May 21, 2009 7:44 pm

Why Britain has to curb finance

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The UK has a strategic nightmare: it has a strong comparative advantage in the world’s most irresponsible industry. So now, in the wake of the biggest financial crisis since the 1930s, the UK must ask itself a painful question: how should the country manage the cuckoo sitting in its nest?

The question is inescapable. London is one of the world’s two most important centres of global finance. Its regulators have, as a result, an influence on the world economy out of proportion to the country’s size. In the years leading up to the crisis, that influence was surely malign: the “light touch” approach led the way in a regulatory race to the bottom.

The fiscal costs of this crisis will be comparable to those of a big war. Thursday’s threatened downgrade by Standard & Poor’s is a reminder of those costs. Loss of jobs and incomes will also scar the lives of hundreds of millions of people around the world.

All this occurred, in part, because institutions replete with highly qualified and highly rewarded people were unable or unwilling to manage risk responsibly. The UK, as a country, the City of London and the broader financial industry bear much responsibility for this calamity. This is a time for self-examination.

A recent report on the future of UK international financial services, produced by a group co-chaired by Sir Win Bischoff, former chairman of Citigroup, and Alistair Darling, chancellor of the exchequer, fails to provide such self-examination. This is partly because the committee consisted of the industry’s “great and good”. It is far more because Mr Darling had already decided that “financial services are critical to the UK’s future”. Thus, the report’s remit was “to examine the competitiveness of financial services globally and to develop a framework on which to base policy and initiatives to keep UK financial services competitive”.

If you ask the wrong question, you will get the wrong answer. The right question is, instead, this: what framework is needed to ensure that the operation of the financial sector is compatible with the long-run health of the UK and world economies?

Quite simply, the sector imposes massive negative externalities (or costs) on bystanders. Thus, the recommendation “that the financial sector be allowed to recalibrate its activities according to the sentiments and demands of the market” is wrong. A market works well if, and only if, decision-makers confront the consequences of their decisions. This is not – and probably cannot be – the case in finance: certainly, people now sit on fortunes earned in activities that have led to unprecedented rescues and the worst recession since the 1930s. Given this, the industry has become too big. If implicit and explicit guarantees and externalities, including volatility, were fully charged, the sector would surely shrink.

So how should one manage a sector that produces such “bads”? The answer is: in the same way as any polluting activity. One taxes it. At this point, the authors of the report will surely ask: “How can you suggest taxing a sector so vital to the UK economy?” The answer is: easily. Financial services generate only 8 per cent of gross domestic product. They are more important for taxation and the balance of payments. But this tax revenue turns out to be perilously volatile. True, in 2007, the last year before the crisis, the UK ran a trade surplus of £37bn in financial services, partially offsetting an £89bn deficit in goods. But smaller net earnings from financial services would have generated a lower real exchange rate and more earnings elsewhere. Given the costs imposed by the financial sector, a more diversified economy would have been healthier. Such sacrilegious ideas are, of course, not to be found in the Bischoff report.

How then should the UK approach policy towards the sector? I would suggest the following guiding ideas.

First, the UK needs to make global regulation work. It should discourage regulatory arbitrage even if it expects to gain in the short run.

Second, it must, in particular, help ensure that owners and managers of financial institutions internalise most of the costs of their actions.

Third, it must reject egregious special pleading from the industry. The sector argues that moving derivatives trading on to exchangesmight damage innovation. So what? Maximising innovation is a crazy objective. As in pharmaceuticals, a trade-off exists between innovation and safety. If institutions threaten to take trading activities offshore, banking licences should be revoked.

Fourth, while trying to create a stable and favourable environment for business activities, the UK should try to diversify the economy away from finance, not reinforce its overly strong comparative advantage within it.

Fifth, UK authorities need to ensure that the risks run by institutions they guarantee fall within the financial and regulatory capacity of the British state. They should not let the country be exposed to the risks created by inadequately supported and under-regulated foreign institutions. At the very least, they should not undermine other governments’ efforts to regulate their own institutions.

The “old normal” was simply unsustainable. The “new normal” must be very different. It is far from clear that the industry and government recognise this grim truth.

Write to martin.wolf@ft.com
More columns at www.ft.com/martinwolf

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