How to save capitalism

As the world moves from the life-threatening to the convalescent phase of the financial crisis it is becoming clear that, although it wasn't destroyed by the near-death experience of 2008-09, global capitalism will have been permanently transformed.

The crisis marked the fourth systemic transformation of the global capitalist system, comparable to the upheavals that followed the great inflation of the 1970s, the great depression of the 1930s and the period of geopolitical turmoil that culminated with Wellington's victory over Napoleon in 1815. The new politico-economic system emerging from the crisis can therefore be described as the fourth distinctive version of capitalism—hence the title of my new book, Capitalism 4.0.

The defining feature of each previous systemic transformation has been a change in the relationship between government and markets, and especially in what might be called the fundamental question of political economy: the balance between political decisions based on one-man-one-vote and economic decisions based on one-pound-one-vote.

In classical 19th-century capitalism, politics and economics were in essence distinct spheres with interactions between government and private enterprise largely confined to raising military revenues and protecting powerful vested interests—landowners or craft guilds, for instance. The second version of capitalism, from the 1930s onwards, was characterised by a distrust of markets and a faith in benign, omniscient leadership—the new deal, wartime faith in "heroic government" and the postwar paternalism of "Whitehall knows best." The third phase, defined by the Thatcher-Reagan revolution, exactly reversed these prejudices. Now the markets were always right and governments were universally distrusted. So what will be the character of the fourth phase?

The crisis revealed that governments and markets can both be catastrophically wrong. This may seem a depressing conclusion, but acknowledging the fallibility of both markets and political institutions, far from being paralysing, can be empowering. Fallibility implies a capacity for improvement. It also implies an effort to synthesise politics and economics, instead of assuming an inherent opposition between capitalist market incentives and democratic demands for social justice.

Capitalism 4.0 will be marked by a new recognition that market economies cannot function without competent and active government. This is now obvious in the financial sector, but another essential economic function of government has been demonstrated just as clearly by the crisis. Governments and central banks must now actively manage economic cycles, because inflation targets—the main tool of macro-economic management in recent decades—are not enough.

The dominant economic theories of the 1980s, which assumed rational expectations and efficient markets, left only one important role for government economic policy: to keep inflation under control. But if markets are recognised as inherently fallible and subject to financial swings and Keynesian economic depressions, governments and central banks must again accept responsibility for managing growth and employment and maintaining financial stability that they abandoned in the 1980s. The Bank of England, instead of merely aiming to hit a 2 per cent inflation target, will be set a tolerance range for inflation, unemployment and financial risks, and will be expected to intervene to prevent the economy moving into dangerous territory by focusing on whichever economic variables are flashing "red" at any point in the economic cycle. At the same time, recognising that market forces cannot always be trusted to create price signals consistent with broader social objectives will mean that governments play a greater role in setting energy prices, managing currencies and creating the right environmental incentives.

All this political engagement in economic management and financial regulation may suggest that the coming decades will be an era of bigger government. Yet the opposite is likely to happen, for at least three reasons.

The most obvious reason is that governments have run out of money. Thanks to the enormous loss of tax revenues caused by the recession—the cost of all the bank bailouts were a drop in the ocean by comparison—the spending commitments made by governments all over the world have become unsustainable. Because of the promises on health and pensions made by successive governments to the ageing baby-boom generation, a fiscal crisis would have occurred sooner or later even in the absence of the 2008 meltdown. But the credit crunch brought forward this fiscal crisis by ten or 15 years.

Second, the crisis has aggravated the public distrust of governments as well as of markets. Hence a larger role for government in managing the economy and regulating finance needs to be accompanied by the state's withdrawal from other areas of activity—to maintain a balance between government and private enterprise that is acceptable to sceptical voters.

Third, the reassessment of the relationship between government and business demanded by the new capitalist model will reveal that states can no longer satisfy an advanced society's complex demands for healthcare, education and personalised retirement planning—and that the pre-crisis government dominance of these vast sectors is incompatible with long-term prosperity and growth. To put it another way, as societies grow richer citizens tend to want to spend more on education, health and pensions, but there is a strict limit—which varies from country to country—on how much of their income they are ready to pay to the state in tax and therefore how many of those services can be publicly provided.

The socialists of the 1940s dreamt of nationalising the "commanding heights" of the economy—coal, steel and railways. But even as Labour and Tory governments abandoned this quixotic endeavour, they quietly monopolised the commanding heights of the future economy—health, pensions and education. Reversing this process, in a socially just manner, is the biggest political challenge of Capitalism 4.0.

For all these reasons and many others, the politics of the post-crisis period will defy left-wing hopes of a return to the stateism of the 1960s and 1970s. But it will also frustrate the right-wing demands for reversion to the market fundamentalism of Capitalism 3.0. The new environment will demand that government must expand and contract at the same time.

The simultaneous need for more government and smaller government will demand a reassessment of political priorities on a scale not seen since the 1980s. In comparison with these existential choices, the rows over bankers' bonuses and financial regulation will appear inconsequential.

The Labour hero Aneurin Bevan used to say that "the language of priorities is the religion of socialism." In the post-crisis period, priorities will become the religion of all governments, whatever their political colour. For government debts to be stabilised at manageable levels, taxes, entitlements and government services will have to be reformed in every advanced economy. Neither higher taxes nor reduced entitlements can be ruled out. And both conservative and progressive politicians will be forced to engage in an honest debate about priorities or sacrifice their most cherished objectives: a robust economy and financial system in the case of conservatives, and a viable welfare state in the case of the left.

As a result, the public will in turn be forced to accept that government revenues are not sufficient to pay for the health and pensions entitlements they have been promised. In the US, the dominance of these "entitlements" in public spending is so extreme that even if the government's entire "discretionary" non-defence spending—everything it does in homeland security, education, science, transport, and so on—were cut to zero, the federal budget would still be deeply in deficit, with an unsustainable long-term outlook for public debt.

In Britain and most of Europe, the situation is slightly less dire because tax increases have been accepted as inevitable. Even so, commitments to healthcare and state pensions are still far higher than plausible estimates of these economies' taxable capacity in the long term. The fiscal costs of ageing to the British government—even assuming some moderation in the relentless rise of healthcare prices and no further expansions of health or pension entitlements—are calculated by the IMF as 335 per cent of GDP. That is equivalent to roughly £5 trillion, or almost £200,000 for every British household. In comparison with such figures, concerns about bank bailout costs and fiscal stimulus plans should pale into insignificance. The situation is broadly similar in the US and Japan.

The only scope for debate about the long-term fiscal outlook, therefore, will be over the nature and speed of reductions in public spending. In drawing the new dividing lines between government and private enterprise, politicians who appeal to a priori ideologies—either more government or more market—will be displaced by pragmatists who follow Franklin Roosevelt's call for "bold, persistent experimentation." And even better than experimenting on the citizens of one's own country is to observe the experience of others.

The US, Europe, Japan, and Australasia, instead of boasting of their own superior socio-economic models and rubbishing those of other countries, would do well to study one another's successes and failures. As Bismarck remarked: "Fools learn from their mistakes; I prefer to learn from the mistakes of others."

International experience shows, for example, that transport systems, roads and energy utilities generally work better under private ownership than under state control, even though direction from government is necessary to achieve social objectives (for example, taxes on pollution, subsidies for the social benefits of public transport, insurance for nuclear installations). Yet many services that have long been privatised in Europe are still provided by the government in the free-market US. For example, 89 per cent of US households are served by public-sector water utilities, whereas in Britain and France the proportion is less than 10 per cent.

International comparisons therefore indicate that many assets owned by various levels of US government could be readily privatised to reduce public debts. Such privatisation would also help to reverse the chronic underinvestment in infrastructure that sometimes makes America look like a developing country to visitors from Europe and Japan. In other cases, the benefits of US privatisation experience could flow to Britain and Europe. Higher education, for example, which is state-controlled and decaying in Europe and Britain, is largely private and thriving in the US.

But these are minor matters in comparison with the biggest challenge facing every government: how to reduce the core entitlements to health, pensions and basic education that consume about 70 per cent of tax revenues in all advanced nations. In dealing with these growing burdens, the US, Britain, and Europe can learn a lot from each other.

Health, education, and pensions will be the commanding heights of the economy in years to come. These three activities already account for 20 to 30 per cent of GDP and employment in all advanced economies—far more than the heavy industries once coveted by Nye Bevan. In coming decades, they will continue to expand as populations get older and economic activity becomes increasingly dependent on knowledge, advanced technology and culture. To maintain a reasonable balance of power between the private and public sectors in the post-crisis capitalist system, a more complex mix of private and public funding will be necessary.

Education is the area where private provision is likely to grow most quickly. In higher education, this process will be driven by the dominance of US universities in all branches of knowledge. If other countries want to keep up with knowledge-based industries, they will have to reform their higher-education systems to make them comparable to the fee-based US. For school education, the prospects are less clear. Primary and secondary learning requires government compulsion and subsidies as well as social consensus on broad educational standards. But the fact that good education benefits society as a whole does not mean that schools should be run by the state.

The education of children raises many questions, perhaps more than any other human activity, and no one can claim to have answers to them all. Almost every country in the world believes itself to be facing some kind of educational crisis. Under these circumstances, the best hopes for improvement must surely come from various market mechanisms and experiments, with schools trying out different approaches and with successes distinguished from failures through the trial and error of consumer choice. The standard objection to such choice is that some children will end up with a worse education than others, either because their parents make the wrong decisions or because the most popular schools will not admit everyone who applies. But after fifty years of claiming to deliver uniform educational standards, centralised systems have manifestly failed in this objective. This is hardly surprising, since parents can never be prevented from promoting their own children's interests in a free society.

As boundaries are redrawn between state and market after the crisis, education will experience more competition and private provision. It is morally and economically desirable that this does not reduce educational opportunity or harden class stratification. There are many policy tools available to prevent this, including pupil premiums for poorer children, means-testing, needs-blind admission and scholarships.

Healthcare, however, represents the greatest challenge to government finances and is the sector where dysfunctional relationships between government and private enterprise have done most damage to economic efficiency and stability.

It is far from obvious whether the British are right to view medicine as a public good, to be provided equally to all citizens by the government like law enforcement, or whether it should be treated as it is in the US—as a private purchase, not very different in principle from the consumption of food, clothes or housing, which are left to private enterprise even though they are essential human needs. But such theoretical and moral issues will no longer be the driving forces of health reform as governments start to clear up the fiscal debris of the crisis.

Whether or not voters experience a Damascene conversion in their attitudes to sickness and health, the US and Britain will become increasingly aware that their healthcare systems are unaffordable. Both countries will have to redraw the boundaries between the market and the state—albeit in opposite ways.

US healthcare costs have long been out of line with those of other countries. The US spends $2.5 trillion ($8,100 per head) on healthcare annually—or 18 per cent of its GDP. This is half as much again as the 11 per cent of GDP spent in France and Germany and almost double the 9 per cent in Britain and the OECD as a whole. The world's second-highest spender is Switzerland at only 12 per cent of GDP. Yet in the US, medical outcomes such as cancer and cardiac survival rates are generally no better than the OECD average and substantially worse than in France, Switzerland and Japan.



Until recently, the vast disparities between US and foreign health costs made no impression on public opinion in the country. Americans simply assumed that the rest of the world was out of step. They knew their system was expensive, but falsely believed it delivered more innovation and greater satisfaction than the "socialised medicine" in other countries—invariably using the rationing in Britain's NHS as a counterexample. In a mirror image of the false dichotomies distorting the US healthcare debate, Britons have been told that American-style privatisation, which would more than double costs and simultaneously reduce the scope of their healthcare, was the only alternative to a state-run NHS.

In clinging to these false dichotomies, the US and Britain have ignored the multitude of other countries, such as France, Germany, Switzerland, Canada, Australia, Sweden and Japan, that have mixed public and private provision—with insurance schemes, means-testing, payment for hospital and doctor visits and so on—and deliver far better outcomes and greater customer satisfaction than the British system, at far lower cost than the US. But why should anything change? The answer is that the financial crisis will force a change.

In the US, the escalating costs of Medicare and Medicaid account for most of the long-term costs of ageing that are driving the state toward insolvency. In Britain, the dark, almost unmentionable secret that will haunt politics in the next decade is that the NHS has become an incubus, sucking the life out of all other public services, which have to be starved of funds to meet its demands. NHS spending has risen from 6.6 per cent of GDP in 2001 to almost 10 per cent of GDP in 2010, accounting for two-thirds of the increase in the share of public spending in national income.

Yet given how much of this state spending on health is consumed by the relatively affluent elderly it represents a transfer not only from the young to the old but even from the poorer to the richer. A reduction in the share of state spending, therefore, would not necessarily damage quality of life for those on middle and lower incomes as long as access to high-quality acute care remained universal.

The rational response to the fiscal crisis would be for Britain, along with the US and most European nations, to start acknowledging that the commitments made to ageing baby boomers for government-funded health, pensions and long-term care simply cannot be fully honoured. Yet these are precisely the "entitlements" protected and ring-fenced by politicians in these countries. If this ordering of priorities is maintained, all public services apart from those serving the old and the sick will drastically suffer. Multitudes of public employees will lose their jobs, many more households will sink into poverty, and education will deteriorate—all to ensure that spending on the NHS can keep growing.

Good schools and affordable universities are more important for future prosperity, as well as for social justice, than hospitals, which cater almost entirely to ageing citizens who make little economic contribution and are society's richest demographic group. Yet in an era when government spending must be strictly prioritised, the new Lib-Con coalition has made exactly the opposite judgement. While most politicians claim to be obsessed with education, in reality all parties have favoured health and protected pensions while ruthlessly squeezing universities and schools.

With post-crisis financial consolidation running into the baby-boom retirement bulge by the end of this decade, political progressives will soon be forced to make a choice: if they want to preserve education and decent public services for the working population, if they want to maintain a welfare safety net for people suffering genuine hardship, and if they want to serve the interests of public-sector workers outside healthcare, they will have to acknowledge the inevitability of NHS reform. The left will have to start campaigning actively for healthcare to be partially privatised. Meanwhile, Conservatives will be the ones who campaign most vehemently to defend the state's responsibility for healthcare, using the inexorable growth of health spending as a Trojan horse to subvert all other government programmes.

In the new political economy emerging from the crisis, protecting the NHS will be the surest way to accelerate the dismantling of the postwar welfare state—just one of the many paradoxes characteristic of capitalism's next era.