I think over quite a long period of time the middle class in industrialized or developed economies has been I think squeezed. What we’ve seen over the last 20-25 or even 30 years, both in the Western Europe and in the US and in Japan, is that a very large proportion of the benefits of economic growth have based gone to people at the top of the income scale, so the top 10% of income owners and particularly the top 1%. What we’ve seen everywhere is a very big increasing inequality.

So, in the post war period, from 1945 to 1980, we saw a real narrowing of inequality in pretty much every country. Since then we’ve seen things ballooning back out again. And that has taken place at the same time as most countries have liberalized their economies, embraced a greater degree of financial liberalization and of market liberalization more generally. Now, the problem of course is that many people increasingly are starting to blame the market economy and markets for this phenomenon. To an extent that is the case. Markets have often been liberalized without being regulated properly. But markets should, in theory at least, prevent groups and societies from co-opting a disproportionate share of assets or of wealth. But at the moment they don’t seem to be doing that and governments have to find a way of ensuring that benefits of the economic growth are distributed more evenly throughout a society.

If they cannot do that, then I think we will start seeing an opposition to liberal economic policies, we will start to see more pressure for protectionism, for a greater role for the state in economic management. And this will be a problem in the sense that productivity growth which is what drives any increasing living standards in the medium to long term is driven by competition. So, governments need to find a way of maintaining high levels of competition because that’s what leads to productivity growth, but accompanying policies aimed at boosting completion with policies aimed at combating inequality. So, there will have to be more redistributive tax and welfare systems etc. It is not good enough just to liberalize markets and expect the most economically and socially beneficial outcomes. Markets need to be regulated properly and I don’t think they have been.

It is very interesting that you are saying that if governments fail to redistribute income more evenly that would create more opposition to market economy as such. So, does it take us back somewhere to the middle of the 19th century?

I don’t think we need to go back quite that far, I mean capitalism on various occasions in the past just had to be saved from itself…

That’s a good idea by the way. I’ve never thought about that.

And we saw that in the post war period obviously. On various occasions in the past we’ve seen governments having to step in to ensure adequate levels of demand maintained because of course without sufficient levels of demand then it becomes very hard to sustain popular support for economic liberalism for a market economy. I think we are back to where we were several decades ago, yes, and if we are going to flourish economically and if we are going to maintain social support and widespread political support for the market economy, then governments are going to have to intervene in various ways. That doesn’t mean intervening to support particular companies or particular interests, that’s the last thing they should be doing. As I said they should be encouraging competition.

But they are going to have to look at the balance of power I think between capital and labour. I know that sounds very Marxist but at the moment what is happening is that the share of national income all over the West, the share of national income accounted for by labour in the form of salaries, wages and other employee benefits, it is declining steadily. At the same time the proportion of national income accounted for by the corporate sector has risen dramatically. But the corporate sector is not investing that money because there isn’t any sufficient demand.

Of course business will always claim that they need to pay less tax, if they pay less tax they will invest more. They always said that we need more flexible labour markets. If we have more flexible labour markets it will be easier for us to justify investment. We’ve had 30 years of liberalization of labour markets, we’ve had 30 years of cuts in business taxes and we’ve seen a steady fall in business investment over that period of time. So, I think it is not just in the liberalized labour markets and cut taxes on business – that alone won’t generate strong business investment. There needs to be a demand for whatever these companies produce and that means looking at the demands out of the question and looking at households and labour – employees – how they get the money to buy stuff.

But Mr. Tilford, if we are talking about boosting the demand, at the current moment many European governments are implementing some kind of austerity measures. And those austerity measures are smashing the middle class – the locomotive of consumer demand.

The problem we have in Europe is that the strategy for dealing with the economic downturn is all supply side and no demand side. There is no doubt that reforms are needed in some European economies, in whichever country you want to look at. But Europe’s problem is not just a supply side problem, Europe’s problem is also a demand side one. There is just an insufficient demand in the European economy to justify investment. And the strategies that they’ve employed for dealing with the crisis are making that worse because governments are cutting public spending at the time when there is nothing offset that.

It is ok to cut public spending if the economy is growing strongly because business investment is strong or because exports are going rapidly. But to cut government spending by as much as they are doing at the moment when there is nothing to offset – exports are weak, business investment is very weak – all that does further weaken these economies. And it does obviously hit those on the lower and medium income sides.

Northern European governments still are a little bit more cautious about their middle class policies. Whereas countries like Greece and Spain, it looks like it is not their own decision, but their policies are really undermining all prospects for economic growth.

Partly, because members of the Eurozone have no choice. In the countries that have lost or countries that have weak public finances within the Eurozone have no choice but tighten public spending, even if that’s the worst thing possible for the economic growth and hence for their public finances in the medium term because of the structure of the Eurozone. Basically, as soon as it appears that a country has any kind of fiscal problem investors start to down the sustainability of that country’s membership of the Eurozone. And then they start pricing in sort of convertibility risks. So, if we look at the cost of borrowing in Spain or Italy – it is very high not because those countries’ public finances are uniquely weak but because investors don’t believe that their membership of the euro is sustainable.

So, they are demanding a very high premium to buy their debt and that’s forcing these countries into pursuing very high levels of fiscal austerity which will almost inevitably undermine their growth prospects going forward because they are cutting investment on education, on infrastructure etc. Also by reforming their welfare states in a rather poorly thought through fashion they are probably doing a lot of damage to demand as well.

I was talking to several Greek experts last week and their point was that Greece and Spain are made to sacrifice themselves for the good of other Eurozone countries. Is there any rational to that?

I think there is absolutely no doubt that the strategy the Eurozone as a whole is employing to go out this crisis is going to have or has a considerable political implications that some countries are being forced to bear the full cost of adjustment for a crisis that was caused by both the north and the south of the Eurozone. This crisis was caused by huge capital flows from the north of the Eurozone into the south which led to big sort of construction booms in Spain, pushed up their costs related to the rest of the Eurozone. This is a problem caused by both sides and it can only really be solved by both sides making adjustments, by big debt write offs basically. But that’s not happening. And what is happening is that the countries in the south are being forced to carry the full cost of adjustment. That won’t work economically and ultimately won’t work politically.

Mr. Tilford, why won’t we try to implement something like the Chinese recipe? Remember back in 2007 what they did – they boosted the consumer spending of lower and lower middle classes.

I think ultimately we will come to that in Europe. I think over the next few years there will be a backlash against what we’ve seen over the last 20 years where a burden of taxation has moved steadily from capital to consumption and to income tax. That has depressed the spending power for the low and medium incomes. I think ultimately that will have to change but I don’t think it is going to happen any time soon. The intellectual consensus is so strong that the way to get economic growth is basically to alleviate the corporate sector and boost taxes on consumption. That is the sort of mantra that governments hear from everybody – the ECB, the IMF etc. I think it is going to be long time before we see that changing.

Sir, thank you so much. And just to remind you our guest speaker was Simon Tilford – chief economist at the London-based Centre for European Reform.