LECTURE

HOW TO BUILD THE ECONOMY OF THE FUTURE

Joint Joseph Rowntree Foundation/University of York Annual Lecture

Since the onset of the financial crisis, which seems to defy all attempts to bring it to an end, a growing number of people have begun to question the fundamentals of an economic system that has benefited only the rich minority. It would be a mistake to conclude that economic growth itself is the problem, however. The trends that have brought about the present instability and inequality are technological and political, as well as financial, and have deep roots. To address them will require substantial institutional reform, on a scale not seen since Victorian times.

Diane Coyle

27 FEBRUARY 2012

Introduction
Both logic and economics tell us that the unsustainable will not be sustained. If we are trying to peer into the future, and to shape it, there is great uncertainty, but that concerns how things will change rather than whether they will change. The word sustainability has become shorthand for concern about the natural environment, but its broader meaning is the ability of the next generation to achieve a standard of living at least as good as our own and to look after the next generation similarly.1 Sustainability broadly understood is about both the stewardship of resources of all kinds, natural and other assets, and the equipping of future generations with the capabilities needed to use those assets well. The financial and economic crisis under way since 2008 makes it plain that the Western industrialised economies have not done a good job of fulfilling their responsibilities to future generations. Apart from the green issues, it is evident that the financial system had become literally unsustainable: it could not continue as it was, and did not. The financial issues are linked to the fiscal ones, the sustainability of existing patterns of government spending and revenues. And this in turn is related to social questions work and unemployment, incomes and inequality, the shares different kinds of people contribute to and derive from national economic output. In this lecture I want to reflect on the nexus of economic and social characteristics of the UK and other similar countries (building on my book The Economics of Enough2), and specifically on what is unsustainable and what kind of future society we might in that case hope to shape. I will focus on the question of inequality as the lens for looking at the welfare of future generations. Inequality is both an increasingly prominent focus of political debate and the outcome of several structural economic trends. What has caused the increase in inequality? What are its likely consequences for economic growth, living standards and political outcomes? What should and could be done to reverse the trend towards increased inequality? If we conclude that the present degree of inequality is unsustainable and is bound to lead to change, what should we be doing to ensure that what we are building is the best possible future? I will suggest that we should learn from the Victorian and Edwardian reformers, people like Joseph Rowntree, whose response to the unsustainable injustices of their own time came in the form of extraordinarily creative social innovation. They, like us, had experienced major technological changes that profoundly altered the structure of the economy. Social institutions took decades to respond. We have had a technological revolution in the past generation, but not yet the institutional adjustment to it. I will start with a description of the startling increase in inequality within the advanced economies in recent years, then consider its possible causes and its likely effects. I will discuss some practical immediate steps that could be taken to address aspects of inequality and will conclude with a discussion of the need for wide-ranging institutional innovation.

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How bad are things for the 99 per cent?

These are dire economic times. The Western economies are not growing, and have not grown since 2008, when the gravity of the financial crisis became apparent with the collapse of Lehman Brothers. By the time GDP (gross domestic product) regains its 2008 level, the recession can we now call it a depression? will have been far longer and deeper than in the first half of the 1930s. Without growth for the past four years and counting, the unemployment rate in the UK has reached 8.3 per cent of the economically active population, the highest rate since 1994. It has been especially hard for young people looking for their first job. About a fifth of those under 24 are unemployed, others will have taken jobs for which they are overqualified. A bad start to working life will scar their whole lifetime satisfaction and earning capacity. The combination of population growth, longer working lives and productivity growth means that GDP growth needs to exceed at least 2 per cent if unemployment is not to continue rising. There is no present prospect of 2 per cent-plus growth. Without any economic growth at all for years, unemployment, poverty and social problems are becoming more acute. There is, of course, a heated debate between political parties and between different groups of macroeconomists about the scope to ameliorate this situation by either reversing public spending cuts or at least postponing them. Standard demand management analysis says that the short-term effect of fiscal tightening is bound to be contractionary; the heat in the debate is all about whether the long-term costs of relaxing efforts to cut the deficit now would outweigh the short-term benefits, and indeed about how long the short term lasts. The UKs fiscal context certainly doesnt offer much scope for using public spending or tax cuts to boost the economy. Although the net national debt is currently only about 75 per cent of a years GDP, less than many other OECD (Organisation for Economic Cooperation and Development) economies, the annual deficit was an uncomfortably high 8 per cent or so of GDP in 2011, and the structural government deficit also one of the biggest among the rich countries. Whats more, as long as the banking system remains so fragile, all of the retail deposits in the UK are in effect contingent government debt; it is unthinkable that any government would let a bank collapse wipe out the savings of ordinary depositors. That is potentially up to another 75 per cent of GDP. The government also has large liabilities hidden from everyday view, and not only all that due to off-balance-sheet spending such as the PFI (private finance initiative) schemes. Todays taxes will not support the level of government spending on pensions and healthcare that the current system will require as the population ages. The modern welfare state was designed for a young and growing population; we have an old and relatively stable population. By 2014, the UK will have another 1.4 million over-65s. This is an implied debt increasingly acknowledged in the political debate, but not officially measured; recent estimates from NIESR (National Institute of Economic and Social Research) suggest that tax revenues will need to be 67 per cent higher as a share of GDP by then to pay for these promised services at their current level and quality.3 (The UK is lucky in this regard. The demographic trends and implied government debts are far worse in many other OECD countries.) Still, whatever the scope for adjusting public spending cuts in the short term, the fiscal position does not leave room for throwing a lot of government spending at social problems. But the problems of poverty or social exclusion appear to be getting worse and also more salient in the political arena. In the quite recent past, the degree of inequality in particular (in the rich countries, as opposed to global inequality) has generated a lot of comment. There is good reason for this. Inequality has returned to 1920s levels in the US and 1940s levels in the UK, and is seemingly heading inexorably for the 1890s levels. It has increased in most of the OECD countries, and several others are just as unequal as the UK Italy, New Zealand and Poland, for example. The degree of inequality in these societies is comparable to countries we would not normally regard as our peers in any way, such as Albania, Mozambique and Kyrgyzstan.

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However, the story of inequality is one that long pre-dates the financial and economic crisis. A recent OECD study4 traces the trend to the early 1980s and shows that all but a handful of member countries have experienced a significant increase in income inequality (see Figure 1).

Figure 1. Income inequality increased in most, but not all OECD countries Gini coefficients of income inequality, mid-1980s and late 2000s

Source: OECD Database on Household Income Distribution and Poverty

The American figures, the most extreme, attract the most attention. The Occupy Wall Street movement chose We are the 99 per cent as its slogan because the top 1 per cent of the American population earns over a fifth of national income (and has almost two-fifths of the wealth), compared with their share of about a tenth of the national income pie in 1980. The level of inequality in the US has returned to 1920s or 1930s levels, with a similar but less extreme pattern also in some other countries for which such long runs of data are available. In the UK, the top 1 per cent earned about 13 per cent of total incomes in 2008.5 One of the striking aspects of the pattern of change is that much of the increase is attributable to extraordinary increases in incomes at the upper end of the distribution not just in the top 10 per cent but the top 1 per cent and 0.1 per cent which has been combined with broadly stagnant or even (in the US) declining real incomes for people in the middle deciles of the distribution. Another way of expressing the same phenomenon is that nobody outside the top income decile, particularly the middle classes, has shared in the increase in national income that has occurred since 1980. In the US, the share of national income going to all but the richest fifth of the population has actually declined substantially since 1980; the real incomes of most households have stagnated. In the UK, real median wages almost tracked GDP growth from 1980 to 2000 but the share of national income going to low and middle earners has declined since then.

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Figure 2. US: Real income growth, by quintile Percentage Change in Real After-Tax Income, 1979-2007

Source: Congressional Budget Office

Figure 3. UK: Share of income groups in GDP The share of GDP going to low-to-middle earners has steadily declined

Source: The Resolution Foundation

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The seven causes of increased inequality

Why has this been happening? Why has it happened in most rich countries but been most pronounced in the US and UK? It was around 1980 that the long post-war period of either stability in the income distribution or slow equalisation of incomes went into reverse. There is no consensus among economists about the most important cause. This is because there are several possible explanations, and it is hard to disentangle them.

1. Skill-biased technical change

The information and communication technology revolution under way since the early 1980s has changed the skills required in the workforce. As organisations have introduced the technologies, they have automated many routine jobs in both manufacturing and services. Examples range from assembly lines where robots have replaced most human workers to banks back offices. The demand for labour has shifted towards jobs requiring low skills that are hard to automate, for example care assistants and cleaners, or jobs for people with high levels of cognitive skills to work with computers, doing the things the machines cant do.6 The evidence for this skill bias can be found in changes in the pattern of relative wages, with a substantial increase in the ratio of graduate to non-graduate earnings, and also in the fact that job growth (from 1979 onwards) occurred in the bottom and top two deciles of the income distribution.7 This phenomenon has been repeated around the developed world, not just in the UK.8

2. Winner-takes-all dynamics
A second technology-related explanation for increased inequality is the economics of superstars9, also described as winner-takes-all dynamics.10 There have always been some professions in which a small advantage of talent translates into a large advantage in terms of income because consumers arent sure what they might get and so prefer to pay for something that is familiar. The classic example is a movie star. The larger the scope of the market, the bigger the income advantage so people who star in Bollywood or Hollywood movies will earn more than those starring in French or Kenyan ones. The new technologies are both extending the scope of the market in many cases, but more importantly introducing winner-takes-all dynamics to many new markets such as legal services, medicine or even economic punditry. The evidence for the spread of the winner-takes-all phenomenon is the fractal pattern of the distribution of earnings: not only are high earners pulling away from the rest of the population in the overall distribution of income, but the same is true within the top 10 per cent of earners, and the top 1 per cent of earners. Back in 1994 Paul Krugman wrote:

[W]hat is certainly true is that the growth of inequality in the United States has a striking fractal quality: The pattern of widening gaps between education levels and professions is mirrored in the pattern of increased inequality of earnings within professions. Lawyers make much more in comparison with janitors than they did 15 years ago; but the best-paid lawyers also make much more in comparison with the average lawyer.11

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3. Globalisation
In the economics literature, the effects of technology and the effects of trade have sometimes been portrayed as mutually exclusive explanations for the loss of middle-income jobs and increased inequality. But not only might both explanations be correct, globalisation is also itself the product of the ICT (information and computing technology) revolutions. The growth in trade and cross-border investment since the early 1980s, and the increased international specialisation of production and outsourcing of labour-intensive activities to emerging economies such as China, could not have taken place without computer-based production and logistics and cheap communications. The result has been a large increase in the global supply of workers with low or routine skills, competing with those groups of workers in the advanced economies. The pattern of rising real wages in China and real wage stagnation in tradable sectors of manufacturing in the US and UK is consistent with this explanation.

4. Structural economic change

A further change in the structure of the advanced economies concerns the increasing share of employment and output accounted for by activities in which productivity gains are intrinsically very limited. The canonical example is the performing arts. In a classic paper William Baumol pointed out that there is a limit to the rate at which the productivity of a string quartet can grow, because in the end it will always require four people to play at the composers chosen speed. However, musicians will still need to earn incomes not completely adrift from the level prevailing in high-productivity growth sectors of the economy, even if at the lower end of the income scale. As a result, concert prices will rise in relative terms over time.12 Baumol later extended the example to health care, where productivity growth is slow and sick people require a minimum amount of personal care from others. The share of total expenditure going on health care (where staff costs form the biggest proportion of the budget notwithstanding rapid increases in the costs of drugs and technologies) has consequently been rising. Other person-to-person services have the same characteristics. With the shift in GDP towards services, the scope of similar low-productivity growth activities has increased. Perhaps one day technological innovation will deliver bigger productivity increases in health care, social care or education, but until that happens it is hard to see the relative pay gap for workers in these sectors narrowing especially when so many of them are in the public sector. Increasing their relative incomes requires higher payments, through the tax system or otherwise, for these services.

5. Political change
There are large differences in the level of inequality in different OECD economies, and in the speed at which inequality has been increasing in the past 20 to 30 years, although the broad patterns are consistent between countries. This suggests that political choices and institutional variation make an important difference to inequality, as one would expect. The US is at one extreme, reflecting a series of political decisions since the early 1980s to cut taxes on high earners, and also the lower protection provided by the welfare state, compared with many European countries. Even so, the philosophy of individual enterprise first given political reality by President Reagan and Mrs Thatcher has become widespread, and very high incomes in some fields have become more advantageous in terms of tax treatment, and more socially acceptable, in many countries. In the 1960s and 1970s the social norm was for business executives to be rather similar to their workforces, often climbing from the ranks inside one company. In more recent decades, prevailing social norms have made large differences in income acceptable.13 The increase in the ratio of executive to median pay reflects this change. In the UK, CEOs pay rose by 203 per cent between 2000 and 2009, compared with a 45 per cent increase for other workers.14

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6. Rent-seeking behaviour
Whatever the philosophical or social origins of the large increases in top corporate incomes, there can be little doubt that extremely high pay has become embedded through market power and institutionalised pay structures. Merger waves in leading sectors of the economy, notably banking, have reduced market discipline on prices and service quality and increased the profit share of GDP in the US, to the highest proportion in half a century, but a common pattern in most OECD countries.15 The financial sector stands out for high pay and bonuses, and without question pay levels for bankers have affected attitudes throughout the corporate sector (although the justification that these rewards were based on performance looks threadbare, post-crisis). Nor have shareholders been able to discipline corporate executives: small shareholders have too little of the vote to have any influence, while large shareholders have no incentive to bother. Large companies are characterised by directors who are drawn from narrow circles, sometimes sit on each others boards, and continually ratchet up their incomes through a structure of so-called performance pay designed by remuneration consultants who are hired by the executives whose remuneration they are supposed to be assessing. None of them, nor their big investors, have any incentive to rock the boat.

7. Embedded social exclusion

All of the forces I have just described date back two or three decades, set in train by specific events such as the politics and the recession of the early 1980s, but reflecting deeper structural trends. Inequality quickly became self-reinforcing, however. Large-scale manufacturing redundancies affect specific places and hollow out whole communities. These deindustrialised places often lost the benefit of earlier agglomeration economies the positive spillovers from one activity to another in an urban location such as the northern British cities or the US rust belt cities. With a catastrophic loss of employment, joblessness became the inheritance of the next generation too. Now there are many places where low skills, low incomes, low aspirations, high unemployment, high rates of crime and ill-health, poor-quality education, housing and public services, and other classic markers of poverty reinforce each other in an apparently intractable way. The interaction of these social and economic phenomena build an impassable but invisible barrier. They run between Tower Hamlets and the City of London, between Moss Side and nearby Didsbury in Manchester. It is a pattern Joseph or Seebohm Rowntree would find familiar. Inequality therefore has many, mutually reinforcing causes. In this area, as in so many others, history is over-determined.

The consequences of inequality

I think there can be no doubt that many people have concluded that inequality has reached a degree that is unfair and unacceptable. The point is made more effectively by an image than by citing the figures (see below). The Occupy movements have struck a chord even in individualist America. A more important catalyst as far as the typical voter goes has been the determination of bankers to perpetuate their bonus structures, even when it is plain to the least economically literate person that bankers themselves share a good part of the blame for the current depression. Social norms can change rather quickly consider how quickly smoking has moved from being normal to being frowned upon and I think it is possible that the social norm on inequality has shifted in the same way. The British Social Attitudes Survey includes questions on income distribution, and reveals almost four in five people saying income inequality is too great, a proportion that has increased somewhat in recent years.16 Attitudes to people on benefits have become harsher too, so it is not straightforward to analyse popular attitudes. Still, I think a great many ordinary voters might now agree with Franklin Delano Roosevelts second inaugural address in 1937: The test of our progress is not whether we add more to the abundance of those who have much; it is whether we provide enough for those who have too little.

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Figure 4. Illustration of average income per family by income group

Source: data Emmanuel Saez, visualisation Mother Jones magazine

So the public mood may have changed. But does that concern reflect more than a sense of unfairness? Does the level of inequality we have reached have real consequences, which, say, the level of inequality in 1980 did not have? It is surprisingly hard to identify empirically in the aggregate any effects of inequality on overall economic growth or levels of GDP per capita. This is partly because of the general difficulty of attributing aggregate economic outcomes to specific causes given the complexity and contingency of the economy. Anyway, in theory, it could go either way. Inequality could imply a large pool of savings to finance investment, entrepreneurship or a tax system that is not too progressive and so does not discourage work effort. These would boost growth. Alternatively, inequality could reduce the incentive of poor people to acquire education, or might increase social and political instability, either of which will reduce growth. In general, poor countries are more unequal than rich ones, but it is not possible to tell whether poverty explains inequality or the other way round. And some countries that were poor have been growing very rapidly despite significant increases in inequality. Among rich countries, there is no clear correlation between measures of income inequality and growth, never mind causation. The empirical evidence from aggregate data is inconclusive.17 This runs counter to the impression given by some commentators recently that the harm caused by inequality to everyone, not just those people who are poor, can be proven.18 As I will argue, the kind of structural change experienced in the advanced economies as a result of technological innovation mean there are now stronger reasons for thinking that a more unequal society will experience lower average growth, to such an extent that even the richest groups could be disadvantaged. However, there is no straightforward hypothesis to test empirically, and as just mentioned no evidence of this from previous econometric work. Simple correlations between the degree of inequality and measures of health, crime or other social ills for a small sub-set of countries unfortunately do not establish that an unequal society harms all its members, especially when the causal mechanisms are unclear.

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However, there is more recent evidence suggestive (although no more than that) of inequality of opportunity (rather than of incomes) harming growth: comparing US states, the greater the income inequality due to pre-determined circumstances such as race, gender and family background, the lower the subsequent growth rate.19 One researcher has suggested we need to think about there being two kinds of inequality just as there are two kinds of cholesterol, good and bad, inequality of opportunity being the bad kind.20 Inequality of opportunity may mean there are people whose full productive potential is not being realised, which must harm growth, whereas inequality due to different efforts and skills will incentivise growth. It is also an important negative conclusion that there is no evidence that greater inequality improves economic growth. If we consider inequality intolerable for social or ethical reasons, there is not necessarily an economic sacrifice involved in correcting it. If we look beyond the narrowly economic issues, great inequality of incomes and wealth is likely to have political consequences in the shape of an imbalance of power. In his Theory of Moral Sentiments, Adam Smith described the more or less automatic deference given to those who are rich and successful:

His actions are the objects of the public care. Scarce a word, scarce a gesture, can fall from him that is altogether neglected. In a great assembly, he is the person upon whom all direct their eyes; it is upon him that their passions seem all to wait with expectation, in order to receive that movement and direction which he shall impress upon them Upon this disposition of mankind to go along with all the passions of the rich and powerful, is founded the distinction of ranks and the order of society.21
It is clear in the US that wealth directly buys political influence. As Joseph Stiglitz put it, in an influential article called Of the 1 per cent, by the 1 per cent for the 1 per cent, Virtually all US senators, and most of the representatives in the House, are members of the top 1 per cent when they arrive, are kept in office by money from the top 1 per cent, and know that if they serve the top 1 per cent well they will be rewarded by the top 1 per cent when they leave office.22 Nearly one in two members of the US Congress has net worth in excess of $1 million. Ten are worth more than $100 million. The stagnation of middle incomes harms democracy. As Benjamin Friedman described in his book The Moral Consequences of Economic Growth, political openness depends on a mutual sense of progress or opportunity:

The experience of widely shared economic growth therefore creates a legacy from which a society can benefit socially, politically, morally for decades. And conversely, a significant stretch of years during which incomes stagnate imposes a burden that may well persist long after an economy has once again begun to grow.
He, like others, has noted the adverse political consequences of the combination of depression and extremes of incomes in the 1920s and 1930s.23 Other scholars, such as the philosopher Michael Sandel, have argued that a wide gap between rich and poor weakens civic engagement by creating a tendency for different groups to lead separate lives.24 The political and the economic tendencies reinforce each other. The rich argue against regulation and taxation on the grounds that government harms growth. Rich politicians in Congress, lobbied by rich financiers, are presumably more likely to ensure that regulation does not hobble business too much even when it has to be tightened, less likely to force incumbents to face new competition in their industry, and so on. This in turn keeps profit margins high, and bonuses too. The financial industry donates significant amounts to campaign finance in the US in 2008, the top donors to both the Democrat and Republican campaigns included the biggest banks such as Goldman Sachs and Citigroup, and Wall Street law firms.25

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Thanks to core public funding of political parties in the UK, the link between income and wealth and political influence is not as direct. However, there has been a modest upward trend in the amount and share of party funding from donations.26 Nor does it take a conspiracy theorist to spot the effects of lobbying by the big banks on financial regulation. There is no firm line between valid lobbying about regulatory consequences and undue influence over government decisions, but it is clear that the major banks have good access to ministers and officials to put their case. The political influence of great wealth, leading to effective lobbying, has economic consequences. It will inevitably enhance even further the economic rents captured by high-income groups and occupations and reinforce the reduction in effective competition. Many sectors have become characterised by oligopoly power. Consumers face higher prices, lower quality and reduced innovation than they would in a more competitive economy. Ultimately, the loss of the pressure on business to innovate that is provided by having competitors snapping at your heels will damage the economys long-term growth potential. It is the process of businesses testing each others mettle by competing that makes the economy grow and brings everyone the benefit of better products and services. So although these consequences of rent-seeking by the rich and powerful can take a very long time to manifest themselves, they will eventually profoundly undermine the economys success. One fateful consequence of the rise in inequality, and in particular of the failure of households in the middle-income range to benefit at all from economic growth in the 2000s, was the rise in debt. As before, the US and UK present us with the extreme cases, both recording an extraordinary rise in personal indebtedness (including mortgages) from about 60 per cent of GDP in 1980 to about 100 per cent of GDP in 2008.27 Raghuram Rajan argues that the liberalisation of consumer and mortgage credit meant that the increased inequality of incomes in the US did not have to translate into a corresponding inequality of living standards. People who saw the super-rich buying yachts and building extraordinary mansions could keep up a little bit in their consumption by borrowing. Rajan writes: Easy credit has been used as a palliative throughout history by governments that are unable to address the deeper anxieties of the middle class directly.28 In both the US and UK, the large increase in mortgage debt that many borrowers could not service from their incomes played a direct part in the onset of the Great Financial Crisis, and the insolvency of some banks, leading to the systemic and continuing crisis in the banking system. With the economy now so weak and redundancies increasing, many people are still turning to credit to make ends meet, including short-term debts such as pay-day loans.29

High trust needed for productivity growth

The likelihood that inequality is economically damaging is increasing, I believe, because of the way the structure of the economy is changing. Economic growth is a process of increasing specialisation and accumulation of knowledge, as first highlighted by Adam Smith. There are mutual benefits from specialising and trading. Over time the degree of specialisation, and so the variety and complexity of products, have increased enormously. The cluster of information and communications technologies have made the leading economies far more complex and interconnected.30 This includes supply chains that stretch around the whole world many manufactured products consist of components from a number of countries and a larger number of suppliers, and three-fifths of world trade in manufacturers now consists of intermediate rather than final goods. This is a pronounced change since the 1980s, when manufacturers were more likely to be vertically integrated. Corporations therefore now deal with large numbers of suppliers in close relationships over the specification of components and the logistics of supply. They will have outsourced many functions formerly seen as absolutely integral, from payroll and HR functions to the manufacture of key components. Where the characteristic firm of the 20th century was a large, integrated corporate hierarchy, the 21st century is likely to be characterised by networks of smaller firms with different specialisms.

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Workers in manufacturing in the advanced economies, or in the high value services that account for a growing share of the economy, are unlikely now to be doing the kinds of routine jobs that were easy to monitor. If a worker on the assembly line or the accountancy department was slacking, it was relatively easy to identify. Workers who are now performing service jobs or knowledge work of any kind, or using advanced technical expertise in industry, are using what is known as tacit knowledge, skills derived from expertise that is hard to write down. Their skill and effort is hard to monitor. If a software engineer says he has not yet identified the bug in a large programme, or a lab technician says there is a problem with a certain reaction at room temperature, even a highly knowledgeable manager can only verify this by doing the work themselves. More broadly, the productivity benefits to a firm of introducing new ICTs stem from changing peoples jobs, the flow of work and the structure of the company. Access to ultra-cheap and ample information and communication will only enhance productivity if people are allowed to make decisions on the basis of that information. The reason for the bifurcation of the income distribution into low-paid and high-paid jobs, described above, is that jobs have either become more mundane or more autonomous. Those people who have a high level of cognitive skills need to use their initiative, to be adaptable and able to think creatively. The corollary is that there has to be a high level of trust between them and their employer. The increased level of trust on which modern economies must rest if they are to be successful is apparent in all of these and other ways for example, the greater diversity of the large cities that are the nodes of the global production networks. By definition, there has been enough trust to get us to this point, but there is also a sense of its fragility, underlined by the economic crisis. For example, opinion surveys (across the OECD, not just in the UK) consistently show low (and declining) levels of trust in businesses and in important political and state institutions.31 Questions about the effectiveness of governance have arisen in contexts ranging from banking and corporations to international organisations such as the IMF (International Monetary Fund) and WTO (World Trade Organization). A number of economists have pointed out that open and complex economies succeed against all apparent odds. In his book The Company of Strangers, Paul Seabright describes the everyday miracle of co-ordination of resources and wants in a market economy, and writes: Modern society is an experiment, founded on a human psychology that had already evolved before human beings ever had to deal with strangers in a systematic way.32 This has occurred without any guiding intelligence, but rather as an uncoordinated, emergent complex phenomenon. Although the properties of complex systems are better understood in physics and engineering, their study in the context of the social sciences is in its infancy. We do not know what characteristics of the economy will sustain high levels of trust. However, it is obvious that trust will be sustained only if people on the whole justify the trust placed in them and do not behave opportunistically, even though as I have argued the changing character of the economy is increasing the scope for opportunism. If nobody can really monitor my performance at work, and my contribution will make only a small difference to how well business goes, opportunistic behaviour is rational. In fact, customers of all kinds of businesses know it is pervasive you only have to ring a call centre where the staff are badly paid, and intrusively monitored in terms of the speed of pick-up and number of calls handled, to know how badly they can manage to do their job. It is the natural response to having no responsibility and no trust. What might inhibit widespread opportunism and a generalised collapse in trust? Traditionally, a strong work ethic and highly developed sense of guilt has played a large part.33 So too has a sense of cohesion with the larger group, as Paul Seabright discusses in his book with reference to evolutionary psychology and anthropology.

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Most people would see some inequality as inevitable, and in some cases accept very high income and wealth as the fair reward for special talent or hard work. Inequality of incomes is not seen as unfair per se. But inequality due to the way the reward structure has been rigged by City bankers and corporate executives is another matter. A lasting sense of unfairness due to an excessive degree of inequality seems certain to undermine moral constraints on opportunism, however. If society is unfair, and you feel aggrieved, why wouldnt you see what you can get away with? JRF-funded research on last summers riots in England suggested that there was a kind of opportunism in play then.34 If that behaviour becomes widespread, it must certainly work against future economic growth.

What can be done?

It is hardly swimming against the tide of the times to be arguing that perhaps there is a bit too much inequality in the OECD economies. Let us agree that a reduction in inequality would be desirable. Can it actually be achieved? And in ways that do not themselves damage prospects for growth and jobs? For example, an obvious policy such as substantially more progressive income taxes would probably have an adverse effect on growth and can be avoided by high earners more easily than in the past. We are still waiting to see if the higher 50p tax rate has had much effect. Whats more, the increase in inequality in pre-tax incomes is too large to be readily altered through the income tax system OECD tax systems are already all progressive structures. As discussed earlier, the trends are deep-rooted in technological change and globalisation, and common to almost all OECD countries, although to varying degrees depending on the political and institutional context. But this is not to say that nothing can be done to halt and reverse increasing inequality. Although there is no single policy silver bullet, meaning that moving to a less unequal distribution is likely to take a consistent and sustained policy effort, there are several practical measures. Here, in ascending order of practical difficulty, are some suggestions.

Executive pay and bonuses

Given the public mood and shifting social norm already described, the easiest requiring really only the political will to demand or legislate is to curb top pay. Although all executive pay has risen to unusually high multiples of the median, the financial sector offers the most extreme example, and the most extensive payments of bonuses. Not surprisingly, given the failures in the sector and the continuing taxpayer subsidy, it also generates the most anger. In banking, Andrew Haldane, Executive Director for Stability and a member of the Financial Policy Committee of the Bank of England, argued (in a speech in October 2011) on stability grounds for linking pay and bonuses in the sector to return on assets rather than return on equity and share prices. He adds that if the pay of the CEOs of the seven largest UK banks had been designed in this way in 1989, then by 2007 their remuneration would have fallen from 100 times to 68 times that of the median UK household, rather than increasing to 500 times the median. In banking and the corporate sector as a whole, some simple measures to strengthen boardroom governance could end the upward ratchet of remuneration. One obvious one is to require by law much more variety in non-executive appointments, as well as non-executive-only membership of remuneration committees. Greater transparency in reporting actual remuneration is another, as most companies disguise the truth in complicated and obscurely priced long-term share incentive plans and pension contributions. The tax system could address abuses via golden hellos and golden parachutes. In short, there are plenty of practical ways to curb excessive boardroom pay, and the myth that lots of top executives would leave the UK to work overseas would quickly be overturned.

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Competition
I noted earlier that the share of corporate profits in national income is at an all-time high. One explanation for high executive pay is that it reflects the successful extraction of monopoly rents, unconstrained by either competition for customers or shareholder vigilance, and the rising profit share of GDP would support this. Again, the financial sector offers the most egregious example. In the UK, there has been no successful new entry into banking for a generation, but instead consistent consolidation. Consumers rarely switch banks and barriers to entry are high. Two large merger waves since the 1980s have resulted in decreased competition in many other sectors of the UK economy, reducing this highly effective constraint on management rewards. At the same time, major institutional shareholders have shown no inclination to constrain executives either perhaps because the people running these big institutions have themselves enjoyed the benefits of decreasing competition and high pay.

Public spending
The progressivity of the tax system is often the focus of discussion when it comes to redistribution, but public spending is a more significant and effective tool. Reformers of the late 19th and early 20th century were clear about the central role public goods played in creating a better society for the benefit of all, particularly education but also everything from investment in public health via the water and sanitation systems to municipal libraries and parks.35 Although it is not simple to assess the distributional impact of public spending because many categories are hard to allocate to specific groups in the data, and because the cost of provision is a poor measure of the benefit received, still public expenditure is weighted towards lower income deciles in cash terms and is highly progressive in proportionate terms.36 This does not, as the IFS (Institute for Fiscal Studies) points out, imply that public spending cuts are automatically regressive. However, the distributional impact is a sensible prism for public spending decisions, and one that politicians with their eyes on the median voter will appreciate. On some specific areas of welfare spending (including pensions and social care) as well as on tax reform, the UK government has to hand a series of highly regarded expert reports that have considered both sustainability and fairness as essential criteria the Hutton Report and Dilnot Report in the first two cases and the Mirrlees Report on the tax system. It is hard to see why all this work should be ignored.

Education
Sometimes it seems that education reform is the solution to every problem, but when it comes to incomes, education is absolutely a decisive factor. The technological revolution has changed the character of the demand for labour, and consequently the pattern of relative incomes. The supply of labour has inevitably responded slowly, but respond it must to address the basic forces driving recent shifts in the income distribution.37 There is a parallel with an earlier era of innovation in the early part of the 20th century, when new manufacturing technologies and electrification along with globalisation and empire required the creation of a better educated mass workforce to man the assembly lines. The increased returns to higher education since 1980 have already brought about a large rise in the proportion of young people going to university. Individual incentives work reasonably well at the tertiary level students are quite astute at figuring out the likely benefits of the additional cost and time. The challenges in primary and secondary schools are much tougher, as schools are part of the cluster of markers of economic disadvantage. Poor areas and poor pupils have weaker schools. However, there is strong evidence that the effect of improved schooling on future attainment and earnings is greater in secondary than tertiary education, and larger again in primary education. So, improved education with a focus on the early and primary years will have a large potential impact on earnings although it will take a generation. Whats more, improvement does not mean offering the same kind of education but a bit better, but rather a change in the character of provision.

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Social policy
The evidence I just referred to on the relative importance of early years education extends to pre-school years. Anybody with any experience of the kind of primary school serving a low-income community will know that the childrens prospects are greatly affected by aspects of their home life, such as the greater likelihood of illness at home, bad housing, inadequate nutrition, a lack of parental support for reading or homework, possibly violent neighbourhood surroundings, and so on. Public policy has certainly recognised this through schemes such as Sure Start. However, social interventions of this kind are not straightforward. It is not always easy to evaluate them, especially as some of the effects might not emerge until the children are grown and working. Whats more, such schemes take the state into family life, and one can reasonably feel uncomfortable about either the paternalism or the intrusion involved.

Institutional innovation for social change: is there an app for that?

Each of the above headings for policy reform covers a huge and complicated range of issues, and weve been grappling with them for some time already. Its important to be realistic about the scale of the economic and social challenges ahead of us. This is not a matter of the government just doing X, Y or Z. I want to end with some thoughts about the institutions of the modern economy. The Western economies are in the throes of what even the Financial Times describes as a fully-fledged crisis of capitalism, just as much as in the 1930s or the 1970s.38 These episodes occur whenever the basic forces driving the economy technology, demographic change, natural resources get out of kilter with the way we organise society. Or, to put it even more broadly, when efficiency the production of goods and services and fairness the distribution of goods and services are out of alignment, and impossible to align easily in ways consistent with individual freedom. There are sharp trade-offs between these three fundamental criteria, efficiency, fairness and liberty. The structural tensions will ultimately require a process of institutional and political innovation, which is by its nature likely to be slow and even haphazard. Unfortunately, many people have utterly unrealistic expectations about how quickly and easily any economic problems can be solved, still less challenges like inequality resulting from underlying structural trends. Public debate encourages the myth that there are silver bullet solutions, and that either the government or the market, as appropriate, can implement or bring about change quickly. Part of the problem is the prevalent idea that between them government and market account for the entire domain of economic activity, and in mutually exclusive ways, albeit increasingly with a role for the third sector formal voluntary activity or social enterprise. This is an over-simplified categorisation. Neither the state nor the market functions well without the other, and both tend to fail in similar contexts and for similar reasons such as the existence of externalities or information asymmetries. In such contexts, economies develop an array of alternative non-state, non-market institutions. The business firm is one of these. As Herbert Simon once said, a visitor from Mars would be astonished to hear it described as a market economy, looking at the far greater extent of transactions within firms than between firms and their customers.39 However, there are other types of institution that could prove important in shaping adjustments to the structural trends I have been discussing. In addition to social enterprises, I would add, for example, unions, mutuals and co-operatives, families and faith or cultural groups, philanthropic foundations, some for-profit technology businesses, pressure groups, sports and arts clubs. The country is awash with organisations with a potential economic impact, some traditional but many much newer possibilities.

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To give one example, sociologists highlight the importance of so-called weak ties in economic life. Your family gives you emotional support, but to find a job you need to ask around all your acquaintances. Facebook extends this network of acquaintance and is available to everyone with a smart phone, which is most adults of working age but especially young people. The local JobCentre Plus is the wrong kind of tool for linking unemployed young people into the social networks that will help them find jobs. Another example. Unions no longer play much of a role in achieving higher pay for much of the working population; their membership and power has diminished greatly. This means, among other things, a loss of pooled information about what employers pay for certain jobs. An individual worker has no knowledge about what other comparable people are paid. The information asymmetry means employers are in a good position to pay as little as they can get away with. Some unions, such as the NUJ (National Union of Journalists) for freelance rates, do try to collate pay information on the going rate. But could there be a new technology solution to the diminution of transparency in the labour market? Enterprises such as mySociety have achieved great feats of transparency in the arena of political data. Perhaps the same is possible with economic and financial information?40 Is there an app for that? There probably should be. A third example is one of the growing number of social enterprises, Raspberry Pi.41 It is behind the development of a powerful, tiny computer that will cost only 22, can be linked to any TV monitor and keyboard, and runs open source software. The ambition is to encourage children to play and then to learn to programme, emulating the impact of the BBC Micro in the 1980s in enthusing the generation that built the successful UK videogames industry. It is a private response to the shocking inadequacy of the ICT curriculum in most schools, and if successful will by itself contribute a lot to increasing essential skills among the workforce. The new technologies are disruptive. They have swamped one traditional industry after another, and in other parts of the economy have contributed to large gains in productivity as well as large gains in income for a small proportion of the population. But these disruptive technologies have not yet disrupted government or social institutions in the same way. I began this lecture by saying that the unsustainable is not sustained. How it is not sustained is an open question. It would be easy to be gloomy about future prospects from the depths of a depression, with unemployment rising and inequality heading for Gilded Age levels. However, the example of an earlier generation of social reformers is inspiring. The late Victorian and Edwardian era also experienced dramatic technological changes, economic upheaval, a long trade depression and dreadful social conditions. Yet the same age brought massive investment in private and public goods such as schools, water and sewerage systems, bridges and railways, on such a scale and with such longevity that we still rely on them today. The creation of a successful modern industrial economy involved radical institutional innovation, both required by and enabled by technological change.42 The institutions created by those generations of political and social innovators served us until the technological basis of the economy changed again. It is an example we should keep in mind now, when looking for inspiration in anxious times.

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Endnotes
1 2 3 Solow, Robert M. (1992) An Almost Practical Step Toward Sustainability. Washington DC: RFF Press Coyle, Diane (2011) The Economics of Enough: How to run the economy as if the future matters. Princeton: Princeton University Press www.niesr.ac.uk/pdf/150311_171852.pdf; see also Willetts, David (2010) The Pinch: How the Baby Boomers Took their Childrens Future and How They Can Give it Back. London: Atlantic Books Divided We Stand: Why Inequality Keeps Rising (2011). Paris: OECD http://www.ifs.org.uk/publications/4108 Levy, F. and Murnane, R. J. (2004) The New Division of Labor: How Computers Are Creating the Next Job Market. Princeton: Princeton University Press Changing Wage Structures: Trends and Explanations (2010). London: LSE working paper Goos, M., Manning, A. and Salomons, A. (2009) Job Polarization in Europe, The American Economic Review, Vol. 99, No. 2, pp. 5863 Rosen, Sherwin (1981) The Economics of Superstars, The American Economic Review, Vol. 71, No. 5, pp. 84558 Frank, R. and Cook, P. J. (1995) The Winner-Take-All Society. Why the Few at the Top Get So Much More Than the Rest of Us. New York: Free Press. See also Coyle, Diane (1996) The Weightless World. London: Capstone Krugman, Paul (1994) Peddling Prosperity: Economic Sense and Nonsense in the Age of Diminished Expectations. New York: W. W. Norton Baumol, William J. (1967) Macroeconomics of Unbalanced Growth: The Anatomy of Urban Crisis, The American Economic Review, Vol. 57, No. 3, pp. 41526 Krugman, Paul, For Richer, New York Times, 20 October 2002; Hearing Before the House Committee on Government Oversight and Reform, 110th Congress 17 (23 October 2008) (testimony of Alan Greenspan, Former Chairman of the Federal Reserve) High Pay Commission, Interim Report and Final Report, December 2011 Ellis, L. and Smith, K. (2007) The global upward trend in the profit share, BIS Working Papers No 23. Basel: Bank for International Settlements (The rise in the UK profit share was among the least pronounced since 1960, although rising since 1980.) http://www.natcen.ac.uk/series/british-social-attitudes Alesina, A. and Rodrik, D. (1994) Distributive Politics and Economic Growth, The Quarterly Journal of Economics, Vol. 109, No. 2, pp. 46590; Barro, Robert J. (2000) Inequality and Growth in a Panel of Countries, Journal of Economic Growth, Vol. 5, No. 1, pp. 532 For example, Pickett, K. and Wilkinson, R. (2009) The Spirit Level: Why Equality is Better for Everyone. London: Allen Lane Marrero, G. and Rodrguez, J. (2010) Inequality of Opportunity and Growth, Ecineq Working Paper 154; http://www.ecineq.org/milano/WP/ECINEQ2010-154.pdf See Francisco Ferreira, http://blogs.worldbank.org/impactevaluations/node/731 Smith, Adam (1759) Of Propriety, The Theory of Moral Sentiments. New York: Prometheus Books (2000) http://www.vanityfair.com/society/features/2011/05/top-one-percent-201105 Friedman, Benjamin (2005) The Moral Consequences of Economic Growth. New York: Alfred A. Knopf Sandel, Michael (1996) Democracys Discontent: America in Search of a Public Philosophy. Cambridge, Massachusetts: Harvard University Press Data collated from public sources by www.opensecrets.org http://www.electoralcommission.org.uk/party-finance/party-finance-analysis/ party-funding#D&PF%202001 For cross-country comparisons, see Debt and Deleveraging, McKinsey Global Institute; http://www.mckinsey.com/Insights/MGI/Research/Financial_Markets/Debt_and_ deleveraging_The_global_credit_bubble_Update Rajan, Raghuram (2010) Fault Lines: How Hidden Fractures Still Threaten the World Economy. Princeton: Princeton University Press

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29 Rigby, Elizabeth About 1m take out payday loans, Financial Times, 3 January 2012; http://www.ft.com/cms/s/0/6c4889d6-363b-11e1-a3fa00144feabdc0.html#axzz1iTnDGpHI 30 See The Atlas of Economic Complexity; http://atlas.media.mit.edu/, and Hausmann, R. and Hidalgo, C. A. (2011), The Network Structure of Economic Output, Journal of Economic Growth, Vol. 16, pp. 30942 31 Ipsos MORI tracks trust in different UK professions 32 Seabright, Paul (2004) The Company of Strangers: A Natural History of Economic Life. Princeton: Princeton University Press 33 Rose, David (2011) The Moral Foundation of Economic Behaviour. New York: Oxford University Press 34 http://www.guardian.co.uk/uk/2011/dec/05/summer-riots-consumerist-feast-looters 35 See, for example, the survey essays in Gladstone, David (ed.) (1999) Before Beveridge: Welfare Before the Welfare State; www.civitas.org.uk/pdf/cw47.pdf 36 http://www.ifs.org.uk/publications/5299 37 Goldin, C. and Katz, L. (2008) The Race Between Technology and Education. Cambridge, Massachusetts: Belknap Press. Also Saint-Paul, Gilles (2008) Innovation and Inequality: How Does Technical Progress Affect Workers? Princeton: Princeton University Press 38 Financial Times special series, January 2012 39 Simon, Herbert A. (1991) Organizations and Markets, The Journal of Economic Perspectives, Vol. 5, No. 2, pp. 2544 40 I thank my colleague BBC Trust chief economist Paolo Siciliani for this suggestion. 41 http://www.raspberrypi.org/about 42 Allen, Douglas (2012) The Institutional Revolution. Chicago: University of Chicago Press

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