Reading the latest Sunday Times City rich list reminds one of the old 1920s Wall Street joke about the broker who took a client from out of town on a tour of downtown Manhattan. At the harbour, he pointed out all the yachts belonging to the brokers and bankers. ‘Where are all the customers’ yachts?’ asked the naive investor.
The City rich list is stuffed full of brokers, bankers, hedge fund managers and private equity partners, most of them virtually unknown outside the Square Mile. Yet they’ve all amassed fortunes, often in just a few years that defy belief. To get on to the list, you need to be worth £40m. That’s up from £25m a year ago.
Of course, it’s hard not to be envious of these extraordinary sums. After all, no other industry offers its employees the possibility of making so much money. But it should also concern us, since the very success of the City has seriously destabilised the rest of the economy. And that has left us all vulnerable to what happens in the markets.
Look at the commissions hedge funds cream off!
The problem is that none of these people featured on the list ‘make’ anything in the conventional sense. Instead, they make their money from commissions and fees and spreads on other people’s transactions. Forty-three of them (out of a total of 100) work for hedge funds, whose management fees – typically 2% per year plus 20% of profits – are a licence to print money.
What these people do for a living is undoubtedly important to the smooth functioning of the financial system, but it is also a tax on the rest of the economy. The customers, who pay this tax, are people like you and me, who give our savings to the City to invest, and ordinary businesses who go to the City to raise money.
The conventional view is that this doesn’t matter. The City brings huge advantages to Britain. The super-rich mostly live in London, spend their money in London and pay UK taxes. Their wealth helps provide employment for millions of other people, thereby making the south east of England the most prosperous region in Europe.
What’s more, the City is the UK’s biggest export earner. If its earnings are a tax on economic activity, much of it is paid by foreigners. Last year, London’s financial institutions achieved net exports of £19 billion, according to a report by the trade body International Financial Services London. That is three times more than a decade ago.
All this is true. But the flipside is that the City’s success has proved a mixed blessing for the rest of the economy. The City’s export earnings – combined with the huge windfall from North Sea oil over the last two decades – have pushed sterling to levels that have proved ruinous for many industries. Manufacturing in Britain has virtually ceased, and with it has gone valuable jobs and skills.
The result is that Britain’s balance of trade is dangerously out of kilter. The trade deficit in goods deteriorated by more than £10 billion in 2004 to a record £58 billion, according to IFSL. But this decline has largely been masked by the phenomenal surplus from the City. Yet the current account deficit, which includes trade in services and investment income, rose only from £17 billion in 2003 to £23 billion last year – that’s less than 2% of GDP.
True, so long as the City can keep earning huge sums, we’ve got nothing to worry about. There will always be plenty of jobs polishing the brokers’ and bankers’ yachts.
But what if the City’s fortunes take a dramatic turn for the worse? That is not as far-fetched as you might think. Financial institutions are struggling to maintain their profit margins. Competition is driving down commissions and fee income and narrowing spreads and eliminating arbitrage opportunities. The big investment banks increasingly rely on their own proprietary trading to boost their earnings.
Meanwhile, there is the ever-present danger of a systemic financial crisis. After years of easy money, the global economy is awash with debt. Many economists fear this is unsustainable. Given the volume of derivatives traded in the markets today, nobody knows what would happen if a giant corporation, such as GM, were to default on its bonds. Nor does anybody want to find out.
The danger is that a crisis in the markets could do untold damage to the rest of the UK economy. The current account deficit would deteriorate rapidly, causing sterling to fall, inflation to soar and interest rates to rise. Living standards would plummet.
What can we do to protect ourselves against this? The answer is not much. No one is suggesting we do anything to damage our most successful industry. Besides, it’s not as if there is anything we can do to bring back all those lost manufacturing jobs and skills – although we can invest in training and structure the tax system to try to prevent any more industries disappearing.
Beyond that, we will just have to keep our fingers crossed and hope the optimists are right that the City’s remarkable success over the last 20 years is sustainable. Perhaps it is. But I’d feel a lot less nervous if I could see a few more customers’ yachts.
By Simon NixoSimon Nixon is Executive Editor of Breakingviews.com, and a regular contributer to the Fleet Street Letter. For more from Simon and his FSL colleagues, including Brian Durrant, William Rees-Mogg and more, click here
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