While the then prime minister’s sentimentality was roundly ridiculed, wanting to turn the clock back to an idealised past is par for the course for conservatives. What, though, are we to make of ostensibly progressive voices such as Jon Cruddas and Jonathan Rutherford clinging on to a romanticised Olde England, albeit a grittier one of community-owned ports and ancient fish markets? ‘Labour’s future in England is conservative’, they declare. Really?

On one thing, the need for financial reform, Cruddas and Rutherford are right. As I argue in Aftershock: Reshaping the World Economy After the Crisis, our bloated banks need to be broken up. Britain’s financial sector is a government-subsidised racket that makes monopoly profits in good times, gets bailed out in bad, crowds out productive industries, destabilises our economy and subverts our politics. Just because the government taxes away some of those monopoly returns doesn’t mean that the UK benefits from being fleeced by the financial sector.

Unfortunately, the rest of Cruddas’s and Rutherford’s often incoherent argument is wrongheaded. They defame New Labour by lumping it together with Enoch Powell, ‘the prophet of the Thatcher revolution’, while also accusing it of destroying the party’s English working-class roots by abandoning the country to immigration and multiculturalism – the very things Powell hated. So were New Labour and Enoch Powell intellectual soulmates or mortal enemies? They can’t be both. And when the two authors call for Labour to ‘confront and turn the page on what Powell started’, their prescription sounds a lot like watered down Powellism: Labour, they argue, should ‘fight for an England which belongs to the English just as they belong to the land’. Nick Griffin would no doubt agree.

Their analysis of last year’s election defeat is also confused. The notion that Labour lost because it was New Labour is bizarre. Tony Blair assembled a broad coalition of voters that delivered three election victories. While the Iraq war did a lot of damage in 2005, New Labour still won. What changed between 2005 and 2010? Gordon Brown proved to be a disastrous prime minister. The man who boasted that he had abolished boom and bust presided over the worst recession since the 1930s – a global crisis, yes, but one which this champion of the lightly regulated City did nothing to prevent. And while people weren’t convinced by Cameron’s Conservatives, they were mightily sick of 13 long years of Labour rule.

Yes, of course Labour needs to reconnect with those white working-class voters who feel it does not address their concerns about housing, jobs and public services. Labour’s biggest failure in office was housing: cheering on the property bubble while not building enough social housing. Affordable housing should be at the centre of the next manifesto: a tax on land values, for instance, would encourage the private sector to redevelop brownfield sites and help pay for a new generation of affordable homes. Labour can improve on its good record on jobs with a Danish-style commitment to lifelong learning and employability, combined with a generous but tough welfare system that provides a hand-up rather than a hand-out. Increased investment in transport – another area where Labour failed to deliver – would help spread growth and opportunity. Last but not least, a genuine commitment to good education for everyone, especially the poorest – not a piffling pupil premium carved out of a shrinking education budget – is essential. We can learn from Finland, whose schools are rated the best in the world. All this could help break the vicious cycle of deprivation that is scandalous in a rich country like ours, while also stimulating growth.

It would be a terrible mistake, though, to wrongly blame our economic and social problems on Britain’s openness to the rest of the world. Trade with China, foreign investment and Polish workers all boost growth and create jobs. Now, more than ever, if we are to break out of our unhealthy reliance on debt-fuelled consumption, housing and finance, our future prosperity depends on exporting to China, investment from India, educating foreign students and a diverse workforce that generates new ideas and businesses. And an open economy also needs to be flexible – otherwise we could end up like Spain, with a 20 per cent unemployment rate and 40 per cent of young people out of work. There is nothing progressive about a rigid labour market that ossifies the economy and excludes outsiders.

In any case, Labour cannot win again solely by appealing to a dwindling band of white working-class English voters. It also needs to win back middle-class voters, those of immigrant descent, and Scottish and Welsh voters for whom talk of ‘forever England’ holds little appeal. Labour needs to be about tomorrow’s Britain – which, like today’s, will be wonderfully diverse.

In our age of easyJet, Facebook, curry and kebabs, American TV shows and foreign news, Greenpeace and other global campaigns, national boundaries are blurring, while people within Britain are also freer to express their differences since the liberating 1960s. Is that such a bad thing?

While Cruddas and Rutherford fret about ‘what in our differences do we hold in common?’, the answer is simple: we live in the same country, vote in the same elections, accept the rule of the majority while protecting the rights of minorities, use the NHS, watch the BBC, speak English, and share aspirations for a richer, fairer and more secure future.

Our diversity too can unite us. Since modern Britain is inescapably diverse, any definition of shared identity that fails to recognise this inevitably excludes some members of society and thus divides it. Londoners treasure the city’s diversity as a key part of its identity. We all celebrate diversity in national football teams – is it such a stretch to apply this more widely? Our diversity ought to be a source of strength, not of weakness, a reason to belong not an excuse to exclude. We should embrace it rather than seek to deny it.

The problem is partly that the causes of the crisis are misdiagnosed. This is primarily a crisis not of the euro, but of the global financial system. Not long ago, market fears focused on the dollar and the US Federal Reserve’s quantitative easing. And the key issue in Europe now is not the merits of the single currency but the parlous state of its banking system.

During the bubble years, the global financial system underpriced risk and misallocated capital. Too much was lent too cheaply to American subprime borrowers and Spanish property developers, Icelandic and Irish banks, Dubai and Greece.

Among the biggest lenders were European banks. They now hold mountains of debt – government, bank and property – that they wish they didn’t. Many are illiquid, and depend on cheap ECB finance to stay afloat. Many have also incurred huge losses that they have only partly recognised; as a result, some are, in effect, insolvent. The stress tests of EU banks were not stringent enough to shed light on this – after all, they gave both Bank of Ireland and Allied Irish Bank a clean bill of health.

At heart, the “euro crisis” is a wrestling match over who will ultimately bear these bank losses. So far, EU governments have decided that banks’ bondholders must be protected at all costs, preferring to impose losses on taxpayers instead – even if this stretches governments’ solvency to breaking point. This is explicit in Ireland, much less so elsewhere. Because voters’ tolerance for bank bailouts has worn thin, governments are acting covertly: lending huge sums to Greece and now Ireland so that they can repay German, French and UK banks in full – all under the pretence of “defending the euro”.

This strategy is not just unfair, costly and dangerous; it is ineffective. Governments are burdening taxpayers with huge bills that will impede future growth; Ireland’s “bailout” is actually a high-interest loan of €20,000 per Irish person. They are inviting a populist and extremist backlash; witness Sinn Fein’s recent success. They are corroding support for both the euro and the EU: prudent Germans rage against bailing out profligate Greeks and reckless Irish, the Irish against EU-imposed “reparations”, when their anger ought to be directed at the banks that ultimately benefit. They are encouraging financial speculation, not least by distressed banks: heads they win, tails taxpayers lose. And by guaranteeing banks’ debts, all EU governments are risking their credibility and ultimately their solvency.

Bond markets are now testing governments’ promises: you bailed out holders of Greek government bonds and Irish bank bonds, what about Portuguese, Spanish and other debt? This is a self-fulfilling prophecy: even a sound credit is in trouble if markets refuse to lend. And whereas Greece’s bailout cost €110 billion and Ireland’s €85 billion, Spain’s could top €400 billion – and then, who knows? The crisis could sweep on to Italy, Belgium, France and eventually Germany too. At some point the cost of bailing out banks would prove unbearable – there is a limit to Germany’s ability and willingness to borrow –and the euro could needlessly fall victim to the resulting political and financial turmoil.

Even if EU governments’ ability and willingness to bail out banks is not tested to destruction, the strategy remains misguided. Instead of sacrificing taxpayers to protect bondholders, watching the sovereign dominos fall and failing to tackle the underlying banking problem, what is needed is an EU-wide solution that forces banks to recognise their losses and bondholders to recapitalise them if necessary.

This would involve a much more rigorous stress test to find the holes in banks’ balance sheets. Banks would then be forced to raise additional capital, first from the market and then by converting bondholders’ bonds into shares. The weakest would be sold or closed down.  Until then, the ECB would continue to provide liquidity to banks as necessary.

Freed from worries about bank debt, most governments’ debts would be manageable; only Greece would need to restructure its debts. There would less need for self-defeating austerity; the EU could instead launch infrastructure bonds to boost growth. All this would arrest the financial crisis, boost economic growth, reduce political and social tensions, and safeguard the euro.

This is a decisive moment for the EU. Will the narrow interests of financiers prevail or those of society as a whole?

Optimists claim that the economy is strong enough to shrug off the VAT rise. People barely noticed when VAT was cut from 17.5% to 15%, so why should a rise to 20% make much difference? In any case, the rise is necessary, George Osborne asserts, to help fill the gaping hole in the public finances.

It’s true that few people will balk at paying two or three pence more for a packet of chocolate digestives. But, over a year, it all adds up. During the election campaign the Liberal Democrats claimed that the “Tory VAT bombshell” would cost the average family £389 a year, a figure that Labour is now throwing back at the coalition government.

Worse, VAT hammers the poor hardest, because they spend almost all their meagre incomes, whereas the rich save a big chunk of theirs. The Institute for Fiscal Studies reckons that the VAT rise will lop 1% off the after-tax incomes of the richest 10% – and 2.25% off those of the neediest 10%. That is hardly progressive.

The VAT rise will not just hurt people’s pockets: it will adversely affect jobs and growth too. Lower consumer spending means fewer jobs for people making things and selling them. In April, national insurance will go up by 1%, equivalent to an extra penny on income tax – all this at a time when public-sector pay is frozen, private-sector wages are stagnant, benefits are being slashed and many people are struggling with huge debts, often secured against their depreciating homes. Add big public-spending cuts and the fiscal squeeze will take roughly 2% out of the economy this year.

Unless private investment takes off, the economy will stagnate, unemployment will rise and the deficit will fail to shrink much. The government would be cutting to stand still – lots of pain for hardly any gain.

Of course, the government’s gamble may pay off. As the public sector and consumers retrench, business investment and exports may boom. The government points to countries – such as Canada in the 1990s – that tightened their belts and continued to grow. But circumstances in Britain now are different. Whereas Canada and others offset their fiscal squeeze with monetary loosening, the UK cannot cut interest rates below 0%. Worse, banks deny credit to small businesses that want to invest. And whereas previous belt-tighteners benefited from booming exports, Britain’s main export markets – Europe and the US – are weak.

In the longer term, we need to tap into the boom in emerging economies such as China, India and Brazil, but that will take time. The government isn’t helping by turning away foreign students, damaging one of the UK’s most promising export sectors.

The government claims that the alternative to today’s VAT rise is bigger spending cuts. But that isn’t true. Yes, the coalition government needed to set out a credible framework for stabilising the national debt, but its decision to tighten the screws so far and so fast was a political choice. It wouldn’t surprise me if Osborne was planning pre-election tax cuts for 2014.

Instead of raising VAT and national insurance this year, the government could introduce taxes on carbon and financial transactions next year. And it should levy a tax on land values. Since all the land in Britain is worth some £5 trillion, an annual levy of 1% could raise £50bn a year – without depressing economic activity, because land is in fixed supply: central London can’t be spirited away to a tax haven.

As well as preventing property bubbles (and busts), a land tax would be fair. A mere 160,000 people (mostly hereditary landowners) own more than two-thirds of Britain – and the value of that land increases not through their own striving, but through that of others. Surely it would be better to tax this windfall gain than the hard work and enterprise of those who generate it? And since infrastructure improvements, such as a high-speed rail network, boost surrounding land values, a land tax could also help to finance investment in future growth. There is an alternative to austerity – if only the government would listen.

Even many euro supporters now regret that in the boom years the currency permitted huge capital flows from Germany and other surplus countries to Spain, Portugal, Greece, and Ireland. These imbalances, conventional wisdom has it, are unhealthy – and the European Union is now drafting rules to limit them.

Yet enabling capital to flow from one member country to another without exchange-rate risk is a key advantage of the euro. If this were possible globally, emerging economies would not feel compelled to amass huge reserves to protect against crises and could be net recipients of investment instead. When integrated financial markets work well, they offer investors higher returns, businesses cheaper finance and a better allocation of capital all around.

The problem is not that savings flowed from Germany to Europe’s periphery. It is that they funded property bubbles rather than productive investment. But the blame for that lies with herd-like investors, flawed banks and foolish governments, not the euro. After all, America, Britain, Iceland and other non-euro countries all had huge property bubbles too.

Granted, joining the euro did slash Irish interest rates, creating cheap borrowing that fuelled the boom. But at a macro level the Irish government could have tightened fiscal policy – in effect, run large budget surpluses. At a micro level, it could also have limited banks’ property lending – through higher, counter-cyclical capital requirements for instance – rather than encouraging it with tax breaks.

Ireland’s property bubble was particularly big. The value of its housing stock quadrupled in the decade to 2006, with construction swelling to an eighth of the economy. The price of a typical Dublin house shot up more than fivefold – and has since nearly halved. Such a property crash is inevitably painful. But it need not have led to a sovereign debt crisis. Ireland’s public debt was only 25 per cent of gross domestic product on the eve of the crisis, the lowest in the eurozone.

The government’s fatal mistake was stepping in to guarantee not just all the depositors of Irish banks but also all their bondholders. Now the bust banks’ huge losses are dragging down the Irish state with them. Had Britain’s recession worsened, the UK government might have ended up in a similar situation.

Only cheap finance from the European Central Bank has kept those bust Irish banks on life-support, until now. Outside the euro, Ireland would doubtless have suffered Iceland’s fate: its currency would have crashed and its central bank would have run short of foreign funds to keep its banks afloat. Far from precipitating the crisis, the euro has given Ireland vital breathing space. More’s the pity that the government has failed to make good use of it.

It is true that, outside the euro, Ireland would now enjoy a weaker currency. That could boost exports, and hence growth. But in very small open economies, devaluations tend to feed through rapidly into inflation, so the competitive boost might not have been that great. In any case, Ireland has already slashed wages and prices to restore competitiveness – in effect, an internal devaluation. And if it wished to cut unit labour costs further, it could reduce its high payroll taxes and replace the revenues with higher value added tax or a tax on land values.

Leaving the euro and reintroducing the punt is certainly not a solution, since Ireland would be incapable of repaying its euro-denominated debts in devalued punts. Nor, on its own, is an EU or International Monetary Fund “bail-out” – in practice, a loan at punitively high interest rates. That would merely postpone the crisis.

Irish taxpayers should not be bled dry to pay off investors – among them, European banks and American hedge funds – who gambled on lending to Irish banks. Instead those creditors should take a haircut, via a debt restructuring with the EU or IMF providing a bridging loan until Ireland has fixed its budget deficit. Ironically, it is Germany’s proposal that bondholders should lose out in future that brought this crisis to a head. It is such a good idea that it should be implemented now.

Seen from Washington or London, the economy remains weak. But from a global perspective, it is advancing by some 4% a year – almost as fast as before the crisis. China and other emerging economies account for the bulk of this growth. In effect, Chinese investment has taken over from US consumption as the locomotive of global growth (Reisen 2010).

Yet because it has a current-account surplus, China is widely perceived to be a drag on the global economy. This is misleadingly simplistic.

• Its imports grew by 24% in the 12 months to September, creating jobs and growth elsewhere.
• Its trade surplus is shrinking.
• And, lest critics forget, even Chinese exports have their benefits. Assembled from parts made in other countries, they provide cheap inputs for businesses everywhere. They spur companies outside China to innovate and become more competitive. And they increase consumers’ welfare – why else would people buy them?

Basing conclusions on accounting identities can obscure the more complex, dynamic economic relationships that underlie them (Legrain 2010).

Put simply, if China were to vanish overnight, the world would be in much worse shape. And while it may be desirable for China’s currency to appreciate gradually to accommodate and accelerate a shift towards higher-end production and greater domestic consumption, a higher renminbi is unlikely to do wonders for the US economy (Auerbach and Obstfeld 2010).

For the most part, the alternative to cheap Chinese imports is not goods “made in the USA” but goods made in other emerging economies. Reshaping the US economy to cater more to the needs of emerging economies would do far more to boost US exports. Above all, trying to force the renminbi up with protectionist threats – as the US Congress demands and many respectable and ostensibly liberal commentators now seem to advocate – is to invite a trade war that would beggar us all.

Instead of threatening others, the US should put its own house in order. The Federal Reserve helped cause the mess we are in and is now sowing the seeds for the next crisis. Having wrecked the US economy by encouraging a huge debt-fuelled bubble to inflate, the Fed now finds itself unable to ensure recovery. Even with near-zero interest rates, indebted consumers don’t want to borrow and fragile banks don’t want to lend. Businesses that could generate growth are either starved of credit or too uncertain about the future to invest. As the Fed pumps out ever more money, banks invest it in higher-yielding Treasuries, pocketing easy profits and paying out ill-deserved bonuses, while much of it leaks out overseas. The net result? Hardly any additional US growth.

Since the monetary transmission mechanism is broken, injecting ever more money into the system does not get the wheels of the economy spinning faster. It floods the engine. A better way to stimulate the US economy would be fiscal measures that promote its restructuring and enhance its productive potential – for instance, investment in its dilapidated infrastructure, cuts in payroll tax and retraining subsidies to get people into work and, in the absence of a carbon tax, measures to promote venture capital in the clean-tech industries of the future.

Current US policy is not just ineffectual, it is also dangerous. Banks that ought to fold are kept on life support. Homeowners who ought to default and move to where the jobs are cling on to their depreciated houses in depressed areas. Bubble-prone investors believe in a Bernanke put. Money gushes out of the US and into emerging economies that don’t need it and can’t cope with it. This is economic vandalism.

The strategic rationale for printing money – sorry, “quantitative easing” – may be to force Beijing’s hand on the renminbi. Yet protected by capital controls, adept at sterilising monetary inflows and loath to give in to US pressure, China is unlikely to move much. Carrots – such as a bigger role at the IMF and the opportunity to convert some of its dollar reserves into special drawing rights (SDRs) – might work better than sticks. The victims are instead the Eurozone, Japan, Australia and other advanced economies whose currencies are soaring, as well as emerging economies such as Brazil and Thailand that cannot do much to stem the tide of US cash.

Do Barack Obama and Ben Bernanke really want a repeat of the 1997/98 Asian financial crisis, this time writ-large across emerging economies that account for half the world economy and most of its growth potential? Do they want to pick up the pieces for US investors and financial institutions? Do they not worry that investors might eventually lose all confidence in the devalued dollar and depreciated not-so-safe US Treasuries? Or are they so narrowly focused on the here and now, so blind to alternative policies, and so reckless in abusing American monetary power that they don’t care?

References

Auerbach, Alan J and Obstfeld, Maurice (2010), “Too much focus on the yuan?”, VoxEU.org, 23 October.
Bergsten, C Fred (2010), “China’s currency and the US economy”, VoxEU.org, 1 November.
Krugman, Paul (2010), “Taking on China”, New York Times, 1 October.
Legrain, Philippe (2010), Aftershock: Reshaping the World Economy After the Crisis.
Reisen, Helmut (2010), “Global imbalances, the renminbi, and poor-country growth”, VoxEU.org, 1 November.
Wolf, Martin (2010), “How to fight the currency wars with stubborn China?”, Financial Times, 5 October.
Yiping, Huang (2010), “A currency war the US cannot win”, VoxEU.org, 19 October.

Such questions had never even crossed the minds of most people in rich countries until the recent financial crisis. Economic meltdown might strike poorer places such as Argentina, Asia or Africa. It may feature in the history books: Remember the soup kitchens and welfare lines of the Great Depression in the 1930s. But it did not happen—surely could not happen—nowadays in supposedly advanced economies.

Or so we thought—until September 2008, when banks were suddenly falling like ninepins, markets were plummeting and governments seemed overwhelmed. Was everything we took for granted falling apart around us.

Now that the recovery has begun, powerful voices argue that little needs to change, really. The financial system may need a few tweaks here and there, but otherwise the world should go back to business as usual. The faster economies recover, the stronger such siren voices will grow.

Others feel that everything must change. Global capitalism is a giant wrecking ball that crushes the poor, destroys jobs and is killing the planet; such a dangerously unstable and destructive force needs to be tamed, they argue.

Meanwhile, many people aren’t quite sure what to make of it all. Angry but confused, they lash out at all and sundry: greedy bankers, conniving politicians, dastardly foreigners. Unfortunately, this debate is generating more heat than light and too little action where it is needed, too much where it is not.

Contrary to those who argue that global finance should be left largely intact, it requires radical reform. Yet the changes that policymakers are considering are too timid; some are irrelevant, others wrong-headed. The understandable furor about bankers’ bonuses is diverting attention from much more important issues, not least the unacceptable notion that some banks are “too big to fail” and so have a license to gamble at public expense—heads they win, tails taxpayers lose. Economists call this “moral hazard.” But that is a huge understatement—it is a racket. Capitalism without risk of failure is like power without accountability—it corrupts absolutely.

But while finance needs radical reform, the global economy still offers huge opportunities for progress.

Help homegrown consumers

Westerners often wonder gloomily where tomorrow’s jobs will come from these days. Increasingly, they will come from selling to China and other emerging economies. So instead of worrying that China is going to take everyone’s jobs, people should be looking to the huge opportunities that its growth offers—and going out and grabbing them.

But while emerging economies’ imports will almost certainly continue to grow quickly in the years ahead, will they expand fast enough to fill the gap left by Americans and others tightening their belts? That is the trillion-dollar question on which the world economy’s prospects for recovery rest. The answer depends in large part on whether politicians try to resist the necessary changes to the global economy or embrace them.

It is deeply unfashionable—almost blasphemous—to say so now that the Era of Excess is over and we live in an Age of Austerity, but consumption is wonderful. It’s what makes the world economy whir round. Without consumption there is no production, no income and no jobs. While some people have spent too much and have no immediate desire for more, plenty of people in the world have unmet needs.

People in countries like Germany and Japan pat themselves on the back for being prudent—for squirreling away surplus savings while others spent—yet now that their customers in English-speaking (and many Mediterranean) countries are no longer spending, their production has slumped. Now is their time to be profligate.

Emerging economies are also bursting with people who would love to go on spending sprees.

The world (and your own) economy needs you.

If you’ve got it, spend it.

Now policymakers have to make it possible. But for countries such as Germany, Japan and China that have long focused on exporting, it may be trickier than it seems to stimulate domestic spending and restructure the economy to cater more to homegrown consumers.

The problem starts with the fact that households get much smaller shares of the economic pie than in America or Britain, for example. They then save a bigger chunk of it. As a result, whereas consumption accounted for 71 percent of the U.S. economy in 2008 and 67 percent of Britain’s, it was only 55 percent of the total in Japan, 54 percent in Germany and a mere 37 percent in China.

Consumption in Britain and America is arguably too high. But if Japan and Germany raised theirs to Canadian rates—60 percent of the gross domestic product (GDP)—it would give a big boost to domestic as well as global demand.

Had Germans spent like Canadians in 2008, consumption would have been $220 billion higher. Had the Japanese done likewise, it would have added $246 billion. If China had emulated Hong Kong’s rate—53 per cent of GDP—consumer spending would have been $692 billion higher in 2008. This would have filled the shortfall left by a slump in American demand of nearly 5 percent of the GDP. Together with higher spending in Japan and Germany, that would be equivalent to nearly 2 percent of the global GDP.

Of course, this cannot happen overnight—and would require a currency appreciation (or a burst of inflation) to displace exports and encourage imports. But it could happen faster than people think, not least because China’s economy is growing like gangbusters. Even without much reform, China’s household consumption is growing by nearly 10 percent a year.

Put consumers first

In both Germany and Japan, the underlying problem is that leaders prioritize business interests over consumer ones. This reduces the share of the pie available for personal consumption—and because these domestic economies are so sluggish and inflexible, firms there naturally prioritize foreign markets.

It’s easier to sell Porsches or Lexuses to Wall Street traders than to set up a cleaning company employing Polish or Filipino workers to service domestic consumers’ needs. It’s also less difficult to cut costs by clamping down on wages than by shaking up the economy through real reform.

Germany and Japan should view the crisis as an opportunity for reform—not to embrace American-style casino capitalism, but to cater more to their own people’s needs. While Germany is right to be proud of its exporting prowess, it should recognize that the purpose of selling products to foreigners is to make Germans better off. A bonfire of regulations would allow thousands of service companies to spring up, offering everything from affordable Polish plumbers to nifty price-comparison sites.

It is much easier to start a business in Albania or Sierra Leone than in Germany, according to the World Bank’s Doing Business rankings for 2010. Strikingly, considering how Germany prides itself on corporate competitiveness, investment accounted for a smaller share of the economy in 2007 than in consumer-crazy America.

Why are German entrepreneurs in Silicon Valley rather than the Ruhr? What is so wrong with allowing foreigners to provide good care for elderly Germans? Were Germans really better served by stashing their savings in Ländesbanks that bought toxic American assets?

Even allowing for the financial bubble’s inflation of American and British growth, Germany has performed dismally in the past decade. Now that demand for its exports has collapsed, perhaps it should try its hand at something else, too.

Get the right kind of recovery

The problem is not just a lack of consumer demand. It is a distorted pattern of supply. The world economy remains geared toward resuming the old, unbalanced, u nsustainable pattern of growth.

Look around. Britain’s high streets are littered with banks, building societies, estate agents and other sharks that fed off the credit bubble. America is awash with empty houses, boarded-up shops and eerily quiet shopping malls. Wall Street and the City of London are crowded with bloated banks cranking up to generate often-unnecessary financial engineering. China’s coastal regions are cluttered with factories primed to churn out consumer goods for American homes. Germany is full of idle car factories tooled up to make gas-guzzlers for which there is no longer enough demand. Japan has still not worked off the excesses of its own bubble two decades ago.

For now, the focus is all on recovery, any recovery, at any cost. But unless the world economy shifts to a more balanced, more sustainable pattern of growth, the recovery is likely to be weak and lopsided, and pave the way for another crisis.
The bad old pattern of growth was driven by the seemingly insatiable debt-fueled demands of American consumers. In crude terms, Americans borrowed and spent, while the Chinese produced and lent.

But for now, America’s anxious and over-indebted consumers are no longer willing or able to continue spending like there is no tomorrow. Their incomes are stagnant (or falling), their houses and shares are worth less, they are terrified of losing their jobs and in any case, banks won’t lend anymore. Dawn has broken, and it feels more like dusk.
The big fall in American consumer spending is the main reason why global demand has ultimately collapsed. Left unchecked, this would have caused a depression: Since one person’s spending is another’s income, if everyone tries to cut back at once, a vicious spiral ensues as falling production chases falling consumption downward. So governments had to step in to try to fill the gap.

Now the priorities should be maintaining employment (but not specific jobs), protecting the vulnerable and investing in healthier patterns of growth. Slashing payroll taxes would boost disposable incomes and support employment without protecting specific jobs at the expense of others. Cushioning the blow on the vulnerable is humane and supports spending.

The best way for governments to increase demand is through spending that encourages economic adjustment and boosts the potential for growth. Governments could provide subsidies to workers—those still in jobs, as well as the unemployed—to retrain and acquire new skills, as Denmark does. In Britain and America, increasing investment in crumbling infrastructures would put idle hands in construction to work, help shift the balance of the economy away from consumption toward investment and raise these economies’ growth potential. Better transport networks, in particular, would boost exports. It should also be a priority in emerging economies, where infrastructure is barely keeping pace with growing needs.

A sustainable recovery requires a thorough overhaul of the world economy to cater to more balanced, healthier patterns of growth. This involves a profound change in people’s behaviors, a restructuring of the corporate landscape and a shake-up of government policies.

Americans and Britons need to rediscover the virtues of living within their means, rather than wrongly viewing their homes as cash machines. Germans and Japanese need to give in more to the joys of consumption, rather than continually squirreling away nuts for a rainy day; storms don’t come much bigger than this.

Economies dominated by housing and finance need to invest in more productive sectors. Those in which exporters hold sway need to invest in sectors that service domestic consumers’ needs. Governments everywhere should tackle the obstacles that prevent businesses and people from adjusting—gummed-up labor markets, entrenched producer interests, barriers to innovation and enterprise.

Opening up further to international trade, investment and human flows would also help. At the same time, governments must intervene when markets fail—shake up finance, encourage greener technologies, help people retrain and find new jobs, and make it safe for emerging economies to tap global capital markets.

The new opportunities are huge. But when people and countries are set in their ways, change can be difficult and slow. The bubble mentality is hard to overcome, as are deeply ingrained saving habits. Dominant financial interests in the Anglo-Saxon world and export ones in Germany, Japan and Asia will fight reform tooth and nail. Governments may duck difficult reforms and pander to powerful lobbies.

Invest in clean technology

To make the shift to a low-carbon future, the world needs a mixture of four things: greater energy efficiency, smart national policies, new technologies and lots of capital. But all too often, public debate overemphasizes the first two at the expense of the latter two. In the ultra-green view, the prescription morphs into abstinence by social pressure and government diktat. Policymakers, naturally, place themselves center stage, imagining that a blizzard of meetings, plans, initiatives, standards, regulations and so on will do the trick. They are also prone to trying to micromanage people’s lives in ways that are extremely costly to the economy and to individual freedom.

But while governments’ roles are central—after all, only they can enforce a price for carbon—they should concentrate on helping the poor adjust and setting a framework that attracts bundles of finance into the clean tech sector and enables technology entrepreneurs to experiment and find new solutions.

Given the complexities of climate change and global politics, the best we can hope for may be an imperfect global deal. Enforcing it and ensuring any transfers between countries are well spent will be huge challenges. But that need not be a reason for pessimism. As long as governments provide sufficient incentives in the short term and a credible enough commitment for the medium term, clean technologies are likely to make huge progress over the next 10 to 20 years.

If investment continues to pour into clean tech research, with some of the world’s brightest minds and sharpest businesspeople competing to clean up and save the planet, new and better solutions are likely to be found. Existing technologies can become much cheaper and new ones will emerge. The seemingly impractical or implausible can suddenly become possible, then probable. And as the market expands, individual companies and the industry as a whole will reap huge economies of scale.

Already, wind power can compete with fossil fuels in some areas, as can solar. Tesla’s Model S, a state-of-the-art electric vehicle, is predicted to be cheaper to run than a top-of-the-range Honda Accord in the U.S.—and will look even more attractive in Europe, where gas prices are much higher. Rising oil and gas prices could help accelerate this switch. The spike in oil prices in 2008 had Americans dashing to ditch their Hummers. Pretty soon, the switch to low-carbon technologies might be achieved even without a complex global climate change deal. After all, it would be easy for countries, companies and people to jettison fossil fuels if clean tech were greener and cheaper. Self-interest, not political bargaining—and still less abstinence—is our best hope.

We should treat the threat of catastrophic climate change as an opportunity to reshape the world economy in a cleaner, more secure, fairer and more efficient way. Carbon-based energy has been a fantastic engine for human progress. But it has always had big downsides—smog, war and dependence on nasty dictatorships—and now it endangers the planet. We should welcome the pressing need to accelerate the leap to better ways of life.

Oil, gas and coal are just means to an end. What is valuable are the unprecedented opportunities of modern living—an escape from drudgery in the home, the mind-broadening delights of foreign travel, cool buildings in hot countries, the freedom to drive where we please. Their extension from a rich minority to the rest of the world is a cause for celebration, not despair. Don’t campaigners for global justice really want poor people to be rich?

So the priority must be to find new sources of energy, not to reject modern lifestyles or try to deny them to others. Imagine: breathable air, solar-powered electricity for rural Africa, no more wars over oil in the Middle East, unlimited energy on tap. Progress indeed. But remember that clean tech is a global industry, powered by people, money and markets that cut across national lines. What would really wreck the world would be a closing of borders, societies and minds. Localism, not globalization, is the true enemy of the planet.

Use the power of positivity

The pain now is real and unavoidable—jobs lost, homes repossessed, mountains of debt remaining to pay off. A home that was once a cash machine is now a millstone. Pessimism is the order of the day.

This crisis of confidence is dangerous. When people feel threatened, they tend to hunker down and turn inward. But trying to shut out the world would make us all poorer. Far from making us safer, it would jeopardize our security. In particular, treating the rise of emerging economies as a threat could in part be a self-fulfilling prophecy. It could prompt nationalist and protectionist responses. It would encourage the development of new relationships and institutions that exclude the West. It would undermine chances of securing developing nations’ cooperation in tackling climate change.

The overarching challenge is to rediscover optimism about the future. It is still in our hands—and it need not be bleak. If companies are to invest in tomorrow’s technologies, people to embrace change and policymakers to make difficult reforms, a positive outlook is essential. Gloomy Americans and Europeans should visit Asia or Brazil and allow themselves to be carried away by their refreshingly positive vibe. Delight in their success and view their growing prosperity as an opportunity, not a threat.

The aftermath of the crisis opens up huge opportunities to reshape the world economy for the better. A fairer, richer, greener and more stable global economy is possible. But to achieve it, we need to rediscover the virtues of open markets, open societies and open minds that go hand in hand with progress: greater opportunities for everyone to chase their dreams and fulfill their potentials.

We must not allow another financial collapse, a debt crisis, a closing of borders, a climate catastrophe or a corrosive pessimism to destroy that huge promise.

But now that the government is actually beginning to implement the policy, the holes in it are becoming all too clear. It will damage the economy without addressing any of the political concerns about immigration.

Theresa May, the new home secretary, has imposed an initial cap of 24,100 on the number of non-EU migrants who can come work in Britain between now and April 2011. She has also announced a consultation with businesses and other interested parties before introducing a more permanent limit. The overarching aim is to reduce net immigration to Britain from “hundreds of thousands” – the actual figure was 176,000 in the 12 months to June 2009, according to the Office for National Statistics – to “tens of thousands”.

The new cap is absurd. Since less-skilled workers had already been denied legal entry by Labour’s points-based scheme, it will only keep out highly skilled workers from outside the EU – people with exceptional talents and those with skills that are in short supply in Britain. Tightening the screws on migrants who are already small in number but make an outsized contribution to the economy will damage the fragile recovery while scarcely denting overall migrant numbers.

Once the arbitrary annual limit is reached, foreign workers will be turned away irrespective of their merit and how much they are needed. Big businesses will not be able to recruit the talent that they need to compete in global markets. A small business that has just won a big export order but cannot find the highly trained engineers it needs in Britain will not be able to hire them overseas. A local school that needs a new science teacher will have to do without. The football club you support won’t be able to bring in a top-class African or Brazilian striker. So much for the government’s claim that Britain is “open for business” – it is actually putting the shutters up.

Only the most extreme opponents of immigration object to highly paid foreign workers with valuable expertise who pay lots of tax and make little use of public services, while many of the government’s supporters in business depend on such migrants. So where is the political gain in clamping down? Most of the new arrivals that people expressed concern about during the election campaign have come from eastern Europe. Short of leaving the European Union, their numbers cannot be curbed by government policy – although because of the recession, far fewer are coming while many more are choosing to go home.

In opposition, the Conservatives had an incentive to fan the flames of public discontent about immigration. But now that they are in government, they would do better to adopt more constructive policies. Since freedom of movement within the EU is here to stay, they should point out its benefits – not just to the British economy but also to the millions of Britons who live, work and retire on the continent.

Since so many of the tensions about immigration revolve around housing, they should ease planning restrictions and swallow their hang-ups about building more social housing. And since public services are another flashpoint, they should make sure that local services respond more quickly to changing needs – and have the cash they need to do so. These are all points the Labour leadership candidates could be making too.

The coalition government should get serious about its immigration policy. By capping foreign talent, it is tilting at windmills.

Faced with a national crisis, who better to turn to for advice than Winston Churchill? A century ago, the great man — who, like the present coalition, was both Liberal and Conservative — advocated introducing a land tax as part of a bold package of fiscal reforms. In his emergency Budget on June 22, the Chancellor should set up a commission to consider how best to implement that recommendation.

Taxing land values would be a fair way to help to plug the budget gap while stabilising — and even boosting — the economy. Land is routinely valued each year as property changes hands. With all the land in Britain worth perhaps £5 trillion, a 0.5 per cent levy could raise £25 billion a year — as much as a five-point rise in income tax.

Neither tenants nor leaseholders would pay a penny; only freeholders and landlords would, with the owner of a large estate paying a higher rate than someone who owns a small suburban semi. The proceeds could be used to cut the deficit and national insurance, creating jobs, boosting take-home pay and stimulating growth. Over time, the aim would be to shift the tax burden off hard-working families and on to idle landlords — as in Hong Kong, where revenues from land taxes keep income tax low, there is no VAT or capital gains tax, and enterprise flourishes.

When the Government taxes successful effort, people strive less — some work less, others don’t bother setting up a business, a few relocate overseas — and since hiring is more expensive, fewer jobs are created. But taxing land wouldn’t crimp economic activity, as Adam Smith explained in The Wealth of Nations. It wouldn’t reduce the supply of land, which can’t be spirited away to a tax haven. And it wouldn’t push up rents, which depend on what tenants are prepared to pay rather than landlords’ expenses.

A land tax would actually encourage development. Since it would be payable irrespective of how land is used, it would stimulate the regeneration of derelict sites — such as Battersea power station, where David Cameron launched his election campaign and which has lain idle since 1982. Infrastructure investment that raises surrounding land values, such as Crossrail or a high-speed rail network, would pay for itself and thus escape short-sighted budget cuts. And unlike property taxes, people who do up their homes would not be penalised.

Taxing land values could also limit property bubbles — and the inevitable busts — without discouraging mobility (unlike stamp duty) or business investment (unlike interest rate rises). Relaxing planning restrictions, as Policy Exchange, the Prime Minister’s favourite think-tank, has suggested, would help too. The notion that we can all get rich by swapping more or less the same stock of houses at ever more inflated prices is a dangerous delusion. Property speculation diverts funds from productive investment in promising companies — and when the bubble bursts, the economy plunges into recession, home-owners are stranded with huge debts and banks laid low by bad loans seek bailouts from taxpayers. Isn’t it time we learnt from our mistakes?

Above all, a land tax would be fair. Land in Britain is parcelled out more unequally than in Brazil: 0.3 per cent of the population owns 69 per cent of the land. The country’s biggest private landowner, the Duke of Buccleuch, owns 277,000 acres, not because of his talent or industry, but because his ancestors seized vast swaths of Scotland.

These “land monopolists” — as Churchill dubbed them — get richer not through their own efforts, but that of others. The Duke of Westminster owns 300 acres of what was once fields and is now London’s priciest real estate — Mayfair and Belgravia. And because so many people have established thriving businesses in the capital, that inheritance is now worth billions of pounds. Surely it would be better to tax that windfall gain, rather than the employees and entrepreneurs who generate it?

For sure, farmers and big landowners would kick up a mighty fuss. But since the typical family of four shells out £750 a year to farmers in higher taxes and food prices because of the Common Agricultural Policy, which also inflates land prices, it’s only fair to claw some of that back. And while landowners would point to the impact on a poor granny in a big house — a bogus argument that Churchill called the “poor widow bogey” — she wouldn’t be forced out of her home; her tax bill could be deferred, or she could even be exempted.

Since nearly all of us earn most of our lifetime income from work rather than from rent, taxing land instead of labour would make most people better off. So the question for the coalition Government boils down to this: do you want to help a big society of enterprising people working hard to get ahead — or a tiny hereditary elite creaming off the rewards of others’ efforts?

Oscar’s life is tough. Now 30, he hasn’t seen his family since he left Honduras. “Not having documents is suffocating. Businesses exploit you. You’re always hiding,” he says. “We need immigration reform. I sent an e-mail to our President.” Your President? “Yes, he’s my President. I love this country. If I could, I’d help this country get back on its feet.” Oscar seems like the kind of guy America would want to hang on to. “I’m afraid of being deported, so my money is hidden,” he says. “Otherwise I could put it in the bank to invest.”

The U.S. is already home to some 12 million illegal immigrants, according to the Pew Hispanic Center. What to do with them–and with America’s broken immigration system–is suddenly back at the top of the political agenda. Tempers are flaring after Arizona passed a draconian new law clamping down on illegal immigrants. President Obama persists with failed policies: erecting a fence along the Mexican border, sending National Guard troops to police it and wishing the issue would go away. Isn’t it finally time for a radical rethink?

America should open its borders. Anyone who wants to immigrate to the U.S. should be allowed to, with the bare minimum of bureaucracy. Those already here illegally should be legalized. Open borders would make this country richer, more entrepreneurial–and more secure.

Critics object that lawbreaking illegals should not be rewarded. Yet for the most part these people’s only crime is wanting to work hard to earn a better life for themselves and their children–the epitome of the American Dream. They do the jobs that most people spurn: pick fruit, wash dishes, pack meat. Without them America would grind to a halt.

Government efforts to stop migration have mainly driven it underground–at huge financial and human cost. Billions of dollars are wasted annually in a futile effort to seal an inherently unsealable border. More people have died trying to cross over from Mexico in the past decade than were killed on Sept. 11. Ever tougher measures won’t work: Documents can be forged or stolen, people smuggled, officials bribed. Even with a shoot-to-kill policy, people got across the Berlin Wall.

Ending this senseless and unwinnable war would make America more secure, not less–instead of chasing harmless migrants, federal agents could concentrate on identifying and neutralizing homegrown and foreign terrorists. Above all, opening the border would bring huge economic benefits.

The case for free migration follows logically from that for free trade. Just as it’s beneficial for goods and services to flow freely across borders, so, too, the people who produce them. Freer trade has made Americans much richer over the past 50 years; unfreezing labor flows could deliver vast gains over the next 50. According to some estimates, removing immigration controls could more than double the size of the world economy.

Heather Mac Donald worries that newcomers are poorer and less educated than Americans. But that’s precisely why they’re willing to do low-paid, low-skilled jobs that Americans shun. Many low-skilled jobs can’t be mechanized or globalized. The elderly can’t be cared for by a robot. Lawn care can’t be outsourced to India.

Fears that immigrants threaten American workers are mostly misplaced. Just as working women haven’t deprived men of jobs, immigrants create jobs as well as filling them–both when they spend their wages and in complementary lines of work. Mexican construction workers, for instance, create jobs for Americans selling building materials, as well as spending their wages at Wal-Mart.

Nor do immigrants depress wages, since they rarely compete directly with native-born Americans for jobs. On the contrary, their efforts often complement one another. A foreign nanny may enable an American doctor to return to work more quickly after childbirth, where hardworking foreign nurses and cleaners enhance her productivity. Research by Gianmarco Ottaviano of Bologna University and UC, Davis’ Giovanni Peri found that the influx of foreign workers between 1990 and 2004 raised native-born Americans’ wages by 2%. Only one in ten–high school dropouts–lost slightly, by 1%. All Americans benefited from higher capital returns, cheaper goods and services and faster productivity growth.

Immigrant diversity and dynamism stimulates new ideas and businesses. Migrants are a self-selected minority who tend to be young, hardworking and enterprising. Like starting a new business, migrating is risky, and hard work is needed to make it pay off. Immigrants are 30% more likely than native-born Americans to start their own business.

That number would surely be higher if we legitimized their status. People who lack formal property and business rights can’t get a bank loan to start a business or ink legally enforceable contracts. Legalizing them would unleash their entrepreneurial energies and swell tax revenues.

Exceptional individuals who generate brilliant new ideas are often migrants. Instead of following conventional wisdom, they tend to see things differently, and as outsiders they are more determined to succeed. Nearly a quarter of America’s Nobel laureates were born abroad. Nearly half of Silicon Valley’s venture capital-funded startups were cofounded by immigrants. No one could have guessed when he arrived at age 6 as a refugee from the Soviet Union that Sergey Brin would go on to cofound Google. How many potential Brins does America turn away–and at what cost?

Many worry that if America opened its borders now, millions would come, the welfare burden would be unsustainable and society would collapse. Yet such fears are misplaced. Most people don’t want to leave home at all, let alone forever. Since 2004 three rich European countries–Britain, Ireland, and Sweden–have allowed people in eight poor eastern European countries (notably Poland) to come work there freely. All 75 million of those eastern Europeans could have moved, yet only 1 million did–and half have already gone home.

The belief that free migration is incompatible with a welfare state–asserted by Milton Friedman and recently echoed by Paul Krugman–is also incorrect. When in 2004 Poles were given the option of moving to Sweden–which has the most generous welfare state on earth–or to Britain and Ireland, which denied Poles access to any benefits until they had worked for a year, less than 1% opted for Sweden. America, too, could deny immigrants access to welfare initially.

Opening up to eastern Europeans gave Britain a big boost. Growth soared. Unemployment fell. Wages continued to rise. Newcomers paid much more in taxes than they took out in benefits and public services. After the global financial crisis plunged the economy into recession, many Poles went home rather than remain unemployed in Britain. Considering that Sweden is as rich as the U.S. and that Romania is poorer than Mexico, if open borders can work within the European Union, they can work in North America.

Allowing people to move freely is not just a matter of economic self-interest. It is also a moral imperative: Freedom of movement is a basic human right that should not be denied to people less fortunate than ourselves. Since migration is inevitable, far better that it be safe and legal. A pipe dream? That’s what people once said about abolishing slavery.

While home owners – especially those who had fallen into negative equity – will cheer the housing market’s bounce, it is high time Britons were weaned off their addiction to property speculation. It is a dangerous delusion that we can all prosper by swapping more or less the same stock of houses with each other at ever more inflated prices. Unfortunately, few politicians – with the notable exception of Vince Cable– propose to do anything about this nationwide pyramid scheme. After all, another fix of house-price inflation that got consumers spending again would appear to be a pain-free way to stimulate the recovery. In truth, though, it would be recklessly unsustainable.

Fortunately, the housing market is not yet as bubbly as the headline figures suggest. Volumes remain depressed: half as many properties are changing hands as two years ago. And while London prices are being pushed up by bulging City bonuses and foreign investors capitalising on the weak pound to snap up prime property in the capital, the rest of the country is looking less perky. Even so, it is astonishing that prices are notching up double-digit growth with the economy stagnant and houses still extremely expensive. Priced at more than five times average earnings, the typical house is more exorbitant than at the height of the 1989 property boom.

In part, this is because the supply of new houses – which is constrained by planning restrictions and the failure of successive governments to build enough social housing – has failed to keep pace with rising demand. This is notably due to more single people wanting to live alone; blaming immigration is a red herring – while house prices at their peak in 2007 were two-and-a-half times as high as in 2000, they would have been only 7% lower had net immigration to Britain been zero over that period, according to Stephen Nickell, of Oxford University, whose testimony is quoted in an infamous House of Lords select committee report that was hardly pro-immigration. Mostly, though, property prices are buoyed by financial factors: the availability of cheap credit and the willingness of prospective buyers to borrow huge sums in anticipation of future gains.

The belief that the “property ladder” is the road to riches does all manner of damage. It saps long-term growth by diverting funds – and talent – away from productive investment. Three-quarters of bank loans go to the property sector; many would-be entrepreneurs become property developers instead. It also promotes an unhealthy reliance on the financial sector and debt-fuelled consumption. And it destabilises the economy, as euphoric booms are inevitably followed by nasty busts.

Rising house prices force many families to squeeze into smaller homes, prevent many people from buying a place altogether, and inflict long commutes on people who cannot afford to live near their workplaces in city centres. They transfer wealth from poorer young people to richer older ones. And they fracture society between property haves and have-nots. The biggest beneficiaries are Britain’s big landowners – the 0.3% of the population who own 69% of the land – who get richer each year without lifting a finger. The Duke of Westminster, who inherited 300 acres of what were once fields and are now Mayfair and Belgravia – the priciest parts of central London – is laughing all the way to the bank.

What, then, should the government do? For a start, ease planning restrictions and build more social housing. That does not imply concreting over the countryside: 3 million new homes at the government’s target density would take up a mere 0.3% of the UK’s land area – even less if they were built on brownfield sites. Second, the authorities should restrict mortgage lending when the housing market is getting bubbly through targeted measures – such as requiring banks to hold more capital against property lending – that do not crimp desirable business investment.

Last but not least, the government should introduce a tax on land values. Taxing wealthy landowners’ windfall gains would help curb property speculation, fund new social housing and reduce the budget deficit. Over time, shifting the tax burden off labour and on to land would create jobs, reward hard work and promote more stable, sustainable and balanced growth. Fixing the housing market should be a priority for whichever parties form the new government.