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It has become an iron rule of recessions that it is the lower and middle-paid sections of the workforce that bear the heaviest burden of the fallout.  Of course, with the economic cake shrinking by 7%, pain was inevitable after 2008. Living standards on average were bound to slide. This recession, however, was meant to be different. “We are all in this together” became the much voiced refrain of coalition leaders. This time, it was claimed, the impact would be more evenly shared that in the past.

A new report that I’ve written for Touchstone, called “All in this together?“, shows just how empty those words have proved to be. Just as in the 1980s and early 1990s, it is those in the bottom half of the income distribution that are bearing the brunt of the rise in unemployment and the cuts in real wages. Those most likely to have lost their jobs have been skilled and unskilled workers in the lowest pay brackets.

It is similar story on pay. On average, real wages fell by 3.6% in the year to June 2010 and then by a further 3.8% in the year to June 2011. But those facing some of the deepest cuts in pay have been those on already low wages working in voluntary organizations, especially those working in social care. Cuts in real pay are also only part of the story. Across the public, voluntary and private sectors, longstanding conditions of work are being eroded, with staff contracts re-written to impose longer hours, poorer sickness and pension provision and fewer holidays.

Moreover, for most, pay levels and conditions are unlikely to return to pre-recession levels, even after recovery. The UK is heading further in the direction of a low-paying economy with weakened employment conditions. The last thirty years have already seen a continuing fall in the share of output accruing to wage-earners. One of the key effects of the crisis is to have fuelled this long-term trend. This is officially recognized by projections by the Office for Budget Responsibility which show that labour’s share of economic output will have fallen even further by four percentage points between 2009 and 2016.

Britain’s twin-track economy, a fast-track for the rich and a slow-one for nearly everyone else, has become more firmly entrenched since 2007. Far from accepting a fair share of the pain, those at the top have found ways of firewalling their own incomes and wealth. Indeed, a small corporate and financial elite has continued to grow its share of the cake through the downturn.

This is not just an issue of fairness. These same trends are also torpedoing the chances of recovery. If the share of output going in wages was the same today as it was in the late 1970s before the thirty-year long wage-squeeze began, UK consumers would now have around £60 billion more in their pockets. Instead the lifeblood of the economy is being further squeezed.

It was the increasingly skewed distribution of the national economic cake that was one of the key, if mostly ignored, factors leading to the 2008 Crash. The same factors are now driving an apparently relentless slide into near-permanent slump.  If the division of the cake now stood at its level of three decades ago, much of the human cost would have been avoided, and we would be well on our way out of this mess.

When Mrs Thatcher and Ronald Reagan launched their campaign to change capitalism from the shackles of regulation, it came with big promises. Markets would be the route to economic renaissance bringing more enterprise and a boost to growth. Yet as I show in my new book The Cost of Inequality, Three Decades of the Super-Rich and the Economy, on all measures of economic performance bar inflation, ‘market capitalism’ has a much poorer record than the regulated model of the earlier post-war period.  

In the UK, the post-1980 era has suffered from lower growth and lower productivity. Productivity growth has averaged 1.9% a year since 1980 compared with an annual average rise of 3% in the more regulated era. The average level of unemployment since 1980 is five times higher. Financial crises have become much more frequent and more damaging culminating in the crisis of the last four years.

The outcome of the post-1980 experiment has been an economy that is both much more polarised and much more fragile. Central to this failure has been the way blind-eye regulation has allowed financiers to cook up business activity that diverts existing rather than creates new wealth.

Wealth creating entrepreneurs – those like James Dyson and Tim Waterstone – who create and build companies from scratch, have become much rarer. They have given way to a new breed of financiers and bankers who can make big money not by creating new companies from scratch, or taking the long view, or being smarter, but by manipulating the financial structures of existing firms – through mergers, hostile takeovers, private equity and re-arranging balance sheets.

It is this that has made a new generation of business financiers super-rich, not by activity which adds to the size of the cake but by grabbing a bigger share of it. In 2011, nearly a fifth of the richest 1000 in the UK – including 51 hedge fund owners – had made their money through finance. Only 11% had made it in industry or engineering. Investing in the companies of the future has become a sideline in the UK. Today private equity companies – from the AA to Homebase – employ a fifth of the workforce. The volume of acquisition activity has increased twenty-fold in the last 20 years.

Yet while these activities provide big fortunes for a few, the evidence is that they are as likely to destroy and divert wealth as create it. When Debenhams was bought by a private equity consortium in 2003, it was stripped of its asset base, re-sold with a huge debt burden, and is now worth a fraction of its original value. Yet the consortium behind the deal tripled the value of its existing investment over 30 months. There are dozens of examples of successful British companies – from Marconi to Allders – which have been destroyed from within by the search for ‘fast-buck’ returns, but not before the City-led executives have walked away with huge jackpots, leaving staff and taxpayers to pick up the bill.

The chase for racier returns has also diverted resources away from the urgent needs of small business. In 2010, while the productive economy was being starved of cash, the banks cooked up £11 billion to finance the quite pointless takeover of Cadbury by Kraft.

The main winners from the market experiment of the last 30 years have not been the ‘deserving rich’ – those that create wealth and jobs – but the ‘undeserving rich’ – those which build personal fortunes by taking wealth from others. Market capitalism has failed on all fronts. It needs to go, replaced by a system that returns us to a model with wealth creation, not wealth diversion, at its heart.

The official numbers in poverty – roughly a fifth of the population – are based on those with incomes below 60% of the median ( the mid-point in the income distribution ). Duncan Smith has openly criticised the use of the median , telling the Guardian last month: “You get this constant juddering adjustment with poverty figures going up when, for instance, upper incomes rise”. Frank Field seems to share this view, arguing that the use of the median is essentially self-defeating.  As he has written: “As families are raised above the target level of income, the median point itself rises”.

Yet both these assertions are totally false. If the rich get richer, as they have, there is no effect on the median – the poverty line stays exactly the same. If all households below 60% of the median were to rise above it, poverty would be eliminated, but the median would stay the same. Both Duncan Smith and Field are, inexcusably or deliberately, confusing the median with the mean, which is the average income calculated by dividing the sum of all incomes by the number of people in the distribution.

There is nothing new about the Conservatives’ sudden preference for an absolute definition, as laid out most clearly by Sir Keith Joseph in the 1970s. This absolute philosophy – although not officially stated – was effectively enshrined in Conservative measures from 1979-1997 and is the main reason why poverty and inequality soared over this period. In particular, from the early 1980s, benefits – from unemployment benefit to the state pension – were raised in line with prices not earnings, thus condemning benefit recipients to minimal improvements in living standards.

Although the average level of prosperity rose sharply under the Conservatives, low and middle income groups found themselves slipping behind the rest of society. Although they failed to cut poverty, Labour at least ensured that, in contrast with the Conservative era, most sections of society shared roughly equally in the proceeds of growth.

Relativism is a core principle of a civilised society. Abandoning it would mean the introduction of a multi-speed Britain, with lower income groups condemned to living standards that slip further and further behind those higher up the income ladder. As shown in the  Breadline Britain surveys, carried out from 1983, the public embrace the idea that poverty is relative. Asked which of a long list of items – from food and housing to clothing and leisure – they considered essential to avoid poverty in contemporary Britain, respondents defined items as necessities which they had considered luxuries in earlier surveys.

If the new Government redefines poverty in the way that is being hinted – by holding the poverty line steady in relation to prices, instead of allowing it to increase with rising prosperity – this would indeed be thinking the unthinkable. It would transform the unofficial thinking of the 1980s into official state policy. The Government might be able to claim, over time, an historic cut in the numbers of the poor. But far from cutting poverty, this would merely condemn a large minority of the population, through no fault of their own, to the living standards of the past.

In the 25 years from 1945, the share of the nation’s output going to wages held steady at close to 60% before rising to nearly 65% in 1975. Since that high point, the wage share has been in inexorable decline. Today it stands at a mere 53%. An even steeper fall has occurred in the United States, while continental Europe has experienced a shallower fall.

Although living standards in the UK have nearly doubled over the last 30 years, some groups of workers, especially those just above the minimum wage, from fork-lift truck and bus drivers to bakers and low-skilled factory workers have enjoyed little increase in real earnings over the period. Most middle and low income workers have enjoyed only small rises in real wages. It is only top executives and financiers and the best paid professionals – medics, accountants, lawyers and engineers – who have enjoyed wage rises in excess of wider rises in prosperity.

The overall decline has been driven by the erosion of employment rights, a reduced demand for unskilled labour and the transfer of jobs triggered by globalisation. These factors have greatly boosted the bargaining power of employers.

As a result wages have been falling behind productivity growth. Over the last three decades economic potential has been growing by 1.9% per year while real wages have been rising by only 1.6% a year. Since 2000 the gap has widened with real wages rising by around half the productivity gains.

These trends have had a profound impact on the economy. In the 1970s, Britain’s problems – its inflationary spiral, low investment and weak productivity growth – were exacerbated by the ‘profits squeeze’ of the time. Yet this squeeze turned out to be temporary, the product of an exceptional set of circumstances including the oil price shock. Today the imbalance of the 1970s has been reversed. The ‘profits squeeze’ has been replaced by a ‘wage squeeze’. As wage increases have slowed, investment returns and profit levels have soared.

Moreover, unlike the short lived profits squeeze of the 1970s, today’s wage squeeze is a proving much more enduring. In the process, Britain has, over the last three decades, been steadily transformed from a relatively high wage, low debt, equal society to a low wage, high debt and much more unequal society.

This new imbalance is a key factor in the current financial turbulence. Why? First, because of the negative effect of low real wage growth on spending power. To maintain living standards, families became increasingly indebted. While households borrowed an average of 45% of their income in 1980, they borrowed 157% – more than three times as much – in 2007.

Secondly, because of impact of the swelling profits’ pool. Some of the extra profits funded higher levels of business investment. But much of it flowed elsewhere. Higher profits were used to justify record dividend payments and the explosion of corporate, executive and financial remuneration. With rates of return on financial engineering exceeding those on manufacturing investment, funding for long term success gave way to short-term, fast-buck deal-making with money moving around at speed chasing the quickest return.

Record returns encouraged the wealthy to borrow more not to finance consumption but to take speculative bets on assets where rates of return exceeded the cost of borrowing – at historic lows from the millennium. Money poured into hedge funds, private equity, takeovers and commercial and domestic property.

Bank lending ratios soared. Business values rose. The financial services sector mushroomed in size while the manufacturing base shrank.

Little of this financial merry-go-round strengthened Britain’s economic base or helped create sustainable businesses and jobs. Most of it simply encouraged financial speculation aimed at building even larger personal fortunes. The shift to profits was the most important factor driving the remarkable personal wealth boom of the last two decades, a boom which concentrated wealth in fewer and fewer hands. In turn this concentration fuelled the asset boom.

As money poured into commercial property, housing, art and commodities, asset prices soared. At the height of the housing boom, for example, top end house prices increased much more sharply than on average. According to Savills, prices for prime central London properties costing over £5 million grew by 50% in the year to March 2007, six times faster than for houses in general.

The ‘wage squeeze’ has not merely contributed to economic turmoil, it is now hampering recovery. Wage freezes and cuts – from British Airways to Honda – are increasingly common. So where is the demand necessary to create a sustainable recovery to come from?

In the short term the stimulus provided by public spending and the Bank of England  needs to continue. But the trend of an ever shrinking wage pool needs to be reversed. To avoid a return to the credit fuelled boom of the past, policy needs to shift from a preoccupation with the City and the chasing of ever rising profits. Policy makers need to accept the evidence that declining wages and the soaring earnings gap has contributed to economic instability. Building a more sustainable and less volatile economy depends on improving the lot of low and middle earners.

A shorter version of this article appears in the Independent today.

In addition, people have been found to have a very poor idea of where they rank in the income hierarchy. To find out how good individuals are at placing themselves, the TUC made a ‘MiddleBritainometer‘ inviting respondents to guess where they stand in the pay league. Over 2000 people have responded and their guesses can be compared with their actual position in the pay league in the results posted here.

On the whole, those on the lowest levels of pay tend to overstate their position, thinking they are slightly closer to the middle than they really are. In contrast, those on the highest levels of pay tend to understate their actual position – they think that they are relatively poorer than they really are. Moreover this tendency for misplacement is greatest amongst the highest earners. The highest paid understate their actual position to a much greater extent than the lowest paid overstate it.

The TUC’s income barometer confirms the finding of other studies: that knowledge of the full extent of inequality is very limited and that there is a widespread misunderstanding of the extent of pay and income relativities. Again, it is those on the highest earnings who appear to be particularly out of touch with reality, especially when it comes to their own pay.

In describing his salary of £64,000 as ‘rations’, Alan Duncan could hardly have put this tendency better. A survey by British Social Attitudes found that under a half of those with earnings that put them in the top ten per cent identified themselves as top earners. They were much more inclined to place themselves towards the middle. One survey of bankers and lawyers on earnings of over £150,000 found that they tended to compare themselves with richer people, inventing a society in which they are a step or two down from the top.

Does any of this matter? Well yes. Surely in a well informed, fully democratic society, opinion formers would be able to distinguish between the real middle and the top, there would be a better public understanding of the real gaps in pay between the top, the middle and the bottom, and the highest paid would not think they are so much poorer than they really are?