Image: City of London skyline. Credit: David Iliff, CC 3.0
In the decade since the financial crisis something has gone badly and obviously wrong with the UK’s political economy. Stagnating wages, low productivity and rising living costs have marked Britain out as an outlier in the developed world. Yet its globalised financial sector continues to generate lavish fees and windfall gains for a brilliant few. Now however, some sense of the downside of hosting an overactive financial sector is becoming clearer. The vigour of finance derives precisely from its ability to capture resources from the rest of the economy. Even as the host sickens, the City of London glows with unearthly health. The proposition that Britain suffers from a financial curse needs to be taken seriously.
Over the next two years in a series of short articles addressing the theme of Lifting the Finance Curse, we will investigate in more detail the costs of accommodating an oversized, rent-seeking financial sector. We will also set out how to alleviate and reduce this drag on the economy. We begin by setting out what we mean by a finance curse, and how to take the first steps to tackle it, by framing it as a problem of political economy. In other words, a problem of the way that politics and economics in Britain combine to promote the interests of favoured insiders.
The finance curse is a set of processes that take root in countries that become over dependent on finance. This is a financial version of the resource curse, which blights some developing countries, with the role of the dominant mineral sector taken by global, or offshore financial centres and oversized, over-prioritised financial sectors.
It involves the crowding out of other sectors, damaged economic diversity and macroeconomic performance, and geographical patterns of over- and under-development. These all spill over to entrench social division and skew policy orientation and political power. Nick Shaxson’s recent book, The Finance Curse: How Global Finance is Making Us All Poorer is the first attempt to describe this process in a systematic way for general readers. This series looks to build out from Nick’s work; to develop proposals for reform in the UK context, and to look at how this would be politically workable, in terms of the constituencies and coalitions it would appeal to.
In our recent analysis at the Sheffield Political Economy Research Institute, we set out to calculate the macroeconomic costs of lost growth potential resulting from the UK’s oversized financial sector, by constructing counterfactual growth pathways, based on growth performance without the 2008 financial crisis, but also from regression formulas derived from a literature known as ‘too much finance’. This literature shows that once credit goes beyond 100% of GDP it starts to impede growth performance. When two of the co-authors of that research conducted a similar calculation for the United States, the biggest contribution to the overall price tag was the calculation for the cost of the 2008 crisis. For the UK however, almost 60% of the figure was accounted for by a category known in the literature as ‘misallocation’, or more precisely, how big and overly dominant finance acts to crowd out and harm other sectors.
Our headline figure of £4.5 trillion, indicating the UK economy is cumulatively 14% smaller than it could have been over the period 1995 to 2015, has drawn a lot of attention. In truth, this is an estimation or a guide which focuses attention and minds on the fact that something dysfunctional is at work in the UK economy. What really matters is the story behind these numbers. It is this that we intend to document and cover more fully over the coming months.
The finance curse provides a framework for exploring and understanding a range of symptoms and processes, and can therefore inform what policy makers should look for and remain vigilant of, and where they should target remedial and preventative action. Seven finance curse symptoms warrant further consideration.
1) A financial version of Dutch disease.
Financial inflows inflate the exchange rate and create other local price distortions (property) so that alternative export sectors find it harder to compete internationally. A range of influential commentators from Paul Krugman to Mervyn King and Ashoka Mody (formerly of the IMF) have identified this as being prevalent in the UK.
2) A form of brain drain
Financial sector rewards and compensation packages draw talents and skills away from higher productivity sectors.
3) Misallocated investment including rent extraction and attraction.
We have seen above how relatively low amounts of finance in the UK go to corporate and export sectors. Risk models often favour high collateral, low productivity investments such as property and other financial assets. When financial firms take positions in predominantly non-financial firms they can demand high short-term returns and restructuring that can damage long-term productivity (rent extraction). Having a large financial sector with a vast range of advisors, brokers and assets and can also as a magnetic attraction to pools of investable funds.
4) Systemic risk, volatility and financial crisis.
Research shows that a high credit to GDP ratio increases the risk of financial crisis, which ordinarily are much more severe in terms of the resulting recessions than usual business cycles are, and this is explicitly recognised in Basel III.
5) Geographical distortions.
Large financial centres and clusters can suck human and financial capital, creating over-development, property and housing distortions, space limitations, overcrowding and infrastructure pressures, while other areas suffer from underdevelopment.
6) Rising inequality and social segregation.
A reliance on a big financial sector brings vast rewards for some, but low paid, low skilled, causal work for others, leading to a reliance on credit to support living standards, further diminishing disposable income, restricted access to home ownership. and fluctuations in demand. Communities and living spaces can effectively become segregated and gated.
7) Concentrations of political power and a narrowing of political agendas.
The lobbying power of the City of London and its informal linkages to elements of the British state is well documented. Public debates around finance narrow, so that more is always presumed to be better and integral to the national interest, even in the face of contrary evidence. Does a country’s political culture and processes support vigilant scrutiny and oversight of financial sector activities, or is there a political silence on the potential downsides of a large financial sector, and is a country’s development trajectory being designed around the needs of the financial sector? How does the existence of vast financial sector shape the mentality of politicians and public officials?
Obviously, these symptoms and their salience in the UK will vary across time. Some will be more pronounced than others, and some may be barely evident at all. But as a frame, this range of interconnected factors gives us a sense of what we need legislators and regulators to be wary of. It can also help to transform the public debate and the collective mindset about finance and its social purpose. By collecting evidence on all of these features, we can start to build a picture of what a programme of action to lift the finance curse might look like. That evidence and the related programme of action will be laid out in a forthcoming series of Open Democracy articles.