When new Labour came to power in May 1997, it accepted the framework of economic policy it inherited from the Conservatives. In doing so, it staked its future on a bet that global capitalism would continue its all-conquering advance. It wagered that the financial markets would continue in a steady upward spiral and that rising living standards would follow automatically for the majority of people. In making this bet, it made another - that globalisation would engender peace. As a result, the world would not in the foreseeable future be faced with a large, destabilising war.
Both bets are looking shaky. In the US, the world's largest stock market boom has been followed by a crash that has savaged the retirement savings of millions. In Britain, the stock market does not have the pivotal place it occupies in the lives of Americans, but a muted version of the same crash is having a similar result. Large numbers of voters will find that their pension funds do not give them the security in old age on which they were banking. At the same time, war approaches over Iraq, threatening to destabilise the Middle East and severely dislocate the global economy.
Capitalism has proved itself to be as prone to boom and bust as at any time in history. Yet the Blair government appears to have few contingency plans against the risk of serious economic dislocation. Gordon Brown's increase in public spending will buffer the economy against recession, but many of the government's policies are still premised on a neoliberal faith that we have reached the end of economic history. Unlike Labour governments in the past, it has an enviable reputation for economic competency. Moreover, with the Tory party reduced to a music-hall joke, it has no opposition to contend with. Labour is now established as the natural ruling party. Yet by failing to plan for the downturn, it has left itself vulnerable to a nasty reversal of fortune.
In embracing the global free market, Labour demonstrated that it was attuned to the spirit of the age. Unfortunately, it was a zeitgeist in which history had ceased to exist. With the spectacular collapse of communism, the turbulent history of capitalism also slipped into the memory hole. Old-fashioned social democracy had many flaws, and at the start of the 21st century it is impossible to reinvent it; the world has changed too much for that to be feasible. But the reality to which social democracy was a response - the bone-shaking volatility of market capitalism - has not changed. On the contrary, it has returned with a vengeance. Global capitalism is probably as fragile today as it has been since the 1930s.
Globalisation has not brought about the end of the business cycle, as some wild-eyed prophets of the new economy imagined. It has magnified the booms and busts inherent in capitalism. During the last boom, markets around the world followed Wall Street in levitating to impossible heights. Now that boom is over, and the global markets are following Wall Street as it falls back to earth. Globalisation means that markets move more or less in tandem throughout the world. It seems never to occur to politicians who bang on about the virtues of globalisation that such synchronous movements can be pretty scary on the downside. Perhaps they believed the party would go on for ever. If so, they were suffering from a loss of historical memory that may yet cost them dear.
It is partly the government's lack of a sense of history that accounts for the mess it is in over pensions. Labour took over from the Tories the notion that the state pension should be de-indexed from average earnings, and tied instead to inflation. In effect, it became an anti-poverty programme. As such, it has been reasonably successful in guaranteeing a minimum income to the poorest; but it has left the working majority facing a bleak prospect. Told to stop relying on the state and to fend for themselves, many people have been sold personal pensions as the way to ensure a decent retirement. They believed that, by investing in the stock market, they could ensure that their standard of living in retirement would not be far below what they enjoyed in working life.
So long as the markets were going up, this sounded fine; but the dangers are now all too plain. In the past, the state pension was a way of reducing risk through a collective saving scheme. Today, final-salary pensions do much the same - where they still exist. In both cases, the unavoidable risk that goes with all investment is pooled, and thereby made more tolerable. In contrast, personal pensions transfer all the risk to individuals. It will be obvious to anyone with a smattering of economic history that this is not a wise move for the individuals concerned, or for the government that will eventually have to pick up the bill.
For many people, the only hope of a decent pension is to invest in equities. Over very long periods, stocks have performed better than any other type of asset; but over shorter periods - which can last as long as 20 years or more - history shows they can deliver very little. The result of allowing collective provision by the state and business to wither away is that working people and their families are exposed to a level of market volatility they cannot afford. It is hardly surprising, therefore, that most people have simply refused to save, relying instead on the rising value of their houses to bail them out of penury in old age. We must all hope that this is a better bet than the stock market has proved to be.
An even more telling sign of Labour's exaggerated faith in the market is PPP (public-private partnerships). Although there may be some contexts in which a mix of public and private investment is viable, it makes little sense as a way of financing Britain's basic infrastructure. Some of the country's vital industries, such as its nuclear power stations, are unattractive to City investors. In others, such as the London Underground, PPP involves breaking up an integrated structure that is safe and has not been shown to be more costly than any alternative. In yet others, introducing private finance has had the effect of creating an inefficient hybrid. This is what appears to have happened in NHS hospitals, where what is left of the public service ethos is being undermined by the profit motive.
The government advertises PPP as a pragmatic solution to the problems of underfunded public services. It is true that voters do not much care how public services are provided; what they want is quality and reliability. If the markets can be shown to provide these better than state provision, so be it; privatisation is the pragmatic solution. By the same token, genuine pragmatism means building up state provision where it works better than market alternatives.
When market forces are as powerful as they are today, the task of government - especially a government whose roots are in British social democracy - is not to thrust markets into every nook and cranny of public life. It is to tilt the balance the other way. Market forces need to be balanced by countervailing, non-market institutions. The idea that public services are evil bastions of producer power that require the internal discipline of market mechanisms is often described as an inheritance from the Thatcher era. Yet the policy of creating quasi-markets inside public services is not even Thatcherite. It may have been mooted in the late 1980s, but it became entrenched only in the dog days of the Major government, when the writing was already on the wall for the Conservative Party. In its policies towards public services, the government is continuing John Major's doomed attempt to run Thatcherism on autopilot.
Rather than injecting markets into any and every institution, it makes more sense to distinguish clearly between those that should be run on market lines and those in which market processes are inefficient or damaging. The government's failure to make this crucial distinction is at the back of the invasive culture of audits and targets to which all publicly funded institutions are now subject. Aside from the destructive impact of these policies on morale, they are the reverse of what is needed when markets are going into one of their recurrent bouts of instability.
Even before the terrorist attacks of last September, the world economy showed signs of weakening. If anything, the overall impact of 11 September was stimulatory, because it brought forward a further easing of interest rates. War in Iraq could have a very different effect. Setting aside the moral arguments for the war - if there are any - it is fraught with terrible economic and geopolitical risks. A spike in the oil price and a further slide in the stock market would deal severe blows to the already battered confidence of businesses and investors. Unlike the Gulf war, when America's allies footed most of the bill, any pre-emptive strike against Iraq will have to be paid for by the United States itself. The impact on the US budget deficit will be significant. There is also a possible knock-on effect on the US economy. How will American consumers react if the war does not end in swift and complete victory, but drags on inconclusively, and perhaps triggers further terrorist attacks? In the past, war has often acted as a stimulant of economic activity. In this case, it could dampen a weak economy. There is already a risk that, in order to rebuild their savings, Americans will rein in their consumption so severely that recession will follow. If war in Iraq turns messy, this danger can only be magnified.
The economic consequences of war in Iraq are worrying, but it is the geopolitical uncertainties that are most alarming. Even if military action succeeds in swiftly toppling Saddam Hussein, the aftermath could be grisly. As George Bush Sr feared when he decided not to march into Baghdad towards the end of the Gulf war, the state of Iraq could well fall apart as the Kurds seek independence and Iran expands into disputed areas. At the same time, regimes that allow their territories to be used as staging posts for the war could come under greater threat from fundamentalists. In the eyes of many observers, Saudi Arabia is already a brittle regime; the war that is approaching could fracture it beyond repair. The effects of an attack on Iraq on the Israeli-Palestinian conflict are unknowable - but few believe that they will be benign. At worst, a pre-emptive strike on Iraq could cause a geo-political convulsion, destabilising the Gulf and having repercussions in regions as distant as the West Bank, Afghanistan and Kashmir.
Contrary to what was widely believed in the 1990s, globalisation has not inaugurated an era of peace and prosperity. Instead, it has magnified the effects of market instability and war. This creates an awkward dilemma for Labour. The government's economic policies are based on an assumption of stability in the global markets. Yet it bases its foreign and defence policies on an expectation of continuing international conflict.
Britain cannot opt out of the world that globalisation is creating. The current regime of unregulated capital flows and global free trade may prove to be ephemeral; but the technological processes that ultimately drive globalisation are unstoppable. Some critics of the government argue that it should have tried to stem the tide of globalisation. In my view, that is wholly unrealistic. There is no way back to the past. Tony Blair and Gordon Brown were right in insisting from the start that the question to be confronted is not whether globalisation is good or bad, but how Britain should respond to it.
Where government policies are at fault is in staking too much on market forces. Britain cannot opt out of global capitalism, but its governments can and should craft policies to withstand bouts of market instability. It is dangerous to link the retirement plans of so many people to the vagaries of the stock market. It is silly to think that the City can fund large areas of public investment. It is not only that such policies are incongruous in a Labour government. The government's exaggerated reliance on market forces carries mounting political risks. Labour's spectacular electoral success comes largely from its being seen as the heir of the one-nation philosophy that the Tories have abandoned. Yet its policies on pensions and PPP seem to be the product of an ideological attachment to market mechanisms of precisely the kind that spelt ruin for the Tories.
In times of economic dislocation, voters are like investors. They flee to safety - if they can find it. At present, the government enjoys the unique good fortune of having no competition; but that does not mean it is secure from shocks. By continuing so many of the policies inherited from the Tories, the government risks getting stuck in the past. The boom years are over. Though the penny may not yet have dropped for many people, we are heading for leaner times. Over the past decade, Britain has been turned into something like a vast hedge fund, the investment vehicle for profiting from the shifts and turns of global markets. But unlike real hedge funds, Britain has few opportunities to benefit from volatile markets. Real hedge funds can be highly conservative in their strategies. As the name suggests, they can hedge their bets - for example, by wagering a part of their assets on the possibility that markets will fall. In contrast, Britain is exposed to all the risks that go with a period of global market instability. There is nothing wrong with gambling on the markets. High-stakes speculation can serve a useful purpose - as when George Soros freed Britain from the straitjacket of the exchange rate mechanism. Even so, it is unwise to stake the future of the country on a bet that markets will always go up.
Old-fashioned social democracy developed in conditions that are gone irretrievably, but it was a response to an enduring truth. Capitalism is prodigiously productive, but it is also highly unstable. Moderating its ups and downs requires more than the counter-cyclical policies pursued by central banks. It requires governments to devise policies and institutions that can act as buffers against market forces. No government can insulate Britain entirely from the turbulence of global markets; but in the perilous times that lie ahead, Labour had better not forget that its historic task is to civilise capitalism.
John Gray's book Straw Dogs: thoughts on humans and other animals is published by Granta