The British governing class has reacted furiously to the European Parliament’s attempt to limit bankers’ bonuses. Once again their central argument is that it is a threat the wholesale financial services businesses that are based in the City of London, which they say is critical to the British economy as a whole. This is an argument that is regularly wheeled out by not just the establishment, but even by normally sensible commentators such as The Economist. The British public at large seems largely unmoved, however. This is a topic that could do with closer examination.
The City is an astonishingly successful business cluster, where I worked for 18 years up to 2005. The main controversy surrounds an very well-paid elite of traders, fund managers and investment bankers. These people, or the businesses they are part of, contribute disproportionately to national income – though exactly how much I am less clear about. Financial services consist of nearly 10% of the country’s GDP, but this includes a lot of businesses that are clearly not part of the City (retail bankers, estate agents, financial advisers, and so on), in spite of attempts by many commentators to conflate the two. But their high income reminds me of the joke about Bill Gates wandering into your local bar and the average income there soaring (this joke needs updating – Bill Gates’s income will have dropped alot in the last few years). If the City bankers leave, the country’s GDP may suffer, but that doesn’t been that everybody else is necessarily poorer.
But, the argument goes, these well-paid people spend their money here and create jobs. This argument is much weaker than it first appears. Rich people don’t spend all that much of their incomes on the sorts of things that create local jobs. A lot of their income is saved, with little of this saving going into productive investment in the UK economy. A more immediate problem is that a lot of their money is going into property, and other things where supply is limited (plumbers, school teachers at private schools, etc). All this does is bid up the price and put them out of reach of ordinary people. Still, if these businesses really are global, and having them on British soil contributes to the British trade balance, then some sort of net economic benefit is plausible.
A sounder argument can be made through taxes. City businesses and their employees pay a lot of tax under Britain’s progressive tax system (mostly income tax and national insurance on those bonuses – global businesses are very slippery on the matter of corporate taxes). How much? I don’t know: but it could amount to 1-2% of GDP (that’s guesswork working from the 10% of GDP for financial services income as a whole). There is an irony here. Very often we hear that our high taxes are damaging the City – but if they didn’t pay tax there would be little point in having it.
But behind this there is a deeper question. Are the services the City provides socially useful? In principle they should be. Our complex economy depends on finance to link those with surplus money with those who have productive investment projects to get off the ground. It’s what pays most people’s pensions. In principle fund managers, even those in hedge funds and private equity, should be helping this along. But a great deal of scepticism is in order. Too much energy is wasted in various intermediate devices – such as derivatives – whose value is difficult to see. Too much money is lost between one end of the process and the other. High profits, an economist will tell you, are a sign of economic inefficiency. It is the industry operators that are getting rich, not their clients. The aim of public policy should be to bear down on the industry to make it much less profitable, while maintaining its socially useful purpose.
But if it a global industry, can’t the British economy rake in the benefits of this inefficiency at the expense of the rest of the world? There are problems. First is that as global governments get to grips with the dysfunctional wholesale finance industry, it will gradually become less profitable, and the benefit reduces. The EU tussle on bonuses is but one part of this process, even if it is badly directed. The second problem is that the British taxpayer can become more embroiled in the industry than it should be. The bailout of British banks in 2009 surely wiped out many years of tax revenues derived from them. In any case income from financial services tends to be volatile, and so less useful – it disappears when you need it most. A further problem is that high City pay diverts the brightest local people away from more socially useful work.
So overall I find the case for special treatment for the City to be unpersuasive. What we actually want is for London to be a global hub for a smaller, less profitable and more functional financial services industry. The government is doing some quite sensible things: raising capital requirements, and separating investment from retail banking. This should limit the government’s exposure to bailouts, and reduce the level of finance (“leverage” in the jargon) available for trading operations, which believe is the critical issue. Other actions are more ambiguous: tougher regulation sounds fine, but it is in danger of harming decent retail banking businesses and reducing the level of competition as a by-product.
And as for the EU bonus regulations: I don’t think they will help much. They do not tackle the central issue, which is why banks are making so much money in the first place, and able to pay such large bonuses. But neither do I think they will do any real harm. Lower variable pay, and hence higher fixed pay, for banks may sound as if it increases risk, but it will force managers to ask more searching questions about what they are doing. And if more whiz-kids go to Singapore, so be it.