Click on Layout and select Page Elements
Click on Edit in the Blog Posts box
Check the Labels box
To add a list of labels in the side bar click on Layout again and then click on Add a Gadget
Scroll down the list of Add a Gadget options and select Labels. Click Save
The Labels list will not appear in the side bar until you add a label for a post
Voila; you now have labels
You can rearrange the placement of the Label list by going to Layout and holding the left mouse button down on the Labels element and dragging it to the desired position. Then click Save on the right side of the Add and Arrange Page Elements screen.
Here's the finished view
