Shrink the City and you’ll pay a heavy price

Anatole Kaletsky

Mortgages will be harder to get, we’ll have fewer foreign holidays and Britain will be less equal. Sound like a good idea?

At least there is one thing that all sensible people in Britain can agree on. The country’s financial institutions are overheated (to quote Gordon Brown) and bloated (Lord Turner of Ecchinswell); their behaviour is totally unacceptable (George Osborne) and outrageous (Vince Cable). Everyone seems to believe that Britain’s financial sector is too big, whether in its overall level of activity or in the amount of money the banks, insurance companies and hedge funds suck in from the non-financial economy and then pay out to their shareholders, employees, tax collectors, landlords, lawyers, computer engineers, receptionists, cleaners, taxi drivers, publicans and other suppliers.

The case for the defence of Britain’s financial businesses, which the banks and insurance companies have been characteristically incompetent at making, begins with the long list of stakeholders at the end of the previous paragraph. The question of whether bankers should make less money and whether this money should be paid in fixed salaries or bonuses is a secondary one. So, too, is the issue of whether banks should be subject to legislated incomes policies, as proposed by President Sarkozy, or whether the responsibility for controlling financial salaries should fall on the sleepy shareholders, who have been fleeced by bankers’ extortionate pay demands.

Neither of these should be confused with the much more important issue of whether the financial system is too large, too dominant and too active for the good of Britain’s economy and society. And whether, as a consequence, the British Government should take action deliberately to reduce its size, as suggested last week by Lord Turner, chairman of the FSA.

Gordon Brown is, to his credit, one of the few politicians in Britain to grasp the distinction between these issues. He showed this again on Tuesday in his response to goading from, of all people, the editors of the Financial Times: “We have got very big financial, business and legal skills in London and I’m one for saying that we mustn’t ever downplay these great attributes in location, the concentration of activities and our historic advantages. So I think the strategy for renewing London for future years is one of emphasising our strengths.”

In saying this, Mr Brown was, of course, directly contradicting Lord Turner. And there are three profoundly important reasons why the Prime Minister is right and the FSA chairman is wrong.

The first is that Britain’s financial sector makes a crucial contribution to the prosperity of every other part of the economy, and one very hard to replace. In principle, other industries could supplant finance as the main driving force of the economy, but to do this would require a big decline in British wages and living standards relative to the rest of Europe and the world.

This is because Britain clearly has what economists call a comparative advantage in financial services; companies and workers based in Britain can generally earn more in this business than in most other industries. And the more Britain specialises in its areas of comparative advantage, the higher will its living standards rise.

This does not mean that everyone in Britain must work in finance, since the economy has plenty of other sectors with comparative advantage, from entertainment and higher education to pharmaceuticals and aerospace engineering. It does mean, however, that Britain has a strong national interest in encouraging the growth of international finance, even if other countries want to curb it.

For Britain to propose an international tax on financial services is therefore like France proposing an international tax on wine or Germany on luxury cars. As far as I can see, there are only two possible justifications for British politicians or regulators to back such proposals, but these lead, ironically, to the two other reasons why Mr Brown is right and Lord Turner wrong.

It is often suggested that finance is now a business in long-term decline, like coalmining in the 1970s, and the sooner Britain gets out of this sunset industry the better. This argument, based on a year’s experience after the collapse of Lehman, is extremely short-sighted.

It is true that the world is going through a cycle of debt repayment and this may curb financial activity for another year or two. But unless globalisation and the rise of Asia are completely reversed, international trade will, in the long run, grow as rapidly as in the past decade.

This trade will continue to generate enormous capital flows and financial activities around the world and, if this happens, Britain will gain at least as much wealth from keeping its comparative advantage in international finance as Germany and Japan do from specialising in machine tools and cars.

But what about the social costs of hyper-finance? This is the third and least persuasive argument for curbing financial activity in Britain. Politicians and the media seem unanimous in believing that the damage done to British society by excessive borrowing, financial innovation and income inequalities far outweighs any possible economic benefits from specialising in finance. This is ultimately a moral question on which opinions will differ. But to make up your own mind, consider the following questions:

• Should first-time homebuyers be able to borrow 80 or 90 per cent of the value of their houses, as they do today, or should they be required to live with their parents until they have saved enough money for deposits of 30 or 40 per cent, as they did until the 1980s?

• Should working-class families own their own homes, as they do today, or should they mostly live in council houses and rented accommodation, as they did until the 1980s?

• Should people on modest incomes take their children on foreign holidays while they are still young, as they do today, or should they have to wait until they are in their forties, as they did until the 1980s?

• Should pensioners have the chance to realise some value from their homes without moving out, as many can today, or should they be forced to sell up if they want to avoid penury, as they did until the 1980s?

These and many other changes in British society have resulted directly from financial innovation, underpinned by such evils as financial derivatives and debt securitisation.

The growth of Britain’s financial sector may have widened income inequalities but that does not mean it has made British society more unequal. In fact, financial innovation and the availability of debt have dramatically narrowed the inequalities in aspirations and lifestyles. If British voters really want to stop or reverse financial innovation, they are entitled to do it. But the economic and social consequences may not be what they expect. (Anatole Kaletsky, The Times)


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