When Prime Minister James Callaghan declared to an incredulous Labour party in 1976 ‘you can’t spend your way out of a recession’, he was widely believed to be driving the final nail into the coffin of Keynesianism.

Thirty years on and a self-professed New Labour government has not simply part-nationalised a number of high street banks, it’s now declaring that public spending is an essential weapon in its battle to fend off the recession into which Britain has slipped.

For some on the left, this apparently strange turn of events signals the death knell of what they term New Labour’s ‘uncritical embrace of the market’. But this would be to misread the essence of both the government’s current approach and the principles which underlay the arguments advanced by New Labour’s original proponents.

One of the central pillars of the New Labour case was the need to unravel means from ends. ‘What matters is what works,’ Tony Blair’s much-derided formulation of this premise, was less a call for the abandonment of principle, than an appeal to reject the outdated policy orthodoxies to which some in the party still clung. Values should be enduring; the policies to attain them, however, should always reflect changing times. And so it should be in economics – where stability, shared prosperity, and high-quality public services must always be the goals of a centre-left government – no less than in any other field of government policy.

That’s why Peter Mandelson, in his interview with Progress this month, is right to remind us that, ‘the New Labour way is to say markets wherever possible, government intervention wherever necessary.’ In other words, the regulatory boundaries between state and market must be subject to adjustment and change, with transparency, competition and the protection of consumers remaining foremost among the government’s aims.

Similarly, the government’s reported intention to bring forward planned capital expenditure in order to help the economy in general – and critical sectors like the construction industry, in particular – are both practical and prudent.

It remains quite a stretch, however, to see this approach as akin to the high-spending, ‘let inflation rip’ economics of the 1970s, against which Callaghan was rightly arguing. And responsible attempts to both assist the economy in the way Alistair Darling is proposing and deal with regulatory failures in the finance industry should not be the prelude to a wider, old left assault on the market economy.

While the prime minister’s internationally acclaimed leadership appears likely to help Britain through the immediate crisis, four challenges now lay ahead.

First, Gordon Brown needs to show equally sure-footed and adept leadership as the recession begins to bite. Empathy, a quality which does not always appear to come naturally to him, will have to be as much in evidence as mastery of the economic detail when the prime minister comes to explain to the country how the government will guide the country through the rough times ahead.

Second, Labour must expose the weaknesses in the Tory approach. Had David Cameron been braver in standing up to the ideologues in his own party, he might have begun to develop a principled yet conservative view of the role of the state: making the case that there was not only such a thing as society, but also a legitimate place for government within it. His caution may now cost him dearly: the intellectual architecture of the Cameron project appears too weak to support the economic challenges now being placed upon it. To take just one example, Cameron’s belief that as society ‘rolled forward’ charities and social enterprises would fill the void left by a retreating state will be severely tested – and very likely found wanting – in the economic downturn.

Third, while the Conservatives may have opted out of this debate, Labour should not underestimate Cameron’s potential for agility. Before the Tories attempt to appropriate this terrain, Labour must unequivocally occupy the new centre ground now opening up. This is the territory which explicitly makes the case for government – and new forms of governance at the global as well as the national level – but, as we have repeatedly argued, also embarks upon a radical devolution of power to individual citizens and local communities.

Finally, ‘it’s the economy, stupid’ may well now be back in vogue, but Labour still appears to lack a clear sense of where, if given the chance, it would take the country in the next decade. What are its aspirations for Britain’s public services in 2015? How can social mobility become a reality for the generation of working-class children entering primary school this autumn? Does Labour really believe that current levels of income tax for low and middle-income earners best encourage work, saving and independence? These questions, and many others, remain largely unanswered.

Still, a government which just weeks ago appeared directionless and listless has found new purpose. But it must not rest on this alone to win re-election in 2010. Labour is, at last, back in the game, but it still has much lost ground to catch up.