Why reducing inequality is an economic imperative

Employment & Income,Inclusive Economy27 Oct 2014Stewart Lansley

The shift from wages to profits has led to an increase in inequality over the last three decades.

This month, Christine Lagarde, head of the IMF, called today’s global income gap ‘staggering’. ‘If we are not careful, the ghosts of the 19th century will haunt the 21st century’, she warned.

Before the 2008 crash, the pro-market political consensus was that inequality is necessary to secure economic health. Today, that consensus is over. Few global leaders, from President Obama to Pope Francis, have not joined in the war being declared on growing inequality. Yet despite this high status condemnation, domestic income gaps have continued to widen through the global economic crisis. It is now higher amongst the world’s richest nations than before the crash.

These levels of inequality should be economic red alerts. The overwhelming evidence is that, contrary to the pre-2008 market theory, excessive levels of inequality slows growth and makes economies much more prone to crisis. The great surge in inequality from the 1980s not only blew us over the cliff in 2008, it also prolonged and deepened the downturn, and is now sowing the seeds for the next meltdown.

The surge in inequality over the last three decades has been driven by a great shift in the share of the economic cakes colonized by capital rather than labour. The sustained shift from wages to profits has been a seismic economic change described by the Geneva-based International Labour Organization as creating a ‘dangerous gap between profits and people’. It is a process that continued through the crisis. While living standards have been falling, corporate profitability has reached new heights. The world is awash with spare capital – a mix of corporate surpluses and privately-owned liquid wealth. In the UK, corporate cash piles have climbed to a record £165 billion, more than a tenth of the size of the economy. American corporations are sitting on cash reserves of $1.45 trillion, up a remarkable 50% since 2010.

According to market theory, the rising profit share should have led to an economic leap forward. Instead, shrinking wage pools have depressed demand, while the surpluses created have been spent in ways that have destabilized economies, distorting incentives and fuelling a boom in financial engineering that has enriched the few while undermining the productive economy. During the crisis – and now – the surpluses could have been used to launch a sustained investment and job-creating boom. Yet, instead, most of them lay idle – ‘dead money` according to Mark Carney, the Bank of England Governor – helping to fuel the longest recession since the 1930s.

Today, the artificially created recovery is already faltering, in large part because of this structural wage/profit imbalance. When they are being used, surpluses are not funding much needed investment that would spur growth, but to feed another round of high-risk but self-enriching financial activity. Investment banks are already promoting a new version of the lucrative collateralized debt obligation, the financial product that wreaked so much havoc in the build-up to 2008.

In the UK private equity groups now hold more cash than at the height of the leveraged buy-out boom before 2007, which culminated in the disastrous $100 billion takeover of the Dutch bank ABN Amro by the Royal Bank of Scotland, creating mass losses ultimately paid for by taxpayers. Far from strengthening the productive economy, the ‘dry powder` held by groups such as Blackstone and the Carlyle Group will trigger an artificial boom in share prices while adding millions to the bank accounts of a few hundred executives paid for by another round of staff lay-offs.

Despite the lofty speeches, the lessons of 2008 have yet to be learned. Economies built around poverty wages and huge corporate and private surpluses are unsustainable. Today’s dominant economic model, with its continued bias towards capital, seems only able to trigger growth through asset bubbles. Creating a more equal distribution of the cake is an economic imperative. Until we correct for these great imbalances, the global economy will continue to stumble from crisis to crisis.