destructive forces. The question is, therefore, not whether but how the state should intervene in markets. In order to enable capitalism to develop its productive (‘good’) dynamics, while unleashing as little as possible of its destructive tendencies, it needs to be reined in: by both state and society. The rein should not be too long, but not too short, either. In an ideal world, global capitalism is in need of global regulation – a global rein, so to speak. But many reasonable and promising measures can be taken at the national or regional level as well. A country such as Germany has sufficient room to manoeuvre to shape its own domestic economic affairs and to decide on the degree of globalisation right for it. One feasible alternative – which in our model would rest on four pillars – would have the following shape.

Pillar 1: Banks and the financial system
Financial systems are, in a manner of speaking, the ‘brains’ of the economic system. And while they are of key significance for dynamic economic development, they can also wreak havoc on an economy. In fact, a smoothly functioning financial system has, in a modern economy, at least four tasks essential for any sustainable growth process. First, by supplying businesses – and innovative businesses in particular – with newly created credit, the financial system sets the stage for investment and successful production processes. Second, by better distributing risk in general, it helps to enable business enterprises to assume more entrepreneurial risks and this tends to lead to higher levels of investment and greater economic growth. Third, a properly functioning financial system should distribute credit to those sectors and businesses that are most likely to generate sustainable growth. And fourth, one of the functions of a smoothly functioning financial system is to collect the smaller sums saved by a large number of savers and to make these resources available for major investment projects. In other words, the function of the financial system should be to make sufficient credit available for the business sector and to support innovative businesses with higher risks. This, though, can be done without either the countless – and, in the end, virtually indistinguishable – financial products currently available or huge derivative markets that tend to proliferate at dizzying rates. Furthermore, real estate and stock markets driven by speculation and short-term orientations and business strategies geared to earning quick profits offer little or no support for the long-term development of economies. Relatively down-to-earth financial systems are perfectly sufficient to expand credit and to finance investments and innovations.

What needs to be done
• Retention of a multi-tiered banking system with a strong public-sector component (savings and cooperative banks)
• Adoption of stricter rules governing the equity that banks are required to hold to cover all possible balance sheet risks; high risks need to be transparent and secured by sufficient equity
• Countercyclical formulation of financial market regulation (reduction of the role played by bank-specific quantitative risk models, reform of Basel II)
• Creation of a European banking oversight agency
• A strict ban on transactions with offshore centres
• Regulation of all financial institutions, keyed to their specific functions in the market
• Adoption of new rules on securitisation, including a licensing or testing agency for financial products and retention of the highest-risk shares when debt instruments are resold
• Setup of a clearing centre for derivatives and a strict ban on OTC transactions
• Expansion of the powers of banking and financial market oversight agencies, enabling them, in the future, to collect and aggregate financial market data and to adopt a macroeconomic perspective
• Abandonment of the principle of ‘fair-value accounting’ and adoption, in its place, of the lowest-value principle
• Reform of existing rating agencies and establishment of government rating agencies
• Adoption of strict rules for manager bonus systems
• Measures designed to correct the short-term orientation of financial markets and their impacts on the overall economy: abandonment of the shareholder-value principle in corporate management and measures designed to strengthen the role of all of a company’s stakeholders
• Expansion of the set of tools available to central banks to include, in addition to interest rate policy, variable equity rules for real estate credit (differentiated by sector and region) and the use of controls on the movement of capital and interventions in foreign exchange markets

Pillar 2: Wages and the labour market
Purchasing power, the central source of demand in developed economies, should be based on a relatively balanced distribution of income, and not on an expansion of consumer credit. Several measures are needed to achieve a balanced distribution of income: first, a reversal of the long-term trend towards a falling labour share of income, which is due chiefly to the financial system’s growing power, virtually uncontrolled proliferation and increasing hunger for risk and profit. Second, the wage structure would need to be modified in such a way as to raise lower-bracket wages. Third, the state would need to use tax and spending policies, including provision of public goods, to intervene in the market-driven distribution of income. Statutory social security systems would have an important – but not the only – role to play here.

What needs to be done
• Wage development needs to be linked to overall productivity development, as well as to the target inflation rate set by the central bank
• Adoption of unified and statutory minimum wages as a means of restricting inequalities in income distribution and preventing deflationary risks
• Measures to strengthen the instrument of the industry-wide wage agreement: compulsory membership in employers’ associations or decisions establishing the industry-wide applicability of collective wage agreements
• Measures to strengthen workers’ rights of codetermination at the company level
• Measures to condition the award of public contracts on fulfilment of minimum standards for wages and working conditions
• Creation of a common unemployment insurance system at the level of European Monetary Union (EMU), aimed, among other things, at strengthening regional coherence
• Adoption of a European minimum wage anchor (with the minimum wage set at 60 per cent of the national average wage) and establishment of a European Minimum Wage Commission
• Coordination of wage policy on the basis of a set of European wage guidelines
• Support for the development of Europe-wide trade unions, employers’ associations and collective bargaining

Pillar 3: Public budgets
A stronger role for the state in a ‘good capitalism’, with a fundamentally new regulatory framework, calls for measures to ensure that the state has the equitable and sound revenue base it needs to prevent any rise of public debt as a share of gross domestic product. Tax policy here serves, on the one hand, to correct imbalances in income distribution and, on the other, to enable investments, in particular in education, research and development, infrastructure and social security. A sound state revenue base is the sine qua non for both countercyclical stabilisation of the economy, based on automatic stabilisers, and the provision of public services of the highest quality possible.

What needs to be done
• Compulsory membership of all income earners in statutory old-age, health and unemployment insurance systems
• Adoption of Europe-wide minimum corporate tax rates
• Measures to further centralise financial policy in the Eurozone based on Europe-wide taxes and borrowing capacities at the EU level
• Deployment of a countercyclical fiscal policy at the European level, including coordination of fiscal policy in the European Monetary Union or the EU
• Expansion of the EU-wide system of revenue sharing, designed to assist individual countries experiencing difficult phases of development
• Adoption of a new Euro Stability and Growth Pact designed to correct current account imbalances

Pillar 4: The world
We make the case here for an economic constellation that fosters increases in productivity and innovation. This would be one marked by a stable and, at the same time, dynamic financial system and based, fundamentally, on growth in domestic or regional demand among the world’s nations, driven by increases in income and thus able to prevent major current account imbalances. The world economy should be linked to a system of relatively stable exchange rates, which could be adjusted to redress any emerging major imbalances. The principal instrument used to combat current account imbalances should be a set of monetary and fiscal policies – as well as appropriate wage policies within monetary unions, such as EMU. Exchange rates should be adjusted as soon as any excessive current account imbalances appear to be emerging. The fact that exchange rate adjustments are ruled out in monetary unions implies a need for stronger integration of, and cooperation among, the countries which are members of such a union.

What needs to be done
• A return to more stable exchange rates with clear-cut rules governing adjustments which need to be effected in the face of current account imbalances. This would be achieved on the basis of improved intergovernmental coordination of monetary and fiscal policies, as well as through control of capital movements and intervention in foreign exchange markets
• Assignment of a stronger role to the International Monetary Fund (IMF) in coordinating economic policy
• Development of a strong international financial market oversight committee with the Bank for International Settlements in Basel, which would be entrusted with the task of monitoring the international financial markets
• Assignment of a stronger role to the IMF’s Special Drawing Rights, enabling them to function, in certain ways, as a ‘world currency’
• Establishment of an international insolvency court for states, which would provide for an equitable allocation of debt burdens between (private) creditors and debtors in case a given country should find itself in an unsustainable debt situation
• Global support for the provision of international public goods, including, for example, solutions for pressing environmental problems
• At the European level, promotion of the institutionalised Macroeconomic Dialogue between the social partners established to improve coordination of wage negotiations in national labour markets

‘Good capitalism’ stands for relatively secure economic living conditions. It is simply not acceptable that workers or business enterprises should be left at the mercy of fully destabilised markets – a situation that we recently experienced in the wake of the US subprime crisis. Precarious jobs and mass unemployment serve only to weaken trade unions and workers. What this implies is a need to pursue policies designed to keep unemployment at low levels and to eliminate the legal loopholes responsible for the creation of precarious jobs. Expanded worker rights and rights of codetermination in the workplace constitute important elements of a balance of forces between labour and capital.

Even if the reforms we propose here were realised, there would still be plenty of room for markets, which must be seen, in their various dimensions, as a key element of individual liberty. That is to say, the concern is not to eliminate or replace markets but to embed them – and this applies, in particular, to financial and labour markets – in institutions and regulatory frameworks.

Good capitalism is possible!

While reading one passage or another of this article, many a reader may think: Yes, this would be a good idea, but it’s completely unrealistic. Fixed exchange rates worldwide? The Americans would never go along with it. Higher taxes for improved redistribution of wealth in Germany? The business lobbies are too strong anyway, so what’s the point of trying? Further strengthen industry-wide wage agreements in Germany? Hundreds of German economists are bound to sign protest declarations and stuff politicians’ mailboxes with them. The list could go on and on.

We are convinced that such scepticism is unfounded. Economic history is full of examples of fundamental change. To give one example, for a long time it was simply inconceivable to have money not backed by precious metals, but today, not one of the world’s major currencies is officially convertible into gold or silver. During the onset of the Great Depressions in the 1930s, it was widely believed that the state was – and should rightly be – powerless when it came to countering the effects of cyclical ups and downs. Just five or six years down the road, however, John Maynard Keynes published his ‘General Theory’ and turned this mindset upside down. Until the onset of the most recent crisis, in 2007, it was likewise all but inconceivable that the governments of the United Kingdom and the United States would acquire major stakes in the largest private domestic banks: today, large chunks of the financial systems of these two countries are either fully dependent on the state or have been nationalised outright. If developments of this kind were accompanied by sustainable changes in the relationship between market and state, then there is no reason to believe that changes in the mode of economic activity familiar to us today should be impossible, either.

Another example is the European Union. When, in 1970, the so-called Werner Plan proposed the introduction of a European currency, the idea was widely spurned as utterly utopian. Even when the Maastricht Treaty was finalised in the early 1990s, people who regarded the idea of adopting a single European currency as realistic were few and far between. The Germans in particular, it was often said, would never relinquish their beloved Deutschmark without a fight. Today, however, we are all paying our bills in euros and cents, as if that were the most natural thing in the world. That, to be sure, is not to say that the architecture of the euro functions perfectly in every dimension of our notion of a ‘good capitalism’. However, the single European currency could, in the face of the current crisis, serve to advance political integration in Europe, and this, in turn, could constitute the foundation for a further step towards our new economic model.

Crises offer opportunities. Unanticipated crises often show that that there was something wrong with the economic model prevalent until they broke out. They offer an opportunity to question all of the orthodox opinions and interests that have been handed down more or less uncritically and accepted as valid, plainly and simply because they are so widespread. In this sense, the current economic and financial crisis offers a good opportunity to step back and take a hard look at what has gone wrong with the economy in recent decades and why it is that our economic system has not always contributed to improving the wellbeing of broad masses of the population. For many people, including many Germans, the neoliberal globalisation project has meant less, or indeed no, participation in the process of social value creation. Quite the contrary, it has led to precarious living conditions, bound up with the risk of social marginalisation or, indeed, exclusion. Social security systems have, at least in part, been at the mercy of the financial markets, with professional and thus also private plans for the future being subverted by crises and new methods of management. Large and growing sectors of society increasingly feel themselves to be mere objects, helplessly exposed to the vagaries of an increasingly uncontrolled market, prone to violent swings. Resignation, or indeed social unrest, may jeopardise social cohesion. In view of these dangers, there can be no doubt that we need an enhanced regulatory framework for globalisation.

In addition, we are convinced that financial capitalism of the kind that has emerged in recent decades, as well as deregulation of labour markets and other elements of the neoliberal project, have contributed in key ways to making the world economy far more vulnerable to economic and social disasters of the kind experienced during the Great Depression of the 1930s. The subprime crisis may be read as a reflection of this. It has unleashed the destructive aspect of this form of capitalism in the rich countries of the North, while devastating economic collapses have always been only too familiar to those living in the developing and emerging countries of the South. ‘Mishaps’ of this kind have the potential to thrust millions into poverty and to lay waste social and economic advances, which took decades to achieve, and this is why capitalism needs to be regulated in ways that will deprive it of its dangerous crisis-proneness.

Although the long-term goal of creating a capitalism restrained by institutions and rules – a ‘good capitalism’ – may, at first glance, appear unrealistic, we can still envision a good number of first steps in that direction. Indeed, today they are already under political discussion. And since any long march must inevitably begin with a small step, we can follow up first changes of this kind by advancing – and transposing into practice – a multiplicity of further-reaching proposals. This is a matter of political will – and, of course, also of the political options available: a question of the play of forces within and between societies, of dynamics that lead to the creation of scope for political action. This is why it is important to seize the present opportunity to initiate, and implement, a series of first reforms which have the potential for long-term change.

One crucial consideration here is that we clearly understand where we are headed. In recent years, many politicians have neglected the need to develop a concrete notion of what shape our society and our economic order may take at the end of the course of reforms embarked on. Many reforms.

According to Gerhard Schröder and Tony Blair, writing in 1999: ‘Social democrats are in government in almost all the countries of the Union. Social democracy has found new acceptance – but only because, while retaining its traditional values, it has begun in a credible way to renew its ideas and modernise its programmes’.1 Ten years on, Europe’s political constellation has changed. Only a few social democratic governments can now be found on the political map. And this at a time when the financial and economic crisis would seem to cry out for social democratic alternatives. Within this short period of time, European social democrats have gambled away their credibility, as demonstrated by the disastrous results of the 2009 European elections.

Why are people no longer voting for social democrats, though they stand for sustainable growth and social equity? Is it because their blueprints for the future have failed to produce the necessary ‘security in change’ for millions? What still remains in government policy of their fundamental values of solidarity and equity?

The demise of the welfare state

After the fall of the Berlin Wall, economic and social conditions changed rapidly across the world, not just in Germany. The dynamic forces of growth in the post-communist countries, particularly in China and Russia, were fuelled so strongly that international trade levels and the globalised division of labour reached new heights. During this phase all forms of regulation – everything organised by the state – became discredited – amongst other things because of the economic and social legacy of ‘actually existing state socialism’.

Calls for the regulation of globalisation fell on deaf ears. Indeed, the opposite occurred – denationalisation and deregulation found their way into the programmes of many parties, including those of social democrats. The neoliberal Zeitgeist of free (unregulated) market economics took hold across the world. The consensus on the need for social (i.e. regulated) market economics was eroded.

Despite Willy Brandt’s warning that ‘only the wealthy can afford a weak welfare state’ (an SPD electoral slogan in 1972), the modernisation theories of the Third Way were aimed at denationalisation in all fields. According to the Schröder-Blair paper: ‘Public expenditure as a proportion of national income has more or less reached the limits of acceptability. Constraints on “tax and spend” force radical modernisation of the public sector and reform of public services to achieve better value for money.’ The state was reduced to its sovereign tasks. Significantly, this meant that its role was gradually rolled back in the public’s perception. The public sector share of GDP, regarded as excessive, became a synonym for collective waste at the expense of individual freedom.

Regrettably, the SPD-Green tax reforms took up this idea and, among other measures, they reduced corporate tax and the top rate of income tax. Beginning in 1998, a step-by-step reduction in the top rate of tax was introduced, from 53 per cent in 1998 to 42 per cent in 2005. The basic rate dropped from 23.9 per cent to 15 per cent.

There is no doubt that the public sector needed to improve its level of customer service, and that red tape needed to be eliminated. Yet the signal sent out by this approach was that the state was a necessary evil, and that the levying of taxes was unacceptable theft from the pockets of the public. This shift in attitudes is expressed in the provocative words of the philosopher Peter Sloterdijk, who talks of state kleptocracy, and depicts a modern finance minister as a ‘Robin Hood who has sworn an oath to the constitution’.2

Sloterdijk argues that the present is stealing from the future, and reaches the conclusion that compulsory taxation should be abolished, with voluntary support from the rich being relied on instead. These sentiments reflect a notion popular in all sections of society in Germany, and undoubtedly in other countries: that taxes should be cut in order to give individuals more, with no questions asked about the consequences within society for equality of opportunity and justice.

Certainly, the mantra of tax cuts was what drove people into the arms of the FDP and CDU/CSU in the 2009 elections – the SPD lost 520,000 voters to the FDP and 870,000 to the CDU/CSU. Although the SPD pointed out that huge debts were being incurred at the expense of future generations, voters were persuaded by neoliberal ideology that tax cuts were just and would boost the economy. Even reminders of the necessity of tax revenue for the financing of education, research, innovation and infrastructure were ignored in favour of the needs of individuals. These attitudes create the conditions for irresponsibility on the part of individuals towards society as a whole and towards the state. The motto seems to be: if everybody thinks of themselves, nobody will be forgotten.

So what needs to happen? The decisive question is whether or not European social democrats will be successful in persuading people of the necessity of state benefits and investments, in the interests of equality of opportunity and social justice. Erhard Eppler has pointed out that the privatisation of the state’s monopoly on the use of force represents a threat to fundamental rights of freedom and justice.3 His view is that the progressive income tax that shaped Europe for one hundred years is now being abolished by neoliberals; and that plans for the introduction of a system of bands in the German income tax system will lead to the end of social equity in Germany, and that this model will eventually be emulated across Europe. As he has pointed out, these plans represent a departure for the CDU/CSU from a long-held position: ‘A man like Ludwig Erhard never had even the slightest of doubts regarding a progressive system of income tax. Under Konrad Adenauer, the top rate of tax was 53 per cent’.4 The consensus within society that ‘those with the broadest shoulders should bear a greater share of the burden’ is to be abandoned in the twenty-first century. This means that European social democrats must urgently redefine solidarity through the use of practical political examples.

The advent of the indebted state

The international financial and economic crisis in autumn 2008 led overnight to a renaissance of the state. Without the decisive action of governments in taking on state loans and guarantees, the financial markets in their entirety would have collapsed. Those who generally call for the rolling back of the state made an about-turn, and called for a state able to take on the risks and to take action, with all the implied consequences for tax-payers. States set up rescue programmes for the banks and the economy; and they organised economic recovery programmes to avert a comprehensive global recession. The G20 states, particularly the USA, China and the European Union, acted in concert. The debts that were incurred – quite rightly – as a result of the economic crisis are intended to help boost the economy and thus safeguard jobs. And regulation of financial markets – both at international and European level – also seems to be on track, although further close observation of this process with regard to the binding nature of transparency and monitoring will continue to be necessary. So far, so good.

Yet if, on top of all this, tax cuts for higher earners are now introduced in Germany, it will lead to an enormous weakening of the state and to further privatisation. As has already been the case, the high levels of debt will be used as an excuse for further privatisation by the state, including public services and social security systems. And higher state debt, incurred as a result of unjustifiable tax cuts, will exacerbate conflicts over the distribution of resources between rich and poor, which could lead to the abolition of social benefits, or to a situation in which compensation for the loss of benefits would only be available to those who had the means for private insurance.

In this way, the ‘fiscal state’, which finances itself through income-dependent taxes, is gradually being replaced by a ‘fee state’ without social criteria. One example of this is the introduction of university tuition fees.

Social democrats would thus be well advised to combat these developments before it is too late. Tax policy is a central political instrument for social justice and equality of opportunity in our society. The resolution passed at the 2009 SPD conference in favour of a wealth tax is a positive signal in this context. Yet this alone will not be sufficient. We need a discussion, including at European level, about what would constitute a socially just and sustainable tax system (for example a transaction tax).

The end of the nation state

Deregulation and privatisation have systematically restricted the ability of European nation states to take action; and this has been exacerbated by the decisions of the European Commission. Rivalry and competition have been transposed into national law through the rules laid down by the European Commission. In many areas, national competences and rules have even been replaced by European ones (for example the Services Directive). And there are also international deregulatory agreements that have to be implemented.

Many individual citizens view the nation state as having become a mere implementor of European regulations (Brussels bureaucracy), or as unable to take action itself. On the global labour market in particular, individuals are seeing the limitations on national laws. This creeping loss of powers by the European nation states does nothing to increase the willingness of individuals to finance these states. Thus the challenge for all European social democrats in this century will be to find answers to market globalisation, with proposals for international and European regulation, as, for example, called for in the SPD’s Hamburg Programme adopted at the Federal Party Conference in October 2007: ‘Where the nation state is no longer able to provide the markets with social and ecological frameworks, the European Union has to take over’. As the programme points out: ‘The federal nation state is not necessarily weakened by each conferral of decision-making power onto the EU. This also applies to taxation policy. Minimum rates for corporation taxes, decided by the EU, would even strengthen it’.

As Jon Cruddas and Andrea Nahles write in their Good Society document: ‘There is an urgent need for a coordinated Europe-wide fiscal stimulus … We need to introduce European-wide reforms in financial and economic governance.’

Willy Brandt stressed that every era demands its own answers. Thus, social democrats in Europe must give priority to clarifying the relationship between individual nation states and the European Union, in order to avoid social Europe being weakened from within. European integration must be deepened through a new form of democratic statehood, in order to safeguard the primacy of politics over economics, ensure cultural diversity, and allow citizens to realise their full potential.

As new SPD chairman Sigmar Gabriel said at the party conference in Dresden: ‘If we take international policy seriously, a European and worldwide left is also needed, which provides clear answers from a social-democratic perspective, rather than varied ones. To me, these are important questions of direction, which must be asked, and on which we must strive to assert our interpretation’.5

Those who wish to live freely and in self-determination must not forget that they rely on support from the public institutions. They therefore need the state, which creates the conditions for solidarity – for equality of opportunity and social cohesion. In order to make this possible, however, social democrats must be successful in anchoring their ideas of freedom, justice and solidarity in people’s minds, in such a way that these ideas do not seem distant from people’s everyday hopes and concerns.

We need a new process of understanding between the citizen and the state, in which citizens accept that they have responsibility in civil society as elements of the state. Policy-makers – particularly European social democrats – are therefore called on to shape and organise this identity process.

Endnotes

1 Europe: The Third Way/Die Neue Mitte, http://library.fes.de/pdf-files/bueros/suedafrika/02828.pdf

2 Cicero (2009), ‘Kleptokratie des Staates’, 25 June.

3 Eppler, Erhard (2009), Der Politik aufs Maul geschaut. Kleines Woerterbuch zum oeffentlich Sprachgebrauch, Bonn, Dietz Verlag.

4 Eppler, Erhard (2009), Speech at SPD conference, http://www.spd.de/de/pdf/091115_rede_eppler.pdf.

5 Gabriel, Sigmar (2009), Speech at SPD conference, http://www.spd.de/de/091113_rede_gabriel_bpt09.pdf.

The political debate in the UK is now all about the size of the state. A recession kicked off by the greed and risk taking of the bankers and financiers has been allowed to flip into a war between the parties about how much public services can and should be cut as we look down the long road to an election that’s probably not going to happen until May.

In the fever pitch of press conferences and document publishing both sides are now engaged in, any notion of a rational debate seems to have gone out of the window. The Tories want to cut this year and cut big. Labour seems to be split between the Chancellor, Alistair Darling, and the Business secretary, Peter Mandelson, saying we have to specify some cuts now to look credible and Gordon Brown and the Education Secretary, Ed Balls, still painting it as investment versus cuts. What is required is a patient explanation of sensible Keynesian politics.

This is because government borrowing is where you would expect it to be at this point in the cycle. As tax receipts go down and benefit payments go up, Britain is bound to be running a deficit. The government should be arguing that it makes no sense to be cutting public spending now. As most quick public spending cuts involve jobs, this is where we should look. Let’s take someone currently earning £25,000 in the public sector. At the moment they do a worthwhile job in a school or a hospital and repay the Treasury about £9,000 a year in taxes. If they are thrown into unemployment then they stop doing a useful job for society and cost other taxpayers around £12,000 a year in benefits to keep them idle. Where is the sense in that, and why isn’t a Labour government making that argument more forcefully? Of course, the deficit needs to be balanced over the cycle and will be as Treasury income rises and the cost of the dole queues goes down.

The problem is the Tories don’t think many public sector jobs are worthwhile and, once again, unemployment is a price worth paying to roll back the frontiers of the state. Meanwhile, Labour is unwilling to make a clear and obvious case for Keynesian demand management in case is scares the horse of Middle England. But even if Labour wins the debate and the election, its strategy for the reforming the state is now incredibly weak.

Over the last 12 years it has tried a mix of markets and targets in a way that grafted the old style bureaucratic socialism of the post-war years on to Thatcherism. People who worked in the public sector could not be trusted to think and act for themselves as paternalism was mixed with a nasty right-wing suspicion that everyone is out to maximise their own utility; there was no such thing as a public service ethos. People would be made to perform more efficiently, which is all that matters in a global economy, by being forced to raise their game through dictate or competition. Both may have a limited place, but as a twin strategy they can be deadly. An over-reliance on targets has been tried and, as we know, didn’t work. It was called the Soviet Union. But an over-reliance on markets just exacerbates the very inequalities in society the public sector is supposed to close. Some are always better placed to make the right choices than others.

The revival of the Left in Britain and across Europe rests on the re-invention of the state as a site for democracy, participation and empowerment. The case is both instrumental and intrinsic. Instrumental, because by far the greatest efficiencies and high quality levels of service will come from workers able and willing to reform the service themselves – working with users as they co-produce health and education services. But intrinsically this is right as the public service grows as a space in which the values of the Left resonate: equality, solidarity and liberty. In a reformed public sector we are equal citizens. In such a position, where people are treated with respect and it becomes ‘their state’, we are much more likely to support the levels of taxation necessary to get us through the kind of recession we are currently experiencing. For the moment we know not what to do – but much more work needs to go into how the state can innovate, be motivated and held to account through voice rather than old loyalties or exit. But at least we are starting in the right place.

The event was quite amazing for a launch of a think tank – a couple of hundred journalists and fellow wonks crammed into a room in a plush hotel near Westminster to hear first a few words from David Cameron and then a speech on what could constitute modern Conservatism from Phillip. The launch showed he clearly has rich backers and good luck on his side. It’s a reflection of his ability to spot a gap in the ideas market, his own ability and self-belief, and the idea that Cameron’s time is coming and that Blond may be his philosopher in residence.

So what does he think and will it matter? Blond is interesting because he challenges Left and Right through a critique of both monopoly capitalism and the big state. The Red bit of his Toryism is his attack on big business and the way it crowds out economic pluralism – the small shopkeepers and producers. He wants Tesco and the rest broken up, cut down to size and localised. But in essence, the same critique is levelled at the state – it crowds out self-help and the mutualism of the pre-war years. The working class has been disempowered by its passivity as recipients of bureaucratic state handouts. Phillip wants to recapitalise the poor and build an associative society within the context of a re-moralised market and truly free markets.

I think he is on to something but draws the wrong conclusions. Yes, we need to regulate and re-moralise the market and there is a space for self-organisation. Indeed, I would argue collective self-organisation is the definition of a modern socialism. But the state has to play a role – a big role – in ending poverty, stopping climate change and many other big challenges society faces like the housing and pensions crisis. And who does Phillip think will regulate the market if not the state?

Sometimes we need a strong centralised state. More often it should be a democratic state in which citizens become active participants in the decisions that guide services and then help deliver them. Phillip has nothing to say about this agenda because he is in essence anti-state. We did Victorian charity and there is a place for it, but just a place. The state matters. What the Left has to get right is both the democratisation of the state and the mix between this transformed state, a regulated market and civil society. Phillip pushes us to work on this hard and quickly.

But does any of this matter; will Philip have any real influence on Cameronism? I hope so, but suspect not. We cannot look into the heart of David Cameron and tell whether he is a good person or not. Like most leaders he will likely take the path of least resistance and tack towards the Mail, the Sun, the CBI and his own unreformed backbenchers and party membership. But we can only guess at this. What we can do is judge him by his actions. Despite warm words about hugging hoodies, being pro-society and raising issues like general wellbeing, his big political decision took him in the wrong direction. His only test to date has been how to react to the economic crisis – a crisis caused by banking greed and risk-taking that nearly turned the lights out.

Skilfully, he has helped turn the debate away from the rich and towards public spending cuts. But this is wrong economically – as cuts will make the recession worse – but politically revealed him as still a small state and tax cutting right-winger. All of a sudden the Tories don’t look new but old. It’s akin to Tony Blair saying at the last minute – no, I think we will keep the old Clause 4. He failed the big test of being new and being compassionate. This, in essence, is because Cameron doesn’t see it as desirable or feasible to make the break with Thatcherism and neo-liberalism that Phillip’s analysis demands.

Standing at the back of the hall with me at the launch was Will Hutton – author in the mid 1990s of the stakeholder’s bible ‘The State We’re in’. Like Phillip, Will was temporarily flavour of the month with the then communitarian minded Tony Blair. At the same stage in the electoral cycle, would-be Prime Ministers like to be seen as all things to all people, to be open to big and challenging ideas. But Will’s ideas were unceremoniously dumped just before New Labour came to power and were never seen again. Is history repeating itself – first time as tragedy and second time as farce?