In the post-war era, the developed world embarked on a long march towards greater equality. What came to be known as the ‘great levelling` eventually ran out of steam, and then in most rich countries went into reverse. The reversal began in the United States in the mid-1970s and then in the United Kingdom from the end of that decade. In both countries, the income gap eventually turned full circle, returning the hiked levels last seen in the 1930s. Across most of continental Europe, the reversal of the earlier trend began later. Nevertheless, by the end of the 1990s, most European nations had succumbed to greater inequality.

This historic reverse has been driven largely by a counter-revolution: the overturning of the governing philosophy of the post-war era based on a model of ‘managed capitalism’. From the 1950s, a small group of pro-market thinkers began arguing that the egalitarian advance was causing economic sclerosis. As the Austrian-American economist, Ludwig von Mises, one of the leading prophets of the superiority of markets, put it in 1955: ‘Inequality of wealth and incomes is the cause of the masses’ well being, not the cause of anybody’s distress…. Where there is a lower degree of inequality, there is necessarily a lower standard of living of the masses.’ It was a view echoed by Sir Keith Joseph, one of Mrs Thatcher’s most trusted advisers, in 1976. ‘Making the rich poorer does not make the poor richer, but it does make the state stronger … 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 reduces incentives and leads to a smaller economic pie.  The belief that too much equality was a drag on economic progress soon became a new global orthodoxy. One group of converts was Britain’s Labour leadership. As Tony Blair put it in 1997, he wanted a society that encouraged ‘levelling up’ rather than ‘levelling down’. ‘Wealth creation was now more important than wealth distribution’ declared Stephen Byers, trade secretary from December 1998. As a result the rich continued to pull away from the rest under Labour, just as they had under successive Conservative governments.  

So is this theory right? Has the rising inequality of the last thirty years brought the promised improvement in economic performance? The answer is no. A recent study – Equality and Efficiency – by two IMF economists, Andrew Berg and Jonathan Ostry, shows that the opposite is the case: ‘that when growth is looked at over the long term, the trade-off may not exist. In fact equality appears to be an important ingredient in promoting and sustaining growth.

Evidence presented in another new study, The Cost of Inequality: Three Decades of the Super-Rich and the Economy, shows that the wealth gap soared under ‘market capitalism` but without the promised pay-off of wider economic progress. On all measures of economic success bar inflation, the post-1980 era of rising inequality has, in most countries, a much poorer record on growth, productivity and unemployment than the egalitarian post-war decades.

The main outcome for the countries that embraced the post-1980 model of market capitalism most fully has been economies that are both much more polarised and much more fragile. So what does this tell us about cause and effect? Has the rise in inequality played any role in creating the present crisis? No according to the only official account of the causes of the 2008-9 crash. The report of the U.S. official Commission, published in January 2011, failed to mention ‘inequality’ once in its mammoth 662 page report.

Yet, again, the evidence suggests otherwise. The two most damaging recessions of the last century – in the 1930s and today – were both preceded by sharp rises in inequality. In the United States in the 1920s, the share of income taken by the top 1% increased from 14 to 24%. From 1990 to 2007, there was a rise from 14.3% to 22.8%.  There have been only two occasions over the last 100 years when the richest 1% of Americans have held more than a fifth of the country’s income pool. And both ended in economic disaster.

So why above this limit might excessive concentrations lead to such turmoil? The principal explanation can be found in the shifting way the fruits of economic growth have been shared. Until the mid-1970s, the gains across the developed world were largely evenly divided. Since then, they have gone increasingly to big business and a small elite of corporate executives and financiers. Between 1990 and 2007, real wages in the UK rose by a half of the increase in productivity (the rise in economic capacity). In the United States, where pay has been lagging even further behind output over the last three decades, the gap between pay and productivity has grown even more sharply.

It is a common story across most rich nations. According to a 2008 study by the International Labour Office: ‘In 51 out of the 73 countries for which data are available, the share of wages in total income declined over the past two decades.’ One of the greatest falls in recent years has been in Germany. From 2003 to 2008 the median wage fell by 9% in real terms, despite a 9% rise in national output. With no national minimum wages, one in six workers there is now paid less than 7 euros an hour.

Allowing the gains from growth to be so unevenly divided has profound implications for the way economies work. First, reducing the relative incomes of large sections of the workforce stifles demand, promoted deflation and prevents economic output being sold. Consumer societies end up without the capacity to consume. In the UK, the equivalent of around 7% of domestic output has been redistributed away from wage-earners over the last 30 years. As a result, consumers in the UK have around £100bn less in their pockets today than if the income gap had not soared. Business and the super-rich in contrast have around £100bn more. In the bigger economy of the United States, the transfer amounts to a figure of around £500bn. 

The political solution to this problem was to pump economies full of private debt. Through the deregulation of finance, consumers were encouraged to borrow more to pay for everyday spending. In the UK, levels of personal debt rose from 45% of incomes in 1981 to 157% in 2008. In the U.S., debt also rose sharply to reach a third more than national income by 2008.

It is an identical story in the 1920s. Borrowing also surged to compensate for stagnant wages. Without this the new consumer goods – from cars to radios – rolling off the mass production lines would have been left unsold. Yet swollen levels of personal debt are not a permanent solution to the problem of shrinking demand. In both the 1920s and the post-millennium years, they did not prevent recession, they just delayed it.

Secondly, high levels of inequality eventually lead to asset price bubbles. In 1920s America, a rapid process of enrichment at the top fed years of speculative activity in property and the stock market. In the build-up to 2008, the rising corporate surpluses and burgeoning personal wealth that were the counterpart to rising wage-productivity gap, led to a giant mountain of global footloose capital. Little of this ended up in productive investment. Most of it financed a surge of wealth-diverting hostile takeovers, corporate raids and leveraged buy-outs, business activity which enriched the few but did little to add to economic efficiency.  

The deepest economic crises of the last 100 years have occurred when living standards have decoupled from output. In the relatively stable post-war decades up the end of the 1960s, wages and profits moved roughly in line with output.  In the run up to the crisis of the 1970s, the wage share soared across the West creating a profits squeeze that threatened the long run sustainability of the capitalist model. 

The 1920s and the post-1980s, in contrast, brought a sustained wage-squeeze and a rising profits share that destroyed the natural process of economic equilibrium essential to stability. On both occasions, allowing the richest members of society to accumulate a larger and larger share of the cake merely brought a dangerous mix of demand deflation and asset appreciation which ended in prolonged economic turmoil.

These lessons have yet to be learnt. The same factors that led to the 2008 Crash are now killing the chance of recovery. While real wages are sinking, top personal fortunes have been growing. Capping and reversing the great national income gaps should be made a central goal of global economic policy. Until that happens and the global concentrations of income are broken up, the solutions to the present crisis will continue to prove elusive.

Stewart Lansley is a former executive producer in the BBC current affairs department. He has held academic posts including the National Institute of Economic and Social Research, The Henley Centre and the Universities of Reading and Brunel. He is the author of The Cost of Inequality: Three Decades of the Super-Rich and the Economy, Gibson Square. stewartlansley@aol.com