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Promote industry. Bag a banker.

17 Jan 2011 - Bruno Prior

Boris Johnson is quoted in MoneyWeek as having said to Management Today:

"To the banker bashers I say, what's your economic model? We can't ignore and hate the bankers. What would that achieve? Show me how reducing financial services boosts manufacturing."


For years, the UK ran a massive balance of trade deficit, i.e. as a nation we bought and consumed more than we produced and sold. It is no more sustainable for a nation's income to exceed its outgoing than for an individual.

For a country under the current monetary system, the way this imbalance corrects, if it lasts more than a year or two, is for the value of the currency to fall relative to the currencies of countries with a persistent trade surplus. Imports become more expensive, and exports become more competitive. In effect, the value of native inputs to the production process fall relative to the value of those inputs in the surplus countries. Wages and other inputs in the deficit country, which were too expensive to be competitive, fall in value relative to wages and other inputs in the surplus countries. People and businesses in the deficit country are less well-off than they thought they were, but this change simply reflects reality and allows those people and businesses to keep earning an income, rather than end up on the scrap-heap.

For that to work, the exchange rate has to fall (or people in manufacturing have to accept a real fall in their income). But the exchange rate responds to a broader balance than the balance of trade: the current account. This includes not only the balance of trade, but also net flows in investment. Thanks to the UK's financial services industry, the UK "enjoyed" a net surplus of investment income at the same time as it ran a balance of trade deficit. The UK still ran a current account deficit, but significantly smaller than it would have been without the financial services. Consequently, the Pound was significantly stronger than was justified by the state of our economy outside the financial-servives sector. This made British non-financial businesses, including manufacturing, less competitive than they otherwise would have been. Meanwhile, financial services benefited from a "virtuous" circle, because money is attracted towards strong currencies, and that inflow tends to strengthen those currencies.

It is no coincidence that British manufacturing struggled during the era of financial excess and strong Pound, nor that it has been doing better since the financial crisis and collapse of the Pound.

What Boris was trying to imply was that there was a connection between the manufacturing sector's need for finance and a strong financial sector in the City. This is nonsense. Does he think that German manufacturing is at a disadvantage because the German financial sector is not as bloated as the City?

The whole pitch of the City is that finance is international and not limited to the country of origin. The City's profits benefit three groups: their shareholders, their top employees, and the Exchequer. But the visible income to the Exchequer from taxes on profits and wages in the financial sector have to be weighed against the invisible profits and wages which might otherwise have been earnt in other sectors if the exchange rate reflected conditions in the real economy, rather than in the London bubble. -Ce qu'on voit, et ce qu'on ne voit pas-.

Can a classical-liberal say that jobs and profits in manufacturing and the rest of the real economy are more valuable than jobs and profits in the financial-sector? In the absence of intervention, no, even if the winners seem to be more concentrated and "undeserving" and the losers more widespread and "decent" under the financially-dominated scenario than under a more "balanced" economy. If the balance between financial services and other sectors of the economy is the simple outcome of Britain's comparative advantage in financial services, then that is the most efficient outcome, whether or not it seems like it.

But the balance was not simply the result of natural forces and comparative advantage. An artificially-low interest rate was a significant contributor. Low interest rates penalise prudent and sustainable investments. They attract chancers who disregard the risks of interest rates returning to the natural rate that reflects risk and time preference. The prudent money is driven out of the real economy and into investments that diversify the risk, while the imprudent money makes inadvisable investments fueled by cheap finance and a short time horizon.

Interest rates were set by a supposedly-independant central bank, actually operating to targets and indices specified by the Chancellor of the Exchequer. Those targets and indices were not remotely reflective of the real economy and the natural rate of interest. The financial bubble was not an accident, but a creation of people like Alan Greenspan and Gordon Brown. It was in their power to set policy that reflected the amount of froth in the financial market, and the uncompetitiveness of the real economy. But they chose instead to support speculation and imprudence. The bankers were their cheerleaders and their beneficiaries.

This is just one of a number of ways in which the excess in the financial sector harmed the rest of the economy. A significantly shrunken financial sector with a more prudent ethos operated by people without disproportionate incentives to speculate would be a significant advantage to the rest of the economy in the long-term, even though it would mean tighter credit and lower tax revenues.

Will that do Boris? Someone in your position with your ambitions shouldn't need to ask.

Organisations: UK Conservatives

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