Britain is beset by a crisis of purpose. We don’t know who we are any longer, where we are going or even if there is a “we”. The country is so passionately attached to past glories because there are so few to celebrate in the present. The crisis is compounded since we have been told for 30 years that the route to universal wellbeing is to abandon the expense of justice and equity and so allow the judgments of the market to go unobstructed. Private decisions in markets supposedly are morally and economically better than any public or collective action. As a result the sense of the “we” that binds a society together and gives us reason to belong is being lost. We take refuge in looking after number one, because there is no sense in, nor reason for, doing anything else.

The inevitable consequence is a decline in public integrity and a new carelessness about others. This amoral deficit of integrity takes many guises. It is sky-high executive pay, out of proportion to effort or contribution. It is the phone-hacking scandal. It is the too frequent lack of duty of care to workforces and customers alike. It is the careless, indiscriminate sale of so many of our public and private assets. It is the unwillingness to find ways of investing in ourselves, while we look so regularly to foreigners to revive our industries or build our infrastructure. It is the crisis of trust in our politicians. It is the uncontested acceptance that our children confront a worse world than we faced ourselves – from the size of mortgage they will need to buy a house to lower pensions. It is the new hostility to openness, and the zeal to blame so many of our homemade problems on foreigners, immigrant workers and the European Union. This is all the more tragic because if it were able to regain purpose and integrity, driving forward a cluster of feasible reforms, Britain could be one of the best countries in the world. There is a lot going for this country – from great universities engaging in important research to a deeply held belief in the rule of law; from a stirring entrepreneurialism to the fair-mindedness of our society. When there is some discovery of purpose and the unity it brings – as in the 2012 Olympics – we surprise ourselves with how good we are.

The principal obstacle to the recreation of a sense of we – and along with it the shared vision, ambition and purpose for the country which is the necessary precondition for the extensive reforms that are needed – is inequality. Inequality is like a slow-growing but untreated cancer; it can grow with little apparent effect for a long time while the sufferer lives in happy ignorance. Occasionally there may be unexplained physical weaknesses and complaints that suggest something is awry, but other, less alarming explanations than cancer seem both more likely and comforting. Then suddenly the cancer begins to metastasise with catastrophic effects, but it is too late to stop its now obvious spread, and the implications are often fatal.

Societies, unlike individuals, do not die. But the cancer of inequality produces results that are equally catastrophic. Trust evaporates. There is no sense of common purpose. Creative social, economic and political interaction and deliberation becomes impossible. Capitalism distorts itself and ceases to innovate. Electorates become vulnerable to extreme populism from left or right.

A volunteer at Drumchapel food bank near Glasgow: a warning of trouble ahead. Photograph: Danny Lawson/PA

So far Britain has tried to explain the riots of August 2011, say, or the growth of food banks, in less alarming terms than potentially catastrophic poverty, but in truth they were warnings of trouble ahead. In 2015 it is becoming clearer that we are arriving at a tipping point – a moment when unchecked inequality of both income and wealth is about to metastasise into a serious economic and social cancer. It is inequality that is behind the unsustainable growth of poverty, ill-health and the welfare bill. It is inequality that has propelled the escalating demand for credit. It is inequality that has helped create our fragile banking system. It is inequality that is disfiguring the housing market, with house prices out of reach for first-time buyers as waiting lists for social housing extend to 1.7 million, and a new class of multi-millionaire buy-to-let landlords have become an unwelcome part of the social tapestry. It is inequality that has turned too many aspirant entrepreneurs and top managers in our society into seekers of easy profit, with calamitous consequences for investment, innovation and productivity. It is inequality that is contributing to the collapse in trust in politicians and the democratic process; they are, runs the popular cry, all the same. The growth of inequality is both a warning of the growing dysfunctionality of our capitalism and the principal obstacle to addressing it.

Ever since Mrs Thatcher’s election in 1979, Britain’s elites have relegated concerns about inequality below the existential question of how to restore our capitalist economy to economic health, a matter deemed to transcend all other considerations. The language of the socioeconomic landscape has been commanded by words like efficiency, productivity, wealth generation, aspiration, entrepreneur, pro-business and incentives. To the extent they are significant at all, preoccupations with inequality have been seen as of second-order importance. Some Conservative politicians, notably Boris Johnson in a high-profile speech, even defend inequality on the grounds that it is the natural consequence of some having higher IQ and energy than others, which translates into entrepreneurial success. Inequality is thus the price that society pays for the economic vitality brought by its high energy, high-IQ individuals, along with the rewards they expect and deserve.

Boris Johnson and his fellow Conservative apologists may argue that the rich deserve their income and wealth – the rich certainly think that – but the sheer disproportion between what is now earned by the top 0.1% and what they contribute economically undermines the conceptions of proportionality and due desert that define fairness. Inequality has now reached levels that have become a challenge to us as moral beings. Fairness is a deeply ingrained human instinct: a normative view, with which every human being is endowed, that there should be a proportional relationship between what you do – good or bad – and the consequences. Of course adjustments are made to reflect luck and accident, especially luck that you have made yourself by your own diligence or lack of it. Professor Ronald Dworkin differentiates brute luck – the chance luck of happy or unhappy accident – from earned, deserved luck – option luck as he called it – resulting in part from your own efforts. Brute luck, whether the good luck of being born privileged or the bad luck of being born with genes that dispose one towards ill health, deserved either the taxation of inherited estates (inheritance tax – not a death tax but a we-share-in-your-good-luck tax) or compensation through collective insurance (social insurance or tax-financed public health systems). The option luck of your own efforts – the luck of the concert pianist or sportswoman who achieves success through working hard on their original talent – is their due desert.

In 2015 the scale of income at the top and desperation at the bottom drives a coach and horses through any sense that the distribution is fair. This is brute luck in action. The average pay for the chief executives of Britain’s top 100 companies has quadrupled in a generation. Few would argue that such a pay increase is proportional to their effort or to their economic contribution, or that it is deserved. During the New Labour years the gap between the bottom and the middle of the income parade narrowed a little, with significant improvements in the relative living standards of low-income families with children and of pensioners, but there was little attention to incomes at the top. For 20 years the great British inequality machine has hurtled on, driven largely by the burgeoning incomes of this top 0.1% – almost all of whom are directors, bankers or work in business services and real estate – who captured the lion’s share of any gains in real productivity. In 1995 they took 3.2% of all income; by 2009 that had more than doubled to 6.5%, falling back to 4.8% in 2011 as bonuses fell during the recession.

This growth in pay at the top has little to do with real merit. Top pay is much lower, for example, in mainland Europe and Japan – and even lower in the US, once adjusted for the size of the corporations under management. British executive pay is the highest in the world. British executives have had the brute good luck to be in post in a period when profits as a share of GDP are rising, unions are weak and an “arms race” of executive pay has developed, propelled by ever more grandiose giveaways of shares justified by attempts to incentivise “performance”.

French economist Thomas Piketty believes the ideology of “meritocratic extremism”, the doctrine that extravagant pay is justified by the merit of performance, has hardened into an Anglo-Saxon social norm. Photograph: ERIC PIERMONT/AFP/Getty Images

French economist Thomas Piketty, in his book Capital, calls this the ideology of “meritocratic extremism”, the doctrine that extravagant pay is justified by the merit of performance. He considers it to have hardened into an Anglo-Saxon social norm. He is right. As I noted in the review on fair pay I undertook for the UK government, the way in which decisions are made as to how large bonuses and incentive plans should be is hardly scientific enough to argue that there is a robust link with performance. For example, bonuses of 200% have become routine; but why do so many companies use such rough and ready round numbers – hardly a sign that anybody has thought carefully about what is needed to produce performance and much more like a pure bung – and then accompany them with requirements for their eligibility that are far from demanding and transparent? The truth is that remuneration committees are engaged in a pay arms race in which everyone is trying to ensure that their executive team is in the top quartile of pay – and what constitutes top-quartile pay is not some objective incentive, but a socially determined norm that is always on an upward ratchet.

For example, the Fair Pay Report noted that one of the best determinants of any CEO’s pay in the US was the size of his or her social network. The more examples of highly paid members there were in one’s network, the more generous a remuneration committee felt it had to be. “Super-salaries”, as Piketty calls them, thus have almost nothing to do with carefully calibrated performance and everything to do with the attempts of CEOs and boards to keep up with each other in a status race substantially influenced by social and psychological rather than economic concerns. In his Theory of the Leisure Class, a book published in 1899 when inequalities in wealth and income matched those of today, economist Thorstein Veblen captured this social dynamic well in his concept of conspicuous consumption. There is a logic to the need of the already very wealthy for more wealth: they show it off to demonstrate where they are in the social pecking order. Veblen writes that, while the livery worn by personal servants, the nature of pets and the grandeur of parties may seem to be economically irrational if not futile, to the very rich these are subtle, socially honed indicators of standing.

For example, rich men’s wives at the end of the 19th century had a particularly important role, he argued, as highly visible “ceremonial consumers of goods”. The sophistication of the household they ran, the quality of its furnishings and the extravagance of their clothes indicated the standing of their husbands.

We now live in an era of “conspicuous reward”. Bonuses have become what wives’ dresses and servants’ livery were in the 1890s: signs of worth. Moreover, Veblen observed that the choice of what the rich conspicuously consumed was very important: one of the reasons sports such as shooting and yachting attracted such spending was that they were the best ways of acting in a peaceful way on predatory, aggressive, “aristocratic” behaviour – character traits the very wealthy were anxious to show they possessed.

Similarly, the successful CEO today shows the predator instincts behind his success by doing something extravagantly but peacefully competitive – taking part in the America’s Cup (Larry Ellison, CEO of Oracle), ballooning (Richard Branson) or racing at Le Mans. Owning an island in the Pacific (Ellison owns Lanai in Hawaii) or the Caribbean (Branson owns Necker Island in the West Indies) shows your need for extreme privacy and luxury – the quintessential expression of a natural aristocrat. Meanwhile, your exquisitely dressed partner – usually but not always a wife – runs an elegant mansion in Manhattan or central London. The sexes may have grown more equal between the 1890s and the 2010s, yet it is still women – as wives – who are typically leaders in “ceremonial consumption”.

The problem is that these are no longer the harmless peccadilloes of the super-rich, presented as fundamental to incentivise performance. Rather, the US and British economies are increasingly being run in order to deliver these lifestyles, with disappointing wider economic results.

But there is an additional twist. One of the fastest ways of boosting profits in an era when trade unions are weak and union representation in much of the private sector has collapsed is to downgrade employees’ terms of employment and working conditions, and reduce wages. Managements’ bargaining power has been further increased by the threat – and sometimes the reality – of moving work offshore, and, since the accession to the European Union in 2004 of eight new members, which lifted inward migration levels from the EU by some 100,000 a year, by a larger pool of incoming migrant workers ready to work for keener wages. Over the last generation, the weakening of trade unions’ countervailing market power has seen around 5.5% of GDP being moved permanently from the workforce to shareholders.

Average real wages at first stagnated and are now falling . Indeed between 2008 and the end of 2013, as an important study published by the National Institute for Economic and Social Research shows, real annual wages fell for the typical worker by 8%, or £2,000 – a fall the report describes as unprecedented. The falls for young people up to the age of 29 were even greater – 13% for 25- to 29-year-olds, 14% for 18- to 25-year-olds. Part of the explanation is that the growth in productivity has become negligible. This is compounded by top “super managers” ensuring that whatever paltry gains are made go not to workers but to profits, which then inflates the share price and, via related bonuses and incentives, those managers’ own remuneration. There has been, as Guy Standing remarks in The Precariat, an orgy of regrading and redefining jobs as less skilled so that they qualify for lower wages; there has also been a growing confidence that employers do not need to pay higher wages in every annual wage round.

The weakening of trade unions has been central to this process; the popular view that the fall in wages is entirely because of immigration is wrong. It is true that immigration has had some impact in some areas, like semi-skilled and low-skilled service jobs in the period up to 2008. But the fall in wages after the recession in 2008, when net migration levels were falling, confirm the view that immigration can only be part of the story. The bigger picture is how the deregulated labour market has interacted with companies whose strategy is driven by shareholder-value maximisation, and with the incentives offered to the super-managers. These raw trends are then exacerbated by the reduction of taxation on capital, companies and higher earners in the name of promoting incentives and “wealth generation”, and reducing social benefits in the name of capping the welfare bill and discouraging “shirkers”. The cocktail is complete.

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 income equality “league table”. 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 socio-economic crisis through which we are living is possible without addressing it. Britain’s capitalist economy is not working effectively, even while inequality has surpassed the levels of Edwardian England.

Ever since Margaret Thatcher’s 1979 election victory, ‘Britain’s elites have relegated concerns about inequality below the existential question of how to restore our capitalist economy to economic health’. Photograph: Tim Graham/Corbis

Simply to own capital in a period when its returns are rising faster than economic growth is to find oneself wealthier through no effort of one’s own. Since the 1970s, wealth in the UK has risen twice as fast as income. Once the returns on capital – invested in anything from buy-to-let property to a new furniture factory – exceed the real growth of wages and output, as historically they always have done (excepting a few periods such as 1910 to 1950), then inevitably the stock of capital will rise disproportionately fast within the overall pattern of output. Wealth inequality rises exponentially.

Anyone with the capacity to own capital in an era when the returns exceed those of wages and output will quickly become disproportionately and progressively richer. The incentive is not to be a risk-taker, but rather to collect rents from the assets you hold – from property to patents: witness the explosion of buy-to-let. Our companies and our rich don’t need to back frontier innovation, or even invest to produce; they just need to harvest their returns and tax breaks. Tax shelters and compound interest will do the rest.

Capitalist dynamism is undermined, but other forces join to wreck the system. The rich are effective at protecting their wealth from taxation, so that inevitably the proportion of the total tax burden shouldered by those on middle incomes has risen. In Britain, it may be true that the top 1% pays a third of all income tax, but income tax constitutes only 25% of tax revenue: 45% comes from VAT, excise duties and national insurance paid by the mass of the population. The proportion of total tax contributed by inheritance tax, now a largely voluntary tax, has plummeted to £3bn, or less than 0.5% of all UK taxes, which even though it is now forecast to rise with increased house prices is still a sixth of the level immediately after the war. The wealthy have become ever savvier about hiding their wealth – and more capable, in an era of globalisation and free movement of capital, of doing it.

As a result, the burden of paying for public goods such as education, health and housing is increasingly shouldered by taxpayers on average incomes, who don’t have the wherewithal to sustain them. Wealth inequality thus becomes a recipe for slowing, innovation-averse economies, tougher working conditions and degraded public services. Meanwhile, the rich get ever richer and more detached from the societies of which they are part; not by merit or hard work, but simply because they are lucky enough to be in command of capital which over time receives higher returns than wages. Our collective sense of justice is outraged.

The cascade of consequences is formidable. Workers, struggling to maintain their living standards, have borrowed extraordinary multiples of their income to make money in the only other certain way – through the housing market. House prices have been bid up well beyond a sustainable relationship with wages. None of this would be possible without credit. British banks have lent £1.2 trillion in mortgages. But if inequality has fuelled the demand for credit – whether through mortgages or payday loans – it has also helped drive the supply of credit and thus added further impetus to the creation of an extraordinary financial system biased to lend to property and not to enterprise. Recent statistics reveal that one in 10 people over 55 now have assets worth £1m or more, the consequence of owning property and pensions in a period of rising property and share prices. Poorer wage earners left out of the boom have to rent, creating a new class of private-sector landlords whose collective equity is now estimated to top £800bn. Your chance of getting on the housing ladder early or late in life is closely determined by the wealth of your parents: Shelter estimates that parents in aggregate give their children £2bn a year to help them buy their first house. The brute luck of birth thus becomes essential to future housing wealth. Nobody would argue, I hope, that today’s generation of young people “deserve” the British housing market.

Societies where brute luck – of inheritance or of being vested with disproportionately extravagant share options – determines lifestyles and life chances are not just unfair, they become gummed up and unstable. Britain has the capacity to be a genuinely great and innovative country in which the mass of its citizens flourish and its companies spearhead the new. There is plenty of good on which to build. But that requires vision and renewed shared purpose to deliver the necessary reforms and take on the vested interests who benefit from the ways matters are currently organised. It cannot be achieved if we indulge and ignore inequality.

© Will Hutton. How Good We Can Be by Will Hutton is published by Little, Brown (£16.99). To buy it for £13.59 click here