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To achieve recovery we need a pro-active government committed to tackling inequality

This article was first posted on Shifting Grounds on 7 December 2012.

Over the last year, inequality has been racing up the political agenda. ‘Inequality', as President Obama has put it, ‘is the defining issue of our time`. Yet for all the talk, the income gap - apart from dipping slightly in 2009 - has been rising through the crisis.

The root cause of the growing gap has been the way the gains from growth have become increasingly colonised by big business and a small financial elite over the last three decades. Wages have been squeezed in favour of profits and living standards for most have fallen well behind GDP growth.

Yet more and more opinion is now coming to accept that economic stability and durability depends on linking living standards more closely to growth. This decoupling is also a key explanation for the current paralysis. Inequality has sucked consumer demand out of the economy and has not been replaced by a boost to exports or investment.

To lessen future instability, governments need to move from a passive to a much more pro-active role by making the distribution of the cake a central element of strategic economic planning.

In the UK, the ‘distribution question` has barely featured in the policy-making machinery. Although there were plenty of internal debates about social mobility and tackling poverty under Labour from 1997, the wider issue of the macro-economic implications of inequality were ignored by the Treasury to the Cabinet Office. No single economic forecasting model in the UK incorporates the impact of changes in the concentration of income on vital outcomes like private investment, living standards and overall demand.

When independent researchers first showed how living standards have been little better than stagnant since 2003, the findings came as a complete surprise to government. When shown the evidence by the TUC in late 2008, advisers at number ten were dismissive. One senior government economist went so far as to deny the figures were true.

One of the dominant pre-occupations of the development of economic thinking through and beyond the nineteenth century was why labour ended up with such a small share of the cake. It is time to return to this pre-occupation. Until recently, the government machine was only interested in what was happening to changes in overall output - GDP – and not how the fruits of that growth were being shared. That has now changed with the report of the Office for National Statistics, Measuring National Well-Being. Recognition is an important step, but bringing growth and living standards into line requires a new approach to economic management.

First, through the addition of a new set of economic indicators and targets beyond growth, inflation and unemployment. These should include the wage share, pay ratios and the share of income held by the top. Each indicator should be given a target compatible with economic stability. Thus the wage share target could be set at the average of the two post-war decades (around 60 per cent)—a level that brought equilibrium at a high level of employment and growth along with sustained stability. It is currently well below this target and according to the Office for Budget Responsibility, is heading lower. The ratio of pay between the very top and the middle stands at well above 100:1— close to triple the typical pattern of the 1950s and 1960s. The top 1 per cent holds more than 15 per cent of national income— a near threefold increase over the 1970s, and well above the level consistent with stability.

Secondly, government should bring together the best available research on the most effective policy instruments - from tax and industrial policy to the role of collective bargaining and corporate governance - for meeting these targets. When the targets are breached—as all of them are at the moment—then policy needs to be adjusted accordingly. Larry Summers, former adviser to President Obama and Treasury secretary under Clinton, has made a similar proposal in respect of fiscal sustainability and credit creation. He has called for the introduction of ‘contingent commitments’ with the Federal Reserve making assurances about action when thresholds are reached in areas like unemployment and inflation.

The level of inequality in society is too important to be left to the forces of the market and to the muscle-power of the few. But unless government takes a more decisive role, accepting its obligation to promote faster growth and its more even distribution, the gap between the runaway rich and the rest will continue to soar.