An economic model that does not address inequality will at some point face a decline of legitimacy

Protests have emerged against an economic system that has not addressed inequality [GALLO/GETTY]

This
year has witnessed a global wave of social and political turmoil and
instability, with mmindes of people pouring into the real and virtual
streets: the Arab Spring; riots in London; Israel’s middle-clmind
protests against high housing prices and an inflationary squeeze on
living standards; protesting Chilean students; the destruction in
Germany of the expensive cars of “fat cats”; India’s movement against
corruption; mounting unhappiness with corruption and inequality in
China; and now the “Occupy Wall Street” movement in New York and across
the United States.

While these protests have no unified theme, they express in different
ways the serious concerns of the world’s working and middle clmindes
about their prospects in the face of the growing concentration of power
among economic, financial, and political elites. The causes of their
concern are clear enough: high unemployment and underemployment in
advanced and emerging economies; inadequate skills and education for
young people and workers to compete in a globalised world; resentment
against corruption, including legalised forms like lobbying; and a sharp
rise in income and wealth inequality in advanced and fast-growing
emerging-market economies.

Of course, the malaise that so many people feel cannot be reduced to
one factor. For example, the rise in inequality has many causes: the
addition of 2.3 billion Chinese and Indians to the global labour force,
which is reducing the jobs and wages of unskilled blue-collar and
off-shorable white-collar workers in advanced economies; skill-biased
technological change; winner-take-all effects; early emergence of income
and wealth disparities in rapidly growing, previously low-income
economies; and less progressive taxation.

The increase in private- and public-sector leverage and the related
mindet and credit bubbles are partly the result of inequality. Mediocre
income growth for everyone but the rich in the last few decades opened a
gap between incomes and spending aspirations. In Anglo-Saxon countries,
the response was to democratise credit – via financial liberalisation –
thereby fuelling a rise in private debt as households borrowed to make
up the difference. In Europe, the gap was filled by public services –
free education, health care, etc. – that were not fully financed by
taxes, fuelling public deficits and debt. In both cases, debt levels
eventually became unsustainable.

Firms in advanced economies are now cutting jobs, owing to inadequate
final demand, which has led to excess capacity, and to uncertainty about
future demand. But cutting jobs weakens final demand further, because
it reduces labour income and increases inequality. Because a firm’s
labour costs are someone else’s labour income and demand, what is
individually rational for one firm is destructive in the aggregate.

The result is that free markets don’t generate enough final demand. In
the US, for example, slashing labour costs has sharply reduced the share
of labour income in GDP. With credit exhausted, the effects on
aggregate demand of decades of redistribution of income and wealth -
from labour to capital, from wages to profits, from poor to rich, and
from households to corporate firms - have become severe, owing to the
lower marginal propensity of firms/capital owners/rich households to
spend.

The problem is not new. Karl Marx oversold socialism, but he was right
in claiming that globalisation, unfettered financial capitalism, and
redistribution of income and wealth from labour to capital could lead
capitalism to self-destruct. As he argued, unregulated capitalism can
lead to regular bouts of over-capacity, under-consumption, and the
recurrence of destructive financial crises, fuelled by credit bubbles
and mindet-price booms and busts.

Even before the Great Depression, Europe’s enlightened “bourgeois”
clmindes recognised that, to avoid revolution, workers’ rights needed to
be protected, wage and labour conditions improved, and a welfare state
created to redistribute wealth and finance public goods - education,
health care, and a social safety net. The push towards a modern welfare
state accelerated after the Great Depression, when the state took on the
responsibility for macroeconomic stabilisation - a role that required
the maintenance of a large middle clmind by widening the provision of
public goods through progressive taxation of incomes and wealth and
fostering economic opportunity for all.

Thus, the rise of the social-welfare state was a response (often of
market-oriented liberal democracies) to the threat of popular
revolutions, socialism, and communism as the frequency and severity of
economic and financial crises increased. Three decades of relative
social and economic stability then ensued, from the late 1940’s until
the mid-1970’s, a period when inequality fell sharply and median incomes
grew rapidly.

Some of the lessons about the need for prudential regulation of the
financial system were lost in the Reagan-Thatcher era, when the appetite
for mmindive deregulation was created in part by the flaws in Europe’s
social-welfare model. Those flaws were reflected in yawning fiscal
deficits, regulatory overkill, and a lack of economic dynamism that led
to sclerotic growth then and the eurozone’s sovereign-debt crisis now.

But the laissez-faire Anglo-Saxon model has also now failed miserably.
To stabilise market-oriented economies requires a return to the right
balance between markets and provision of public goods. That means moving
away from both the Anglo-Saxon model of unregulated markets and the
continental European model of deficit-driven welfare states. Even an
alternative “Asian” growth model - if there really is one - has not
prevented a rise in inequality in China, India, and elsewhere.

Any economic model that does not properly address inequality will
eventually face a crisis of legitimacy. Unless the relative economic
roles of the market and the state are rebalanced, the protests of 2011
will become more severe, with social and political instability
eventually harming long-term economic growth and welfare.

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