Tackling inequality: a new role for the state

In the last thirty years, a rising share of the global economic pie has been colonised by the world’s rich. It is this concentration of income that is the real cause of the present crisis. It created the conditions for the 2008 Crash and is now driving us into an era of near-permanent slump.

Stewart Lansley
19 March 2012

The economic orthodoxy of the last 30 years holds that a stiff dose of inequality brings more efficient and faster growing economies. As the Austrian-American economist, Ludwig von Mises, one of the leading prophets of unequal market capitalism, put it in 1955: “Inequality of wealth and incomes is the cause of the masses’ well being, not the cause of anybody’s distress.” It was a view echoed by Sir Keith Joseph, one of Mrs Thatcher’s most trusted advisers, in 1976. “The pursuit of income equality will turn this country into a totalitarian slum.”

In 1975, an influential book, Equality and Efficiency: The Big Trade-Off, by the late American economist Arthur Okun, argued that too much equality leads to a smaller economic pie. Although it was a theory that originated with the new right, it came to be embraced across most of the political spectrum, including by the New Labour leadership.

The evidence is now clear – the thirty-year long experiment in making economies more unequal has ended in failure. Both the US and the UK economies – where the experiment was most strongly applied – have become much more polarised and much more prone to crisis. The two most damaging crises of the last century – the Great Depression of the 1930s and the Great Crash of 2008 – were both preceded by sharp rises in inequality. In contrast, the most prolonged period of economic success and stability – the post-war era to the mid-1970s, a period dubbed the ‘great levelling` – was one in which the proceeds of growth were evenly shared, between wages and profits and across earnings groups.

The division of what economists call ‘factor shares’ – the way the output of the economy is shared – has crucial implications for the way private enterprise economies work. As one of the founding fathers of classical economics, David Ricardo, put it in 1821, “The principal problem in Political Economy” is to determine how “the produce of the earth … is divided among … the proprietor of the land, the owner of the stock or capital necessary for its cultivation and the labourers by whose industry it is cultivated”.

Allowing wages to fall too far behind the growth of output upsets the natural mechanisms necessary to achieve economic balance. This is because de-linking earnings from output sucks demand out of the economy. Purchasing power shrinks and consumer societies lose the capacity to consume.

In the UK today, wage-earners have around £100 billion less in their pockets (roughly equivalent to the size of the nation’s health budget) than if the cake was shared as it was in the late 1970s. In the bigger economy of the United States the sum stands at £500 billion. In contrast, the winners from the process of upward redistribution – big business and the top one per cent – are sitting on growing corporate surpluses and soaring private fortunes that are sitting idle. It is this imbalance that is the real cause of the lack of recovery.

Concentrating the proceeds of growth in the hands of a small global financial elite not only brings mass deflation it also leads to asset bubbles. According to pro-inequality theory, growing corporate surpluses and burgeoning personal wealth should have unleashed a new era of rising private investment and faster growth. Instead, they led to a giant mountain of global footloose capital. Only a tiny, and falling, proportion of this sum ended up in productive investment. Money poured into takeovers, private equity, property and financial and industrial engineering became the source of many of the biggest fortunes, but mostly by extracting wealth from existing companies. 

The central lesson of the last thirty years is that an economic model that allows the richest members of society to accumulate a larger and larger share of the cake brings a dangerous mix of demand deflation, asset appreciation and a long squeeze on the productive economy that will end in prolonged economic turmoil. A widening income gap merely intensifies the business cycle, raising the height of the peaks, deepening the extent of the crash and extending the length of the trough.

For the last thirty years we have been operating a faulty economic model. Yet it has survived the second deepest recession of the last 100 years largely intact. To escape today’s era of slow and intermittent growth and prolonged instability requires the great concentrations of income and wealth to be broken up – just as they were in the 1930s. Instead, across the globe, the great wealth divide has continued to grow through the recession. 

Achieving more equal societies now means a fundamental shift in our approach to political governance. There needs to be wider recognition that we have been backing the wrong theory on the impact of inequality, with disastrous consequences. A model of capitalism that fails to share the proceeds of growth more fairly is not sustainable. The traditional case against the growing income gap, based on social justice and proportionality, needs to be extended to embrace the evidence about the damaging economic impact of more polarised economies.

Above all, the pursuit of more equal societies needs to be elevated to a primary goal of domestic and global economic policy. This would add a new dimension to the current debate about the role of the state. In the UK since the 1980s, even under the three post-1997 Labour governments, the role and impact of inequality has played at best, a marginal role in the machinery of government. Although there have been plenty of debates at the highest levels about social mobility and about tackling poverty, the wider question of the division of factor shares and the macro-economic impact of changes in the concentration of income have been largely ignored by the Treasury and the Cabinet Office.

No single economic forecasting model in the UK – including those constructed by independent institutions as well as by the Treasury and the Office for Budget Responsibility (OBR) – incorporates the impact of changes in the distribution of income on vital outcomes like private investment, living standards and overall demand in the economy. The OBR published a chart in 2011 – tucked away in an appendix –which predicts that labour’s share of output will continue to fall until 2015. But the repercussions of this trend were then ignored.

The question of ‘factor distribution’ ought to be at the centre of strategic economic thinking. It is this that determines the course of living standards and had a major impact on the stability and durability of the economy. Yet, remarkably, it slips through the net of current policy-making machinery

As one former senior adviser to number 10 under both Tony Blair and Gordon Brown, Gavin Kelly, put it on a recent Analysis programme on radio 4, “The truth is that no department in Whitehall really sees it as their job to worry about big trends in living standards facing the working population of this country. Obviously everyone has an interest in it but no-one really owns it.”
This hands-off approach needs to change. Lowering inequality, especially by achieving a better balance between wages and profits, is a goal that needs to be embraced by the government machine. This requires, first, the adding of a new set of economic indicators to those such as inflation, productivity, growth and unemployment. These should include pay ratios, the wage share, the share of income held by the top one and 0.5 per cent and the pattern of average tax rates. Information on all these trends is collected by the UK’s Office for National Statistics and by most rich countries – though sometimes with a lag. Yet the analysis of this data and their implications has mostly been left to independent researchers.

Each indicator should be given a target that is compatible with economic stability. Thus the wage share target should be set at the average of the two post-war decades – between 58 and 60 per cent – levels that brought equilibrium and sustained stability. At 53 per cent – and heading lower – it is currently well below target. Average tax rates should rise by income decile. At the moment, they are higher amongst lower income households than amongst higher income households. The share of income enjoyed by the top one per cent currently stands at 15 per cent, well above the level consistent with stability. The ratio of pay between the top and the bottom stands at well above 100:1, more than double the typical pattern of the 1950s and 1960s.

Alongside these new indicators, government should bring together the best available research on the most effective policy instruments for reaching these targets. These need to be designed to restrict the level of economic inequality to within the limits that prevent instability. They would range from tax and industrial policy to the role of collective bargaining and corporate governance. When the targets are breached – as they clearly are at the moment – then policy needs to be adjusted accordingly.

Such a strategy will no doubt lead to cries of outrage from the lobbyists employed by those likely to be most affected. There is already a concerted campaign in defence of big City pay-outs, despite them being one of the key sources of imbalance. As Michael Spencer, the chief executive of the interdealer broker, ICAP, and with a fortune worth half a billion pounds, wrote in the Independent on the 10 March, “High pay is good for Britain. In fact it is vital”.

There has been much talk but little action on the question of the falling wage and rising profit share. Ensuring a better balance between these key economic outcomes is as necessary to economic success as controlling inflation and managing the fiscal deficit. Yet, by abdicating responsibility for their levels, governments across the rich world have helped set domestic and global economies on a path of self-destruction.

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