For Ralph Miliband governments could never tame capitalism. New Labour thought otherwise – and then came the financial crisis. But what will David or Ed do if they gain the leadership? By John Gray

Viewed from one angle Ralph Miliband was a theorist of revolution who failed to notice the radical transformations going on around him. A lifelong Marxist, he never doubted that the future would be shaped by the struggle against capitalism. In fact it was capitalism that proved to be the revolutionary force in the late 20th century, consigning socialism to the memory hole. By the time Miliband died in May 1994, the Soviet system had been replaced by a type of resource-based authoritarian capitalism, while China's Communist party was overseeing the development of an unbridled market of a kind that Milton Friedman could only dream about.

In Britain in the 1980s Miliband managed to convince himself that Labour, which he had always bitterly attacked, might, under the influence of Tony Benn, turn into a genuinely socialist party. In fact Labour split, which more than any other single factor enabled the continuing dominance of Thatcher. Probably only the battles fought by Neil Kinnock prevented Labour disintegrating altogether. When John Smith became leader, the party began the "prawn cocktail offensive", a rapprochement with the financial sector pursued through private lunches with leading City figures, which formed the prelude to New Labour. Only weeks after Smith died (in the same month as Miliband) the party would start burying any trace of its socialist past.

When he gave the Bennite wing his intellectual support, Miliband was colluding in the politics of make-believe. Yet in one vital respect this intractably oppositional Jewish refugee from nazism had a firmer grip on reality than the social democrats who eventually prevailed in Labour's internecine conflicts, and when he ridiculed Anthony Crosland's vision of a domesticated and pacified capitalism, he left the party with a dilemma it has not been able to resolve. Like Marx, Miliband understood that states and governments are never autonomous actors; their options are shaped, and often foreclosed, by the distribution of power and resources. This was the central theme of Miliband's The State in Capitalist Society (1969), a penetrating assault on social-democratic thinking in which he developed and extended the argument against revisionism of his earlier Parliamentary Socialism: A Study of the Politics of Labour (1961).

In The Future of Socialism (1956), Crosland had argued that Labour must distinguish between means and ends (a theme pursued later by Blair). Capitalism had changed fundamentally, and rather than opposing it Labour should use the market to advance socialist values. Properly managed to ensure steady economic growth, free markets could be used to promote an egalitarian society in which everyone could live the good life. Against this rosy vision, Miliband urged – rightly, I've always thought – that the world had not changed as much as Crosland and his fellow-revisionists imagined. Capitalism remained an unruly beast, and the idea that governments had learnt how to tame it was just an illusion.

The oil shocks of the 70s were an early warning of the fragility of the postwar order. The shocks were not fatal, and capitalism survived the crisis (as it will survive the present crisis, in one form or another). But it was already becoming apparent that while governments could withstand upheavals in the global economy, the state was not the directing agency social democrats imagined it to be. As Miliband saw it, the state was a servant of these forces rather than their potential master. Of course he exaggerated. The interests of capitalists are often at odds, and in any case politics is driven by far more than class conflict. Even so, Miliband's view that the state is constrained, reactive and hemmed in by market forces has become increasingly plausible with the passage of time. But if this is so, what role can there be for a party that aims to make capitalism a force for the collective good? Can a future Labour government succeed where past governments have failed and harness capitalism to a vision of social improvement? Or should Labour accept that it is capitalism itself that must be changed?

These are precisely the questions that face Miliband's sons as they contend for the Labour leadership. The clash between the two has an undeniable drama, and it is not just a matter of sibling rivalry. It occurs at a time when the world economy is in a crisis the founders of New Labour believed to be impossible. Lacking the Marxian insight that capitalism is inherently volatile and constantly mutating, they never doubted that the deregulated finance-capitalism that developed in the US towards the end of the past century would last. The left had to overcome its suspicion of the free market, and accept that only by exploiting its productivity could government improve society: social democracy and neo-liberal economics were actually complementary.

Just like Crosland, though without his Keynesian grasp of the dangers of recurring boom and bust, New Labour believed capitalism had been tamed. But as Ralph Miliband suspected and events have confirmed, the anarchic energy of the free market is not so easily controlled. The fall of communism was celebrated as a triumph of capitalism, which now became practically world-wide; but the effect was to make capitalism more unstable, as disturbances in one part of the system were rapidly transmitted to all the rest. The fragmented world of the cold war was more resilient to shocks, and also more hospitable to social democracy, than the world that ensued. Governments found that few of the levers they used to control the economy worked as they had before. New Labour did not want to control the market. A feature of the understanding it reached with the City was that financial markets would continue to be deregulated. In part this was accepted as the price for power, but it also reflected New Labour's Fukuyama-like faith that market capitalism was the final stage of economic development; the future lay with the self-regulating market.

As could be foreseen, things turned out rather differently. With regulatory controls relaxed or scrapped the financial institutions whose support Labour had wooed became predatory, raking in vast profits from strategies whose risks they did not understand. Inevitably this hubris led to their downfall, and the financial system imploded. The market millennium lasted hardly more than a decade, leaving a legacy of unsustainable debt.

The happy conjunction of neo-liberal economics with social democracy on which New Labour was founded is now history. This is the truth evaded in Tony Blair's autohagiography. If New Labour is obsolete it is not because of the personal defects of Gordon Brown, Blair's delusional moral certainty and incessant war-mongering or even the dysfunctional relationship between the two leaders. It is because American finance-capitalism, the model for virtually everything that New Labour ever did, has blown itself up.

The problem with the debate between the Milibands is not that it risks turning into a public family feud. It is that neither of the two contenders has come to terms with the bankruptcy of the New Labour project in which each of them was involved. Neither has acknowledged, or perhaps fully understood, the implications of the financial crisis for a future Labour government. It can only mean an erosion of the very foundations of Britain's social democratic inheritance. Yet in different ways, each of the Miliband brothers still sees government as capable of controlling market forces – the illusion their father presciently exposed.

In his Keir Hardie lecture in July, David Miliband spoke eloquently of moving away from state paternalism and reviving Labour traditions of mutualism. The state can no longer be the centre of knowledge and initiative – its function is rather that of empowering society. Top-down Fabian control must be replaced by open democratic relationships. No doubt these are desirable goals, if very much in the spirit of the prevailing conventional wisdom and perhaps not so different from Cameron's fluffy "big society". The larger difficulty is that Miliband is harking back to Crosland (whom he recently cited as his political hero) at a time when Crosland's thinking is no longer applicable.

Crosland's vision was based above all on economic growth – steady, continuing and robust. Following Keynes, he believed that wise economic management could create a society of abundance. But the effect of the financial crisis has been to curtail growth, at least in developed economies. Even if the economy recovers, governments will not have the largesse he assumed would be available. Bailing out the banks has passed the burden of debt on to the state, and no British government can expect to avoid large-scale cut-backs in borrowing and spending. Instead of the market generating wealth that could be used by governments for collective purposes, the resources of government have been pre-empted for the repayment of debts incurred by the market's excesses. Against this background, the post-paternalist state is likely to mean higher unemployment and cash-starved public services.

Unlike his brother, Ed Miliband has chosen to define his candidacy explicitly in terms of New Labour's failings and argues forcefully for the need to remodel capitalism. "Britain's big question of the next decade," he has written, "is whether we head towards an increasingly US-style capitalism – more unequal, more brutish, more unjust – or whether we can build a different model, a capitalism that works for people and not the other way around". Once again these are noble aspirations but far removed from reality. Globalisation is an idea that has been greatly over-hyped, yet governments' freedom of action has without question been reduced as capital has become more mobile. Even the US may soon find it difficult to fund its ballooning federal debt. But if American capitalism is entering a crisis zone, Britain will not have the luxury of forging a new economic model; it will have trouble just staying afloat. Ralph Miliband's pessimistic assessment of the future of social democracy could well be vindicated.

If one of the Miliband brothers wins the Labour leadership and becomes prime minister he will confront in an acute form the constraints on the power of the state his father astutely identified. Rather than controlling or reshaping capitalism, a Miliband government would find itself struggling to preserve Britain's social democratic inheritance in the face of capitalism's renewed disorder. Ralph Miliband seems never to have lost the Marxist faith that history would eventually open the way to a truly socialist society. He would surely have appreciated the curious dialectic through which it has fallen to his sons to defend the social democracy he so fiercely attacked.