The Red Road flats
The rationale is that inequality is the price we pay for the capitalist economy to work effectively. But it isn't working effectively. Photograph: Murdo MacLeod

It's inequality, stupid. It's inequality that is behind poverty, ill-health and the growth of the welfare bill. It's inequality propelling the escalating demand for credit. It's inequality that has created our fragile banking system and its still feral proclivities. It's inequality that has provoked the collapse in productivity, and the stagnation in innovation and investment – evident before the financial crisis and even more so now. This is the truth that cannot yet be spoken.

Yet reality will out. Ed Miliband's "cost of living" crisis is a sideways route into opening up an argument over inequality. As he knows full well, the problem is not just the gnawing away of average living standards, but how the effects hit you more savagely the lower your income. It matters how the cake is shared. If George Osborne calls for the minimum wage to rise to £7 an hour, be sure that some acute Conservative political antennae are recognising that the salience of inequality is rising. Finally, it is tiptoeing on to the national stage.

The sheer unfairness of who gets how much is the first reaction to inequality, a challenge to us as moral beings. It is not just that so many incomes at the top, many times higher than a generation ago, are plainly undeserved and unrelated to merit; it is also about the multiple ways that inequality expresses itself. Your starting point in life and your parents' networks are ever more important in determining your life chances, whether you want to get on as an investment banker or actor. Your chance of getting on the housing ladder early or late is closely determined by the wealth of your parents.

Inequality is all around. You can rage at the phenomenon of young people, unable to afford sky-high London rents, cramped into one shared room, while the super-rich dig down under their homes or buy the house next door to expand their living space.

Are the rich so newly virtuous or the young so newly feckless that either deserves the extraordinary change in their circumstances? Nobody, except the rich themselves or their valiant apologist Boris Johnson – drawing our attention recently to their alleged higher IQ (is it higher, relatively, than 30 years ago?) and alleged indispensable role in "wealth generation" (more indispensable than 30 years ago?) – can justify what is happening. Inequality's sole possible rationale is that, however repugnant, it is the price we pay for the capitalist economy to work effectively.

But the capitalist economy is not working effectively, even while inequality has surpassed the levels of Edwardian England. For three decades, policymakers in Britain have tacitly accepted the Johnson thesis or, at the very least, not accepted responsibility for the inequality that has directly resulted from the "reforms" they have initiated. Target number one has been the reduction of trade union power in the name of promoting labour market flexibility. Target number two has been the reduction of taxation on capital, companies and higher earners in the name of promoting incentives and "wealth-generation". And target number three has been not to object to ever denser concentrations of market power, particularly in the City, because Britain "must be open for business".

The result has been a stunning increase in inequality, the fastest in the OECD, so that Britain now ranks 28th out of 34 countries in the equality "league table". But there has also been a weakening in the long-run growth rate, an incredible mountain of mortgage debt, falling productivity and the financial crisis. Usually, these are understood as separate phenomena. Bankers, we understand, created the financial crisis. Productivity is falling because workers have inadequate skills or simply shirk. Mortgage debt is down to crazy house prices, driven by land shortages and inability to build new homes. The low growth rate is because companies lack the confidence to invest.

All those explanations are partially true. But the bigger story is that all have common roots in inequality. The indifference to the growing gap between rich and poor, in all its multiple dimensions, is the first order category mistake of our times. No lasting solution to the socioeconomic crisis through which we are living is possible without addressing it.

The story begins with the evisceration of the institutions in civil society – primarily, but not only, trade unions – that ensured that the share of wages in national income stayed broadly constant. Labour market "flexibility" is constantly portrayed as an unalloyed benefit, increasing employers' room for manoeuvre in controlling wage costs and making hiring more likely. What is never said is that there are trade-offs. Cumulatively, over the last generation, the weakening of trade unions' countervailing market power has seen between 5% and 7% of GDP being moved permanently from the workforce to shareholders. Average real wages at first stagnated and are now falling.

Entrepreneurs are the engine room of a capitalist society, at best making fortunes on the back of genuine risk-taking, usually when they bet their assets and reputation on some innovation. They can also lose everything. But as companies found their profits rising sharply, executives at the top sold the unwarranted proposition that it was because they too were entrepreneurial, rather than the beneficiaries of weakened trade unions. They should, they claimed, receive entrepreneurial returns , even if they risked nothing. Showered in share options and extravagant bonuses, executive pay since the late 1980s has grown faster and to higher levels than at any time in our history.

Some try to explain this radical redistribution of income to the rich as the consequence of globalisation, immigration or the growing importance of skills and education. But while these effects clearly exist, all are modest or small in scale: they cannot explain such a substantial change in the wage and profit share. That has been fashioned as a matter of political and economic choice.

The cascade of consequences is formidable. Workers, struggling to maintain their living standards, have borrowed extraordinary multiples of their income to make money the only other certain way – through the housing market. Withdrawing equity from one's home, now estimated by estate agents Savills at £1.8tn in total, is the sole reliable route to sustain living standards. House prices have been bid up well beyond a sustainable relationship between wages. Poorer wage earners left out of the boom have to rent, creating a class of private sector landlords whose collective equity is now estimated to top £800bn. After being temporarily halted during the financial crisis, the process is now under way again.

None of this would be possible without credit. British banks have lent £1.2tn in mortgages. But if inequality has fuelled demand for credit – whether through mortgages or payday loans – it has also helped drive the supply, and thus the creation of an extraordinary financial system biased to lend to property and not to enterprise. The general rise in executive pay in terms of the share of national income has become most distended and easiest to achieve in finance. The faster and larger a bank could grow its lending, the higher its profits, and in the new world in which banking bureaucrats were paid as entrepreneurs, those profits fed straight through to bankers' bonuses. Bankers knew their balance sheets would in effect be guaranteed by the state. Regulation was weakened by the fashion for believing in free markets. Too much pay at the top and too little pay in the middle and bottom became the structural causes of a financial system that by 2008 had become a predator on economy and society alike.

But easy profit and easy top pay have not catalysed an investment and innovation boom. A company's share price does not rise if it invests and innovates; those are risks that could go wrong. Management teams instead look for low-risk activity – lush government contracts, lobbying to drop regulations, paying workers minimally or using their profits to buy the company's own shares – to keep up their sales and profits.

Thus Britain today. At the bottom, a world of food banks, payday lending and quiet desperation. And at the top, an extravagantly paid elite. Social ills ranging from obesity to depression become ever more entrenched. Yet this same inequality creates a fragile, enterprise-averse banking system, an escalating credit boom, overpriced homes and a low-investment, low-innovation economy. It is also inequality behind so much extra public spending – on housing benefit, policing, care and remedial interventions.
