Anatole Kaletsky: We can't eliminate all risk - but we can prepare

LAST week was the second anniversary of the bankrupcty of Lehman Brothers and the forced takeover of Halifax Bank of Scotland by Lloyds Bank. Two years after this astonishing crisis, the life-threatening phase may be over, but the long-term consequences are only starting to be felt and understood.

We can now see many of the predictions of imminent disaster that dominated the media and financial markets in the year after Lehman were exaggerated and misleading. But it is also clear that the long-term upheavals caused by the 2008-09 financial crisis - in the relationships between politics and economics, in the geopolitical balance between America, Europe and Asia and even in the future of democratic capitalism - are going to be much greater than the petty arguments over financial regulation and bank bonuses that preoccupied politicians and voters on the first anniversary of Lehman.

Lehman was the Emperor's New Clothes moment, when the almost religious zeal for free-market capitalism inspired by Margaret Thatcher and Ronald Reagan, became a global laughing stock. After this humiliation, the era of free-market capitalism that began with Thatcher in 1979 is surely over. What, then, will replace the global capitalist system that crumbled in the autumn of 2008? The answer is - the global capitalist system, but of a new kind.

The traumatic events of 2007-09 did not diminish the fundamental human urges that have always powered the capitalist system—ambition, initiative, individualism, the competitive spirit. But after the crisis, these human instincts will have to create a new version of the capitalist system which could ultimately be more productive, as well as more stable, than the one that collapsed in 2008.

Once we recognize that capitalism is not a static set of institutions, but an evolutionary system that adapts to a changing social and technological environment and reinvents itself through crises, we can see the events of 2007-09 in a new light. Instead of allocating blame among greedy bankers, incompetent regulators or gullible homeowners, the meltdown in the global financial system needs to be put into historical and ideological perspective: as the fourth systemic transformation of capitalism, comparable to the transformations that followed the inflationary crisis of the 1970s, the Great Depression of the 1930s, and the Napoleonic Wars of 1803-15.Viewing the crisis in this historical perspective we can also see that the global boom was not just an episode of mass hysteria, but in part a logical response to four great politico-economic trends that began in the late 1980s: the breakdown of communism, the re-emergence of Asia, the revolution in electronic technology and the creation of a global financial system based on pure fiat money. These benign trends inspired speculation and produced a boom-bust cycle, in a pattern typical of previous periods of productivity-enhancing structural change. What turned a severe but manageable boom-bust cycle into an unprecedented financial disaster was an over-simplified and fundamentalist interpretation of the economic theory of efficient markets, not only by regulators such as Alan Greenspan, Gordon Brown and the Bush Administration, but also by bankers, investors and financial analysts around the world.

The clearest consequences of the crisis will therefore be a permanently more sceptical view of free-market mechanisms, leading in turn to a transformed relationship between public policy and economics. Such shifts in the boundary between economics and politics have been the defining feature of each of the successive versions of capitalism, punctuated by systemic crises.

In the classical 19th century capitalism that emerged after the Napoleonic wars, politics and economics were completely distinct spheres, with interactions between government and private enterprise largely confined to the raising of military revenues and protection of powerful vested interests. The second version of capitalism, from the 1930s onwards, was characterised by a distrust of markets and a faith in benign, omniscient government. The third phase, defined by the Thatcher-Reagan revolution, exactly reversed these prejudices - governments were distrusted and markets were always right. In the fourth phase, the world is beginning to recognise that governments and markets can both be catastrophically wrong.

Recognising the fallibility of both markets and political institutions may seem paralyzing, but is, in fact, empowering. Imperfect knowledge implies a balanced collaboration between politics and economics, rather than an adversarial relationship, and creates scope for leadership, creativity, and experimentation in both government and business. If the world is too complex and unpredictable for either markets or governments to be perfect mechanisms for achieving social objectives, then systems of checks and balances reflecting both private incentives and public interests, will have to be devised.

If financial cycles, banking crises, and self-reinforcing economic slumps are recognized as natural features of the capitalist system, then governments and central banks will again accept the broad responsibilities they abandoned in the 1980s for managing growth and employment, and not merely keeping inflation under control.The implication, which investors, homeowners and businesses have not yet fully recognised, is that interest rates are likely to remain much lower for much longer than almost anybody imagined possible until recently. Short-term interest rates will probably remain at or near zero for the whole of the present parliament and quite possibly for the rest of this decade - and long-term bond yields could well fall further from their present record lows.

THE fact that governments will have to accept broader responsibilities does not necessarily mean they will become bigger. In fact, there are two reasons why governments will probably get smaller, even as their responsibilities expand. First, governments have ran out of money as a result of the crisis. Deficits have exploded, while tax burdens are reaching the limits of public acceptability. Secondly, the failures of big government in the 1970s have not been forgotten.The economic demands of modern societies, from health care and higher education to energy independence and stable mortgage financing, are far too complex to be met by government. They can only be satisfied by private enterprise acting through competitive capitalist markets. Socialists of the 1940s dreamt of nationalising the "commanding heights" of the economy - coal, steel and railroads. 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 will be the biggest political challenge of the coming decade.

In the next era of capitalism, therefore, the ambition of governments should not be to replace markets, but to reshape incentives, so that profit-seeking businesses are motivated to pursue politically desired ends - whether in financial markets and energy investment, or in education and healthcare.

Financial regulation offers the obvious example. The crisis showed that a capitalist financial system ultimately depends on unlimited government support. This is entirely consistent with the new thinking on imperfect knowledge, which acknowledges that no regulatory or market structure will ever eliminate the risk of systemic financial failure. But once it is recognised that situations inevitably arise in which banks require - and obtain - government support, then the right response is not to pretend this interdependence between government and banks is some kind of pathological aberration.Instead we should accept the need for government financial guarantees, just as we accept the need for armed forces and nuclear deterrents - and then create mechanisms for banks, their customers and employees to pay for this protection in advance.

By adopting this philosophy, taxpayer interests can be protected, government revenues can be boosted and we can avoid regulations that stifle all financial innovation or treat finance as an unproductive parasitic activity - a populist spin on the recent crisis surprisingly legitimised by some of the statements of David Cameron, Lord Turner and Mervyn King.

Many other specific examples show how the new thinking about capitalism will transform the global management of finance, of energy and environment, of trade and currency relationships and the growing rivalry between the West and China, none of which can be left to market forces.

If market forces cannot finance home mortgages, can markets be trusted to restore and maintain full employment, reduce global imbalances or prevent the destruction of the environment and prepare for a future without fossil fuels?

What if the US. Britain and other advanced capitalist societies fail to show the ideological flexibility and imagination required to reinvent capitalism and try instead to restore the market fundamentalist system that failed in 2008? This choice will not prevent the emergence of a new kind of global capitalism. It may mean, however, that the newly dominant economic model will not be a democratic capitalism, based on Western values and US leadership. Instead, it may be an authoritarian state-led capitalism inspired by Asian values.

If the West opts for nostalgia and ideology instead of pragmatism and progress, then the new model of capitalism will probably be made in China - like so much else in the world these days.

• Anatole Kaletsky is the author of Capitalism 4.0: The Birth of a New Economy, published by Bloomsbury, and will be delivering the RBS and Scottish Economic Society annual economic lecture "The future of capitalism after the crisis'"at the Scottish Parliament tonight