New Labour has reached a crisis moment. The prime minister has led the country into its worst foreign-policy mistake since Suez. He has no exit strategy from an expensive and dangerous quagmire and in passing has wrecked his own European strategy. The episode has accelerated the political disintegration that was already besetting the government. The coalition that was brilliantly assembled in the mid-1990s – from moderate trade unionists to pro-European businessmen-is fracturing amid widespread disillusion at the government’s incapacity to move the country on from the status quo it inherited in 1997 – Euroscepticism and an uncritical commitment to the Anglo-Saxon business model.

The Iraq crisis has underlined how a political leadership that is unanchored politically and ideologically can make serious errors. New Labour’s founders were never clear about which parts of the social democratic tradition they should retain and which jettison as they wrestled with a new political landscape: globalisation, the rising power of financial markets and the media, the decline of unions and big workplaces, cultural individualism and the withering of mass political parties. It is to New Labour’s credit that it saw all this early, and its reward has been two great electoral victories.

But, as Philip Collins argued in the last issue of Prospect, having severed its ideological anchorage, New Labour has not found a secure new berth from which to develop a persuasive left of centre political narrative and sustain its broad coalition of support. It may be understandable that New Labour doubts the political efficacy of raising income tax; is sceptical about trade unions as they are currently led; wants to keep business sweet; regards universal benefits as wasteful; believes the public sector needs reform; and knows that antisocial behaviour on housing estates requires an aggressive response at which civil libertarians cavil. But it has not found a way of expressing such positions in a manner that remains compatible with core social democratic values: a belief in the public realm and social progress, and an understanding that capitalism must be seen to be fair in its operation. As New Labour has courted the Murdoch press, temporised over Europe, warmed to the American business model and attacked the BBC it is hardly surprising that so many Labour party members have blanched. And now, as the political weather turns, the disillusionment of Labour’s core base makes the government more vulnerable than it should be given the weakness of the opposition, the solid support of one third of voters and its own achievements.

Until this year, Blair and Brown have with skill and some luck managed to hold the ambiguities of New Labour at bay. Brown’s adept economic management, although flattered by the financial bubble, has allowed a sharp rise in government spending while raising taxes in a relatively pain-free manner. There are even signs of improved performance across the public sector as the combination of higher spending and the regime of targets, goals and service agreements, on which Brown has rightly insisted, have taken effect. Standards of literacy and numeracy for ten and 15 year olds are at the upper end of the international league tables, the number of NHS operations has increased and waiting times in accident and emergency units have fallen; even most types of crime are declining.

Yet even here the ideological uncertainty of New Labour, and Blair in particular, about the intrinsic worth of the public sector is in danger of undermining what could be its most considerable achievement. Too much of the public sector reform programme has been sold as a “magic bullet” to lift efficiency without regard to the potential subversion of the “publicness” of the public sector. Foundation hospitals are the classic example. All large organisations experience a tension between the need to decentralise decision-making to reap advantages of local knowledge and the need to centralise to drive change and avoid producer capture. But with foundation hospitals, the site of decision-making, instead of being a managerial issue, became an expression of distrust of the public sector and the idea of equal provision. Small wonder the issue proved so divisive.

Another part of Labour’s core constituency that has been alienated for too little purpose is the unions. The government had the chance to cajole the unions into redefining themselves as European-style social partners. But to do that risked being depicted as pro-union. So instead it undermined its supporters in the union movement by making successive legal reforms as minimal as possible. Its reward is the new trade union awkward squad and a threat to party finances.

The enthusiasts for greater European integration have also been alienated. Part of New Labour’s ambiguity towards the euro is not just timidity before Britain’s Eurosceptic press-it is genuine fear that closer integration will damage the British economy as it now works. Only if there is no attempt to build any aspect of the European economic and social model in Britain will Brown feel able to recommend the euro, forcing the government to argue that this key expression of integration will not Europeanise Britain in any material way. Meanwhile, the euro lobby has evaporated, recognising that there is no chance of a referendum in this parliament and only a small chance in the next.

At the heart of all these problems lies a decision over political economy taken back in the mid-1990s. Blair and Brown both accepted that the US business model-with minimal regulation, low tax on high incomes and profits, weak unions, and companies consecrated to maximising shareholder value-is a superior machine for wealth creation and the only option for Britain given its history and institutions. The famous third way can be boiled down to this: it is to try to combine US economic efficiency with European-style social justice-to “social democratise” the Anglo-Saxon model. Thus the workplace remains the domain of flexibility and efficiency: largely untouched management prerogatives and shareholder-value maximisation. Outside the workplace, the state offers a somewhat improved level of social justice: tax credits to supplement low wages, plus training, better education and health provision.

Adopting this approach has been politically easier and, in its own terms, a partial success. It is clearly better than nothing. But it is a far cry from any attempt to systematically rebase the operation of Britain’s economy and society in social democratic terms, which, as I argued ten years ago in The State We’re In, is what the British left project must be. That does not mean that the ways I thought this might be achieved then can apply in the different conditions now. Indeed, as I tried to argue even then, while one might admire the way, for example, German or Dutch co-determination (unions on company boards) helps to deliver high performance companies, it does not follow that such things can be imported into Britain with our very different traditions. The task is to do something cleverer: reproduce the same processes and values while respecting British history. This is hard enough at any time, it was made harder by the soaring financial markets which made the US model seem like a world beater in the late 1990s while Germany was still being dragged down by the costs of reunification.

In other words, New Labour’s original decision to go with the grain of British institutions was right. Nevertheless, it took two wrong turnings. First, it underestimated the degree to which Britain is a European country with European values-creating potentially wide support for building a British social democratic variant of the European model. And secondly, it was wrong to accept implicitly the argument that the universe of wealth creation and of social justice are independent and even mutually antagonistic. Rather, in a well-designed system they overlap and reinforce each other.

The obvious challenge to my argument is that British adhesion to the Anglo-Saxon model has worked – witness economic performance since Britain was forced out of the exchange rate mechanism in 1992. Yet this has had little to do with flexible markets and low taxes; British growth has rather been flattered by globalisation, the financial bubble, a housing boom and debt-financed consumption. British productivity still languishes despite (or because of) having the least regulated labour, product and capital markets in the EU. The truth, as Michael Porter argued in a paper for the DTI this spring, is that Britain has reaped the one-off benefits of Thatcherite deregulation and now needs to build a new economic model, creating businesses, technologies and institutions to support it. Some of the intellectual groundwork for this has been laid in a series of books: Adair Turner in Just Capital; John Kay in The Truth about Markets; Shoshana Zuboff in The Support Economy and even myself in The World We’re In. We have all argued that wealth generation requires a deeper commitment to long-term organisation building, and the nurturing and marshalling of human capital than that provided by the frenetic financial engineering that is at the heart of the American business model.

New Labour should aim for a business-building rather than financial-engineering culture in our business community. This is not anti-business; it is against one kind of business but enthusiastically for another. There are a cluster of initiatives, ranging from the reform of company law to pension fund reform, that could promote this process-emulating the European model but in a British context.This is the route both to higher productivity and a stronger social contract-with the superior welfare, greater opportunities and higher quality of life enjoyed in many other EU states.

Great companies respect the same values of fairness and pulling together that underpin great societies. Indeed, where US enterprise is successful it is usually because the precepts of the US business model are not observed. Moreover, US productivity growth (measured properly) over the 1990s has not outstripped the whole of the EU.

Aiming for a more European social and economic model in domestic policy, Britain would also become less tortured about whether its ultimate loyalty is to the US or Europe. Britain could instead assume its place unambiguously in a multilateral EU.

The problem for Blair is whether-given what he has said and done-he can lead us where we need to go. He remains a formidable and charismatic persuader. But the notion that he can extricate himself from Iraq, remake our relationship with Europe and rebuild the New Labour coalition, is implausible. There are, it is true, signs that he does want a fresh start. The appointment to key Downing Street jobs of Geoff Mulgan and Matthew Taylor-both men who want to move in this direction-is one signal. The establishment of a forum to discuss public service reform with the unions is another-as is the watering down of the foundation hospital idea.

But the politician who really believes in such a programme is Gordon Brown, the prime minister in waiting. His ability to hold the long-term goal in sight and take small, incremental steps towards achieving it is impressive. The question mark over Brown is whether he could-or wants-to move Britain decisively towards Europe, and thus solve the foreign policy conundrum. In any case, even if the Labour party would prefer him as leader, it will need a first-order crisis to bring about the transition. Yet whoever leads, the larger point stands. New Labour has served its purpose. It must now shed its skin, and emerge as a different political creature.

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