The end of New Labour illusions

"For Britain's part, our openness has enabled us to benefit from low cost goods exported from Asia, while at the same time enabling us to expand our own strength in high value added industries and become the world's financial centre leading in exporting services to all parts of the world.

Our openness, alongside all our economic and labour market reforms - matching flexibility with fairness - have helped keep inflation low, while enabling the economy and employment to grow"

Alistair Darling, Chancellor of the Exchequer, speaking at the London Business School, July 2007.

It is now evident, some 16 months after Darling's speech that every illusion that underpinned his optimism have been blown away. The credit crunch has exposed the economic weaknesses that New Labour had accumulated after 10 years of inflating the UK bubble.

Illusion one - We can rely on Asia to provide us with an endless supply of cheap goods

Over the last ten years, Britain imported huge amounts of cheap tat from Asia. However, it wasn't through the miracle of comparative advantage and specialization that allowed us to do this; it was an overvalued exchange rate rate, foreign financing and a huge current account deficit.

The age of cheap Asian goods has just come to an end. Sterling is falling back and as it does, those imports are becoming expensive.

Illusion two - the current account doesn't matter

Yes, the current account really matters. With sterling on the slide and foreign financing evaporating, that huge external deficit is like a millstone around our necks.

Since our export capacity has all but disappeared, there is only one way that deficit will narrow. The UK needs to import less, and that means falling living standards.

Illusion three - the UK as a world's financial centre

Under New Labour, London attracted huge amounts of foreign capital, which was promptly re-exported back, with a narrow caste of bankers taking a slice. This tasty little wedge generated huge financial sector bonuses, pushed up the capital's property market, and led to a boom in expensive restaurants.

To be fair, those bankers did their bit in terms of tax revenues, allowing New Labour to build up a formidable degree of welfare dependence among the poor.

The credit crunch has turned our financial sector from being an dubious asset into a dreadful liability. The UK is about to shrivel and as it declines, it will take with it London's property market, the novelle cuisine and those tax revenues that have placated the welfare classes.

Our banks are, for the most part, now insolvent. New Labour has already committed billions of taxpayers hard cash to bail them out. The Bank of England also played along, offering countless billions in cheap liquidity.

Illusion four - We have conquered inflation

The credit crunch, despite the supposed lack of loans, ushered in a 16 year high for the CPI. Despite the surge in inflation, the Bank of England now worry about a phantom called deflation, and have cut the bank rate to a sixty year low.

Illusion five - No more boom and bust

The boom has gone and the bust is here. The economy is now in recession, unemployment is rising, and the property market is in free fall. The excesses of the past need to be purged. The UK economy has finally reached its day of reckoning.

Creating some new illusions

New Labour are now looking for an escape. Moreover, Brown and Darling think they have found one. They think that they can spend their way out of trouble, and buy off their banking sector problems. They also have some accomplices at the Bank of England, who see nothing wrong with negative real interest rates. Within a year, these illusions will seem as hollow as the ones that put us in this mess in the first place.