Free-market capitalism has imploded, and Europe’s moment has not come: big-picture explanations of the world rarely hold good for long

Grievous, but perhaps not grievous enough. Sufficient to prompt swift action to prevent the global economy sliding into depression, but perhaps so successful that the option of a return to business as usual has been kept alive.

Almost three years into the financial crisis , all regions are growing, albeit at varying speeds. There is pressure on heavily indebted governments to abandon unorthodox economic policies and return to rigid fiscal austerity. Banks, hedge funds and private equity firms are lobbying hard to water down attempts to rein in their activities.

Adrian Blundell-Wignall, an official at the Organisation for Economic Co-operation and Development, spoke for many last week when he said: “How big is big enough?”

Speaking in a personal capacity at the OECD’s annual ministerial forum, Blundell-Wignall warned there was likely to be a second, even bigger, meltdown unless there was radical reform of the financial sector, including splitting up banks with both retail and speculative arms.

Although this is a sombre conclusion, it may prove accurate. The current crisis has yet to have the cathartic impact of the slump of the 1930s, when the economic cost was far higher and the links between the failure of the old laissez-faire model and the drift to political extremism were plain.

Nouriel Roubini, one of the few economists to spot the sub-prime crisis coming , says in his new book, Crisis Economics (with Stephen Mihm, published by Allen Lane), that it is precisely because the downturn has been handled more deftly this time that the impetus for deep, structural reform has faltered. “Had policymakers failed to arrest the crisis, as they failed during the Depression, the calls for reform today would be deafening: there’s nothing like ubiquitous breadlines and 25% unemployment to focus the minds of legislators.”

But, thankfully, policymakers did avoid most of the mistakes of the 1930s and we are where we are. In the circumstances, what the future holds is either full-blown recovery courtesy of the breathing space provided by central banks and finance ministries; another crash preceded by what the late socialist thinker Chris Harman described as “zombie capitalism”; or reform and renewal.

Full recovery would mean that the global economy could continue to prosper even when governments withdraw the support provided by low interest rates, tax cuts and higher public spending. That looks improbable, particularly since there is likely to be a simultaneous tightening of fiscal policy in many countries.

Zombie capitalism is where governments continue to buy up worthless paper from banks, where fundamentally insolvent institutions are kept alive for fear that their failure would cause systemic risk, where every country tries to export its way out of trouble, where the shrinkage of the financial sector depresses growth rates, and where the global imbalances between surplus and deficit countries remain worryingly large. That looks a more likely option.

What, then, are the prospects for reform and renewal? At the very least, this route is likely to be long, hard and strewn with setbacks. It may not be chosen, as Blundell-Wignall and Roubini fear, until there is system failure. The good news, though, is that the ideological vacuum left by the crisis creates the intellectual and political space for change. Since the demise of communism at the end of the 1980s, the west has had three competing belief systems. The first, free-market capitalism, imploded three years ago. The second, Europe, has taken a fearful battering over the past few months. A third, environmentalism, still has only a limited number of devotees.

Simon Tormey, professor of social and political sciences at Sydney University, put it well during a debate on the future of capitalism at the OECD. This, he said, is a pagan world where there is a scepticism about meta-narratives.

Rightly so. History shows that big-picture explanations of the world rarely hold good for long, and end with a fanatical core of true believers seeking to impose their will on the rest of us. If, as Jimmy Porter says in Look Back in Anger, there are no great causes left to fight for, that’s almost certainly a good thing. The demise of the meta-narrative doesn’t mean the end of politics or the abandonment of the search for making life better. On the contrary, it means a messier world in which there is less dogma but greater experimentation.

Let’s put this into some sort of context. Up until 2007, the credo was that markets worked, period. The world would be a better place if the role of government was diminished and financial markets allowed to get on with making money. If there was a role for the state, it was to champion structural reform of economic life: removing barriers to trade and, by investment in human capital, making their workforces more employable.

What actually happened was that endless financial innovation destabilised the global economy, while the benefits of growth accrued to a small cadre at the top and not to the rest of the newly flexible labour market. There was growth, but only because policymakers actively connived in the creation of bubbles. Indebtedness masqueraded as wealth.

The shorthand term for this model was Anglo-Saxon capitalism, and when it blew up it was thought that Europe’s moment had come. The European Union offered a kinder, more civilised way of running the economy in the 21st century, providing solidarity instead of cut-throat competition, protection for its citizens rather than low wages and welfare cuts.

Bonkers beliefs

Belief in Europe was just as messianic – and just as bonkers – as belief in the market. The idea was that you could take a dozen or more countries of wildly differing economic performance, with entirely disparate cultures, and bolt them harmoniously together. What’s more, you could do this without a common language to facilitate labour mobility or a common budget to transfer resources from rich countries to poor countries.

During the bubble years these fundamental design flaws were kept hidden, but they have been exposed by the crisis. Low interest rates allowed countries on the periphery to grow strongly for a while, covering up their steady loss of competitiveness against the country at Europe’s core, Germany. The financial crash resulted in a deep recession, soaring budget deficits and fears in the financial markets of debt default.

For all the talk of European solidarity, there is absolutely no evidence that German taxpayers will agree to a common fiscal policy to provide the budgetary support for the weaker parts of the euro area that Washington provides for the poorer US states. As such, the only options for countries like Greece , Ireland and Spain are devaluation (ruled out by monetary union), default (ditto) or years of deflation. They have opted for the third course, even though this will lead to slower growth and make it even harder to reduce budget deficits. Europe, touted as a progressive alternative to Anglo-Saxon economics, has become neo-liberalism on steroids.

Ultimately, the problem with the meta-narratives is that they don’t deliver. The postwar era of strong trade unions, full employment policies and capital controls produced stronger, more equitable growth than three decades of deregulation, liberalisation and flexible labour markets. The more integrated Europe has become, the worse it has performed.

China and India prove that it is possible to thrive without a meta-narrative. Both countries have systems of managed capitalism fully in the tradition of the mixed economies that prevailed in the west during the heyday of social democracy. What counts is what works. There is a lesson in that somewhere.

Economics Financial crisis European debt crisis Economic policy Banking Recession Greece Spain Ireland Europe European Union Germany Larry Elliott