Friday Flyer: The Economic Divide stands – but can we prosper?

The UK has often been described as being an economically divided country. Initially this divide was related to the decline of traditional primary (for example, mining) and secondary (manufacturing) industries and the rise of the service sector in London, which increasingly provided legal, financial, accounting and educational services to the rest of the world. Oddly enough both sets of industries, whether in decline or still growing by the late 20th century, had strong roots in the industrial revolution. This simple observation tells us that we cannot know today which sorts of industries will necessarily thrive into the 21st century: Hoxton hipsters making furniture might dominate the pricing of credit default swaps.

In dealing with any form of regional inequality we also squarely face the problem of ex ante and ex post inequality in regions. Whilst it may be clear, in so far as the regional data allows us to understand, that there is considerable inequality of outcome, we cannot be quite sure there is still the same inequality of opportunity as there might have been in the past. For example, nearly 50% of young people now go to university compared to less than 15% a generation ago. At face value this change suggests a considerable increase in opportunity. But many have argued that we have not developed the kind of education excellence in vocational skills required for modern industry and that there is a severe structural mismatch. This failure had the unintended consequence of creating demand for workers with those skills from the European Union just at the time that our relative economic prospects encouraged supply.

A further more subtle point is also often made that even if we think we are doing all we can to level out opportunity in outcomes across incomes and regions and yet there are still inequalities across the distribution, there may be a case of ex post re-distribution because it may not be possible to get past initial constraints in a single lifetime or generation. The problem might be seen most obviously if we turn to the UK’s favourite topic: house prices. How do workers start owning property or move from poor to rich regions on current incomes without support from the previous generation of home owners?

The sense of distributional failure helps us understand the populist political process on which many advanced countries have embarked. So much so that the referendum vote, and populist pressures elsewhere, might be best understood in broad socio-cultural terms as acting to constrain future political choices. The level of schooling, the extent of professional occupation, age, jobs vulnerable to imports, the recent change in the level of immigration and those identifying themselves as English were all significant factors in vote choice at the referendum. Income distribution played a significant role.

One problem might be that macroeconomics is dominated by the view that there is a representative agent who produces, receives income and spends or saves all income. Theory tends to proceed by taking micro-economic problems seriously such as the household consumption problem is evaluated with reference to a utility function and a budget constraint, which accounts for income and expenditure. The solution to the optimisation problems are then analysed numerically with parameters derived from microeconometric studies. In this analysis we do not account for regional or individual heterogeneity.

Many have criticised the reduction of a complex economy into a single agent, arguing that co-ordination by the market cannot be assumed. Indeed many argue that important macroeconomic phenomena, such as unemployment or regional depressions, are the result of co-ordination failure. And that representative agent models where there is no trade cannot capture the essence of financial markets and asymmetric information and help us understand government policies aimed at distribution. If we go on to argue that collective or aggregate choice cannot be represented by a single individual and that aggregate behaviour is best understood as a process involving interactions we need to concentrate on simply facilitating those transactions.

There are perhaps two ways to think about the case for regional reform. One is that we offer subsidies to poorer areas to compensate them for negative shocks. This form of risk sharing may not make sense if the regional or local depression is structural and requires an injection of dynamism. But to thaw out frozen areas of the economy may require heat and light and so the alternative approach is to recognise the gains from trade, promote specialisation and ensure that each region can trade with others at minimal costs. This approach requires more thought to how to allocate funds through the financial system and the role of government in infrastructure development and will contain considerable uncertainty in long run outcomes.

The forces of globalisation have asked questions of the national political settlements in many countries. The current configurations of fiscal transfers may reflect the old patterns of work and employment and have yet to evolve radically to deal with the challenges of the New Economy. I suspect the country’s regions and sectors will continue to show an economic divide for some time to come. One may even be tempted to argue that regional issues may be the dominant theme of this century.