The performance of developed country labour markets over the past two decades has been dominated by two features previously unknown in the post-war era: persistent long-term unemployment and growing wage inequality among people in work.

In both cases, the unskilled or poorly educated have been the main casualties. Long-term joblessness, whether reflected in unemployment statistics as in Europe or rising inactivity rates as in the US, has been primarily concentrated among men with little or no formal educational qualifications. And, while wage inequality in the US and UK has increased along a number of dimensions (including age and experience), the biggest wage gaps are those which have emerged between well and badly educated workers.

Economists are still arguing about the causes of the decline in labour market prospects for unskilled workers - with skill-biased technological change and competition from low-cost developing countries the main contenders. But there is little disagreement that raising the proportion of skilled workers is the right policy response, with policies to boost investment in education and training.

Yet this skill-based approach might carry dangers too, according to a recent theoretical paper by CEPR Research Fellow, Gilles Saint-Paul. Increasing the earnings and employment prospects for skilled workers may actually compound the problem for those unskilled workers left behind. Over the past two decades, persistent unemployment and stagnant wages for unskilled workers have coexisted alongside a rise, not a fall, in the percentage of the workforce with higher educational qualifications. This, Saint-Paul argues may be an important part of the explanation for the decline in relative wages and employment changes for the unskilled over the past two decades.

Saint-Paul’s model suggests that in a world of malfunctioning labour markets, an increase in the proportion of skilled workers, far from restoring equilibrium, may well lead to further deterioration of the employment prospects for the unskilled and may even possibly increase aggregate unemployment. And it implies that the trend may be self-reinforcing if there are increasing returns to education.

His model assumes that labour markets do not clear perfectly and unemployment rates are inversely related to real wages. But the driving assumption is that, while skilled and unskilled workers are perfect substitutes for each other in production, real wages are more rigid for unskilled than skilled workers.

At the initial equilibrium, the unemployment rate for unskilled workers is higher than that for skilled workers (so that there are positive returns to education). Suppose that the relative supply of skilled workers in the population increases. Perfect substitutability requires wages for both types of workers to fall. But, if real wages rigidity prevents the unskilled wage from falling enough, the unskilled unemployment rate will rise by more than the skilled rate.

The rise in the relative unemployment rate of the unskilled may increase the net return to education and encourage a further increase in the relative supply of skilled workers. The incentive to acquire education thus continues to grow, and the relative wages and unemployment rates of the unskilled continue to deteriorate.

Thus, while ‘increased education’ and ‘training' are often considered a surefire recipe for high employment, Saint-Paul argues for caution. In the model, it is true that the unskilled are more exposed to unemployment than the skilled. It does not follow, however, that a shift from the low-skill to the high-skill equilibrium increases employment, and unskilled workers may actually find themselves worse off.

Saint-Paul argues in a separate paper, however, that this increase in inequality may have other beneficial effects. Rising inequality, while clearly bad for the unskilled, might actually be good for economic growth if it encourages more people to invest in education and training.

A key insight of the life cycle theory of consumption is that a crucial determinant of savings - and therefore wealth and capital accumulation - is the need of workers to provide for their old-age consumption. The level of capital accumulation is closely related to the net savings of wage earners. But, he argues, investment in education and training is a kind of saving - the ten-fold improvement in living standards over the last century would not have been possible without corresponding increases in the quality of manpower and its educational level.

The theoretical problem, at least in the (overlapping generations) models which economists often use, is that the return to an accumulated factor does not contribute to aggregate capital accumulation because it typically accrues to the old, who do not save but instead consume all their income. Human capital is no exception to that rule. Even though it is embodied in the workers, it is indirectly owned by the old (or capitalists) who have previously lent their savings to the young in order to finance their education expenses. The result is to blunt the incentive for young workers to invest in education, and this depresses savings.

Saint-Paul argues that workers' ability to earn extra income or rent from their own human capital, over and above the cost of education, greatly enhances the economy's ability to accumulate. And inequality among workers (which is assumed to arise from different costs of acquiring human capital) is one source of these rents. The return to human capital is equal to the marginal worker's cost of acquiring education. The total rent to human capital is therefore determined by the sum over all educated workers of the difference between that marginal cost and their own individual cost. Inequality increases the gap between inframarginal and marginal workers in terms of the cost of getting educated. So the rent, and therefore total savings, will be higher when inequality is larger.

In short, the existence of a talented elite for whom education is less costly - may foster growth because they will be able to appropriate the benefits from their investment in human capital and later reinvest them in the economy. But this is not the only possible route to higher growth. Public education, funded from general taxation, can play a similar role by giving free education to workers who can then consume the income from their human capital. In Saint-Paul’s world, the case for socialism exists too.