On Saturday, several hundred Labour politicians and activists will meet under the auspices of the Fabian Society to discuss Labour's economic policy. It could not be timelier. Labour's economic policy thinking is a mess. Some of it is good, some bad, but none of it coherent. How can Labour make the good shine as we ask "what does it mean to be economically credible?"

It has to start with an honest assessment of the record in government. Those that say Labour shouldn't apologise and just move on are playing fast and loose with the British public. Labour got some things right but much wrong. The party can hide from that fact but the public won't.

Labour invested well in schools, hospitals and Sure Start. It established the minimum wage. Significant achievements. But, crucially, it broke the state by redistributing (good) but through tax credits (bad) instead of ensuring companies paid a living wage. And it did so by stealth rather than with public consent. Labour MPs cheered when Gordon Brown lowered taxes and undermined the state still further. Then, when the banks collapsed and caused the crash – because of Labour's light touch regulation, Brown brilliantly used the state to save the day. But by then it was too late; it was the last gasp of a failed model.

It was all so inefficient and wasteful – not just PFI and the mindless national IT schemes but using the state to mop up the mess created by free markets; dealing with endless symptoms of inequality while never addressing the causes. Labour was always running up the down escalator, letting those at the top do what they wanted while using the state to clear up behind them and never demanding a penny.

Labour must accept that economic efficiency and social justice do not go hand in hand. Indeed, capitalism without a strong state will destroy itself, as we are now seeing.

So the political challenge is not just developing the right political economy but developing a state that can credibly regulate markets to meet society's needs and save capitalism from itself. It is a productive and entrepreneurial state along the lines outlined in Plan B.

So where does that leave us? Confused, that's where. The good news is Ed Milband's brave attempt to define a new capitalism. He is on entirely the right ground. Whether it is crony, feral or predatory the people know when capitalism has gone bad. The problem is that Miliband needs the courage of his convictions. He must set out the parameters of what constitutes a better capitalism. Then, when Cameron inevitably swaggers into the territory he can be tested on it. And when initiatives like the High Pay Commission come out with credible answers, he will be able to comment immediately, rather than let the government successfully steal the show. Ed, you are right on all this. Do it.

But Miliband is in danger of getting it wrong on the fiscal deficit. If cuts are bad then they are bad. Cutting by 80% is better than 100% but it still makes things worse. As Stewart Lansley's seminal book the Cost of Inequality has set out – we are suffering from a historic demand deficit. The cuts aren't working.

Labour is in the wrong place, too, on a financial transaction tax. It's not surprising because it's the same place as the coalition – waiting for a global deal that will never come unless Britain and Europe take the lead. On the banking reform, too, Labour appears to be backing the government – which expects hospitals to reorganise in months but let the banks take as long as they like. Labour seems to have nothing to say about the eurozone crisis or Europe in general and nothing to say either about building a new economy in an era of runaway climate change. None of this is credible.

Credibility will come from saying: we understand capitalism and we know when and how it needs to be regulated. Credibility comes from saying: we know and understand the proper role of the state; making it work efficiently through co-production and moving to stop social and economic crises happening in the first place. Credibility comes from saying: we shouldn't cut until the economy is growing again – and then we might not have to. On this the shadow chancellor has been proved right, but why did he tell the nation only last September that "I would always rather reduce any tax if you possibly can". This is not a credible place to be.

The vast bulk of Labour's millions of lost voters spotted the credibility gap years ago. As Labour praised the city, deregulated labour markets, piled up personal debt and hoped that house prices would go on rising for ever after claiming to have ended boom and bust, it lost the people. They are with the Tories not because they are right but because at least they are consistent. The public are right: Labour messed up. That record now needs to be untangled so that Labour is free to move on as its values demand and the nation needs.

Otherwise it will dance to the tune of the markets, the city and the right – and we know what happens then.

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