The British are a lost tribe – disoriented, brooding and suspicious. They have lived through the biggest bank bail-out in history and the deepest recession since the 1930s, and they are now being warned that they face a decade of unparalleled public and private austerity. Yet only a few years earlier their political and business leaders were congratulating themselves on creating a new economic alchemy of unbroken growth based on financial services, open markets and a seemingly unending credit and property boom. As we know now, that was a false prospectus. All that had been created was a bubble economy and society. Yet while the country is now exhorted to tighten its belt and pay off its debts, those who created the crisis — the country's CEOs and bankers, still living on Planet Extravagance, not to mention mainstream politicians — all want to get back to "business as usual": the world of 1997 to 2007.

This is an affront to Britain's deep sense of fairness – a belief that one should receive one's due deserts in proportion to whatever good or bad one has contributed. This country waits in orderly queues, tries to abide by the rules and profoundly believes in fair play and the rule of law. Yet what is happening at the moment offends every canon of fairness. Most of the working population do not deserve the degree of austerity and lost opportunity that lies ahead of them. It was not their behaviour that created the biggest peacetime public deficit in history, the credit crunch and the business models built on the fiction that it could all continue for ever. Yet while they suffer, those who did cause the crisis have got away largely scot-free. They have exploited their luck and avoided any significant contribution to repairing the calamity they have wrought. No substantive reform has ever been suggested. Rowan Williams, the Archbishop of Canterbury, has suggested that an essential precondition for social closure is that politicians and bankers acknowledge and apologise for the mistakes they made. So far, any apologies and acknowledgements have been mealy-mouthed or half-hearted. There has been nothing to match the scale of the disaster.

Even if such repentance were forthcoming, the mistakes of the recent past, and the disfiguring unfairness that has so surrounded both the recession and the recovery, cannot be quickly forgotten. If the lessons are not learned, they will surely be repeated. The next financial crisis will be even larger, it might even overwhelm the state, and the public anger will be rightly awesome. Nor can any healthy economy and society in future be constructed on provenly rotten foundations. There must be change. It has fallen to the Conservatives and Liberal Democrats in coalition to attempt some, if not all, of the necessary initiatives that might change British capitalism – notably banking and political reform – but it is an open question how determined it will be before well-organised defence of entrenched and privileged positions by the financial, media and bureaucratic elites. Worse, its repudiation of Keynesian economic policies in circumstances that demand more Keynesianism than at any time since the 1930s threatens to overwhelm its best intentions. The consequences are a potential national calamity.

The unbalanced structure of economic growth over the past decade has fed straight through to a disastrous social geography, bypassing the least advantaged and rewarding the wealthy. Throughout the country the poor and disadvantaged live in ever more concentrated wards that are blighted by run-down social housing and over-stretched schools. Within a single regional health authority, those in the most well-off ward can typically expect to live for 14 years longer than those in the most deprived ward. The roll-call of the deprived is bitterly familiar: east London's Hackney and Tower Hamlets, Liverpool's Knowsley, parts of Manchester, Middlesbrough and Rochdale continue to reel from deprivation, while local authorities like Richmond upon Thames, Kensington and Chelsea and Forest Heath in east Suffolk power on. The New Labour government attempted to alleviate this polarisation through interventions such as Sure Start – a national network of children's centres to support young families – investing in social housing, incentivising work, developing apprenticeship and trying to improve failing schools. At best, it achieved small gains and held the line; at worst, its initiatives were overwhelmed by the way in which the economy has developed.

Everywhere there is pressure to control and repress the social consequences of a two-nation Britain. Ever more sophisticated CCTV policing the fortresses of the rich and the desolate housing estates of the disadvantaged has become the iconic social intervention of the age. Hysterical tabloid campaigns create mob justice around incidents of child neglect and sexual abuse. Of course, Haringey social services were terrifyingly ineffectual in the terrible case of "Baby P"; and the Soham murder case revealed the hopeless inadequacy of paedophile-checking procedures. But the atmosphere during both made the Salem witch trials look calm. Consequently, the results – a national system for monitoring millions of adults who are in regular contact with children and a crisis in recruitment for social services– are self-defeating and even irrational. The new coalition government promises to be more liberal. But liberalism surrounded by this capacity for hysteria is likely to be hard to sustain.

It has been the same story with respect to immigration, Europe and the early release of prisoners. Terrified of media censure, the Labour government became ever more authoritarian in response to newspaper campaigns against supposedly antisocial or deviant conduct. So there were populist clampdowns against drug-users and ever-longer prison sentences for offenders, while anyone who dared to question the effectiveness of such policies was shouted down or ignored. For instance, the Drugs Advisory Panel was crippled by resignations as one scientist after another became disillusioned that drugs policy was not being driven by evidence but by the prejudices of the tabloids. Conservative politicians are even more susceptible to the same forces and offer few principled, well-thought-through alternatives. The open question is how long their new partners in government, the Liberal Democrats, will be able to resist these pressures.

The economic bubble, which created a new class of super-rich, fostered social polarisation in other profound ways – the increasing value of skills, the importance of self-presentation and differential access to the wired world of the internet. Britain boasts a burgeoning super-rich sector: there are 47,000 people in this country with an average pre-tax income of £780,000 a year. Another 420,000 have pre-tax incomes of between £100,000 and £350,000. Nearly all of them are male, white and live in the south-east. There is a growing class of "knowledge workers", who reflect the fact that the dynamic parts of the knowledge economy – hi-tech manufacturing, the creative industries, health, business services, education and ICT – need well-qualified and skilled people. But below them are 10 million adults who earn less than £15,000 a year. Few are knowledge workers, and their chance of self-improvement is minimal. Two million children live in low-income working families. Those at the top have enjoyed a world of excess. Financier- cum-retailer Sir Philip Green set the gold standard for conspicuous extravagance when he spent £4m on his son's bar mitzvah in a specially built temporary synagogue on the French Riviera and £5m on his own 50th birthday party in Cyprus. His wife, Tina, got into the spirit of the occasion when she gave her husband a gold Monopoly set, complete with diamond-studded dice. Of course, the properties on the board represented those owned by Green himself. Financier Joe Lewis paid £1.4m for a single round of golf with Tiger Woods. Venture capitalist Ronald Cohen, adviser to Gordon Brown, excavated under his garden in London's Notting Hill to build a £1m private underground swimming pool for his £15m mansion. The Financial Times's "How to Spend It" section provides a window into incredible opulence: the December 2009 edition featured such "über-complex" watches as the Jaeger-LeCoultre Hybris Mechanica Grand Sonnerie (yours for 1.8 million euros) as well as a silk-brocade coat for £7,170. In September 2007 the sale of Damien Hirst's extraordinary platinum skull encrusted with 8,601 flawless pavé diamonds – titled For the Love of God? – to an investment consortium for $100m defined the top of the boom and the character of the age. The purpose of art had become the celebration of astronomical wealth as a luminously decadent death mask, corrupting both the artist – who was reduced to playing the money game – and any buyer who fell for the ruse. Money ruled everything.

Yet the knowledge that such ostentatious consumption is possible has a shadow effect on every British citizen. Individual human beings instinctively compare themselves and are sensitive to what the whole of society values. Anxiety follows when we cannot compete with others to achieve whatever confers status. Today, philanthropy or living according to a particular moral code does not confer status. Only money is able to do that. People start to question whether vocational career choices – in farming, teaching, medicine or science – make any sense when society rewards them so lowly while rewarding finance so highly. Material values start to crowd out altruism, philanthropy and restraint. Two incidents in September 2007 highlighted the new values. Lance Bombardier Ben Parkinson, who lost both legs after a landmine exploded in Afghanistan, was offered £152,000 compensation by the Ministry of Defence. The very same week, Eric Nicoli left his job as CEO of EMI – having failed to turn around the company – with a pay-off of £3m.

Members of the upper middle class increasingly live in gated communities or neighbourhoods where the price of houses is so high that ownership is available only to the very rich. It is a form of social apartheid. Social mobility has stagnated. The next generation of professional men and women will have been educated in ever-richer families. Private education as a passport to the upper echelons of British society has become more important: 55% of top journalists, 70% of finance directors and 45% of top civil servants were privately educated. Yet private schools educate only 7% of the total school population.

The political system and principal parties intensify the problem rather than relieve it because the latter are in thrall to populism and the 24/7 news agenda. Policy is driven by populist initiatives or managerial solutions, with the parties competing over who will be most effective at reducing the deficit, eliminating waste or coming up with the latest wheeze to tackle some social problem or other. Their decline as mass-membership organisations commanding strong identification and affiliation certainly predates the bubble, but that process has accelerated during it.

The interaction between diminished parties trying to appeal to the centre, a powerful populist media and Britain's highly centralised constitution has been toxic to good government. Blair and Brown completed what Thatcher began – the concentration of power at the centre in order to control the news agenda. No 10 has grown into a new royal court, complete with courtiers and factions. Government press officers have grown by 10 times and now number 3,200, a total that the coalition government, for all its rhetoric, will struggle significantly to reduce. The spinning of a media that itself spins is inevitable, but it progressively undermines the legitimacy of politics. For its part, the House of Commons is now more in thrall to the party leaderships than ever before. MPs' expenses claims for moat-cleaning, duck-houses and clock-towers – not to mention the occasional pornographic video – underlined the loss of democratic purpose and vocation among the foot soldiers of the political class. Tony Blair's disregard for the House of Commons was complete: he dropped in for only 5% of the votes, and did not even stay to listen to the Iraq debates. Many laws are barely scrutinised before receiving the royal assent. Political reform has not so much invigorated British democracy as redistributed power from central to local elites in Cardiff and Edinburgh, and sideways to life peers in the House of Lords and judges. The opportunity for more ambitious reform has been squandered. All this is placing core British values in flux. If Britishness once meant a combination of kindness, instinctive liberalism, deference before well-understood social values, belief in fairness, respect for parliamentary democracy, inquisitive internationalism and an understated sense of national purpose, it is dissolving before our eyes. If anything, kindness and liberalism have become objects of scorn. The public domain is now dominated by the tabloid bully, the professional mocker, the seeker of celebrity and the xenophobe.

Worry and concern have replaced pride and faith in Britain and its institutions. One local politician captures the mood: "We don't make anything any more, we don't own anything any more. It's an absolute disgrace. The country's just knackered. People have given up hope. They don't believe in anything, not in themselves, not in their neighbours, not in their history." The speaker is Bob Bailey, former leader of the BNP on Barking council. His party's policies may be a repulsive anathema based on the rank prejudice that alien foreigners are to blame for everything that is wrong with British society – and if they were ever implemented they would be a racist, fascist disaster. But the prejudice behind his sentiments speaks for a growing body of working-class opinion. British society may not yet be broken, as not only the BNP but the Conservative Party has claimed, in the hyperbole of the age. But it is certainly very wounded.

All three principal parties have begun to search for a moral voice, and "fairness" crops up increasingly in the language of all of them. Nick Clegg wants to hard-wire it into Britain's DNA. The coalition agreement purports to promote it. Labour campaigned for a future that is "fair for all". The political class has read the runes: fairness is the new moral mantra. So, at a minimum, we now need our economies and our societies to be fair. But what do we even mean by fairness?

We need a shared understanding of what constitutes fairness in order to restore our society. At present, there is none. The rich argue that it is fair for them to be so wealthy, in much the same way as Athenian noblemen believed that their riches were signifiers of their worth. They believe they owe little or nothing to society, government or public institutions. They accept no limit or proportionality to their wealth, benchmarking themselves only against their fellow rich. Philanthropic giving is declining; tax avoidance is rising; and executive pay is rising exponentially. All three are justified by the doctrine that the rich simply deserve to be rich. Meanwhile, the poor, in their view – and that of a virulent right-wing media – largely deserve their plight because they could have chosen otherwise. The mockery of chavs is premised on the assumption that they could be different if they wanted to be. The poor could work, save and show some initiative. So why should we indulge them by giving them state handouts?

This lies behind the arrogance with which bankers still defend their bonuses, in spite of everything that has happened over the past few years. They are private contracts, insists Sir George Mathewson, former chair of RBS, in which the state has no right to interfere. They are necessary to retain the best, and thus the health of an industry from which the entire country benefits, argues Standard Chartered's CEO Peter Sands. Their wealth is only fair.

When the Labour government announced a one-off tax on bank bonuses in December 2009, City and bank spokesmen warned of a mass exodus. The threat was that they would leave the country rather than pay a tax to contribute to clearing up the mess they had created. Such a tax was not fair, they said. There is no better example of the principle of fairness being grotesquely distorted. The bankers were using it simply as a rhetorical device to justify their unwarranted position as an overpaid financial elite.

This moral edifice must be challenged before any reform can be attempted. The principle of "just deserts" is a key part of our culture. We are not flat-earth egalitarians. But nor do we share the view held by the private-equity or hedge-fund partner in Mayfair that wealth is a signifier of personal worth in its own right. We believe it has to be earned, and we believe the rewards should be commensurate with the discretionary effort. Proportionality is a key value. Its trashing by those at the top of the financial and business community risks an angry populist backlash fuelled not by envy, as they airily claim, but by a visceral human instinct.

This definition of fairness is a radical idea. It is not egalitarian; it is demanding. It challenges the economic and moral questions that have been ignored over the last two decades – the tolerance of towering disparities in wealth and power and the blind faith in individualism and markets. It is why we now need a Truth and Reconciliation Commission for British capitalism – to examine what happened over the last 10 years, apportion blame, demand atonement and use the lessons learned to build something better in the future. Open competitive markets that deny monopoly and offer proportional returns to productive entrepreneurs are the handmaidens of genuine wealth creation; monopoly and market rigging that reward the incumbent and unproductive are its enemies. Britain has too little of the former "good" capitalism and too much of the latter " bad capitalism", one of the reasons it incubated the forces that created the financial crisis. To repeat: fairness is the indispensable value that underpins good economy and society, and it will be the foundation stone of any sustainable new order.

Britain in 2010 is at a crossroads. It has to devise a new way of making its living in the world because the big bet on big finance, property and construction didn't pay off. A wave of new possibilities driven by science and technology is creating fantastic opportunities, but if we do not seize the moment we risk becoming an economic backwater. Britain has to create a national innovation system by increasing investment in research, disseminating new technologies, building great young companies, promoting open access and competition, mobilising finance and revolutionising its approach to education, training and learning. In other words, it has to do nothing less than rethink its whole approach to capitalism in order to unleash a flood of productive entrepreneurship.

This will mean rethinking how ownership is discharged and companies innovate and grow. The City of London must be recast from top to bottom. It will mean creating a pool of workers who are prepared to accept more risk and actively manage their careers in an era of churn and change. The knowledge economy is the future, but this is not just about science, technology, digitalisation and the onward march of creativity. It is about helping the British to become authors of their own lives. It is a revolution of the mind.

The growth of public debt must be capped and Britain's budget deficit reduced. This must be done quickly enough to reassure the financial markets that they are not financing a banana republic but not so fast that it devastates the economy by withdrawing public demand when private demand is already crippled (and when banks are nervous about accepting new risks).

Revenue must be raised – with the baby boomers contributing disproportionately – and the state reshaped so that the universal services as well as welfare provision for the disadvantaged can be maintained. Public sector managers and workers will have to contemplate change, inventiveness and responsiveness on an unprecedented level. The essential "publicness" and universality of services cannot be compromised, but everything from the armed forces to the NHS will have to devise ingenious ways to do more with less. In this respect, the early economic pronouncements of the coalition government were disheartening: too much emphasis on deficit-cutting, too few ideas about how to encourage growth and a lack of subtlety about how to manage an economy in the wake of a credit crunch.

Social polarisation must be halted and reversed. Britain cannot confront its challenges if great swaths of its society are disenfranchised and marginalised. Potential talent cannot be allowed to stand idle; potential opportunity cannot be squandered. Our ailing cities and neighbourhoods must be given their chance. We need to educate the mass of our people to a new level, teach them to use their brains in ways that their 20th-century predecessors never thought possible. This will then trump, or at least mitigate, the familiar cultural icons of class.

Fairness is the value that must saturate and animate the reinvention of British capitalism, our society and the reshaping of the British state. The current British political system and the British media are both in urgent need of reform. If British citizens are to become the authors of their own lives and the drivers of a national renaissance, they need reliable sources of information, genuine opportunities to participate in the political life of the country, and politics itself to possess the power to make a difference. Herd-like, populist, conservative media that disregard the impartiality of fact, do not hold the powerful to account, trivialise the quest for objectivity and, above all, trash plurality – the vital precondition for democratic deliberation – lets down the whole country.

Britain needs to embrace democracy rather than simulate it. Too much power is concentrated at the centre while there are too few checks and balances, too little fair representation of plural strands of opinion and not enough national deliberation and debate. National rejuvenation demands a vibrant democracy that empowers the government of the day to take on incumbent elites and monopolists and build a powerful, legitimate national narrative. Fortunately, the new coalition government seems to appreciate this, and has already outlined its commitment to political reform.

The rest of the world is confronting multiple challenges too. Growth must be progressively decarbonised to limit atmospheric concentrations of "CO2 equivalent" to 450 parts per million, a level that is believed to be consistent with a global average temperature increase of about two degrees centigrade. During the 2010s the foundations will be laid of an economy and society that must burn less fossil fuels and generate a lower carbon footprint. A start must be made on transforming the civilisation that was built on the car, the suburb and cheap individual mobility.

Britain needs to get its house in order, both for itself and because the decades ahead are going to be more turbulent than any since the end of the second world war. There are new centres of global economic and political power; new risks; and new, dangerous ideologies. Britain cannot be inward-looking, nationalist, Eurosceptic or conservative in this emerging environment. However, little of this registers in the popular consciousness.

If the 2010s are not to trump the 1970s as the bleakest most paranoid decade since the war, then there needs to be both a frank acknowledgement of what went wrong in the 2000s and an articulation of where the country must go next in terms of necessary investment, reform and change. Crucially, there also needs to be an appreciation of the values that must underpin all this. This old country, part of an old continent, has to the find the energy to remake itself. Denial and avoidance of unpleasant realities are fundamental human emotions, as common among armies after defeats as they are among bankers after a credit crunch. When George Orwell returned from the Spanish civil war, he could scarcely believe the late 1930s England that greeted him: "Down here it was still the England I had known in my childhood: the railway cuttings smothered in wild flowers… the huge peaceful wilderness of outer London… the pigeons of Trafalgar Square, the red buses, the blue policeman – all sleeping the deep, deep sleep of England, from which I sometimes fear that we shall never wake till we are jerked out of it by the roar of bombs."

Today, England is in another deep, deep sleep in the aftermath of the financial crisis, hardly disturbed by the disaster through which it has just lived, let alone the challenges ahead. Yet the country needs rousing, and fast. The new coalition government, excited by being in office at all, has offered its negotiated programme of government – a remarkable first in British politics – as the means of waking the country. Of course, it contains some good policies.

But if this government is to preside over a transformation, the precondition will be a rediscovery and a reanimation of a core set of moral values that can unite it while giving edge and energy to all of our thinkers and doers. Above all, a wholesale commitment to fairness is vital. Fairness is the essential handmaiden of reform.

© Will Hutton