DON’T BANKI ON IT THE FINANCIALISATION OF THE UK ECONOMY REPORT Tony Dolphin December 2012 © IPPR 2012 Institute for Public Policy Research ABOUT THE AUTHOR Tony Dophin is senior economist and associate director for economic policy at IPPR. ACKNOWLEDGMENTS I wish to thank Amna Silim and Esther Cowdery for research assistance on this project. Nick Pearce, David Nash, Will Straw, Eric Beinhocker and members of the panel that advises IPPR on its economic work commented on an earlier draft of this report and helped improve it, although they bear no responsibility for the final version – this lies with me alone. Work on this project was funded by the Resolution Trust and would not have been possible without their support, for which I am very grateful. ABOUT IPPR IPPR, the Institute for Public Policy Research, is the UK’s leading progressive thinktank. We produce rigorous research and innovative policy ideas for a fair, democratic and sustainable world. We are open and independent in how we work, and with offices in London and the North of England, IPPR spans a full range of local and national policy debates. Our international partnerships extend IPPR’s influence and reputation across the world. IPPR 4th Floor 14 Buckingham Street London WC2N 6DF T: +44 (0)20 7470 6100 E: [email protected] www.ippr.org Registered charity no. 800065 This paper was first published in December 2012. © 2012 The contents and opinions expressed in this paper are those of the author(s) only. NEW IDEAS for CHANGE CONTENTS Executive summary ......................................................................................................2 1. Introduction ..............................................................................................................5 2. Financialisation ........................................................................................................8 Aspects of financialisation ...........................................................................................8 Problems with financialisation......................................................................................9 3. The UK financial sector: exploiting a comparative advantage? .............................13 Financial markets ......................................................................................................13 Gross value added ...................................................................................................14 Profits ......................................................................................................................18 Tax ...........................................................................................................................19 Employment .............................................................................................................21 Related activities ......................................................................................................24 Trade .......................................................................................................................25 Exploiting a comparative advantage or financialisation? .............................................26 4. The negative aspects of financialisation in the UK ................................................29 Bailing out the banks ................................................................................................29 Regulatory failure and capture ...................................................................................30 Lower economic growth and increased instability ......................................................31 Crowding out manufacturing .....................................................................................35 Taking the best graduates ........................................................................................36 Greater regional imbalances ......................................................................................39 Extractive elites and rent extraction ...........................................................................40 Unjustified levels of pay .............................................................................................42 Increased income inequalities ...................................................................................46 Too high a price to pay? ...........................................................................................48 5. What might be done ...............................................................................................50 Culture and moral capitalism in the financial sector ....................................................50 Retail and investment banking ..................................................................................52 Bank lending ............................................................................................................55 Rent-seeking and pay ...............................................................................................57 Financial transaction taxes ........................................................................................59 Rethinking economic policymaking ............................................................................59 6. Conclusion..............................................................................................................62 References .................................................................................................................63 Appendix 1: Employment in financial services and insurance in 2010 ......................67 Appendix 2: OLS regression results ...........................................................................68 1 IPPR | Don’t bank on it: The financialisation of the UK economy EXECUTIVE SUMMARY ‘We live in an economy that rewards someone who saves the lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect the mispricing of securities with sums reaching into the billions.’ Warren Buffett, quoted in Morgan 2012: 24 Warren Buffett is not the only one who wonders if the extraordinary levels of remuneration paid to those at the top of the financial industry tell us something is wrong in society today. Critics of the ‘financialisation’ of the UK economy argue it is responsible for many of the economic problems we face today. Yet its supporters respond that finance is one of the UK’s most successful sectors, contributing hugely to the economy through employment, taxes paid and exports. Where does the truth lie? Without the answer to this question, it is not possible to develop sensible policies towards the financial sector. This report seeks to weigh up the pros and cons of the UK’s large financial sector and provide some recommendations about future policy towards finance. Since the ‘Big Bang’ in the City of London in 1986, there has been a large increase in the role of financial services in the UK economy. Lobbyists for the financial sector argue that Britain is good at finance and that we should exploit our comparative advantage in this area to the fullest extent. They point, for example, to London’s role as a global financial centre and the UK’s trade surplus in financial services and insurance (equivalent to over 3 per cent of GDP in 2011) as evidence of the key role that finance should play in the future fortunes of the UK economy. Before 2007, this view attracted wide support. True, the financial sector had its detractors even then, but they struggled to be heard. The strength of the financial industry in the UK was seen as an important bulwark at a time when manufacturing was struggling to compete with low-cost production in emerging economies. Today opinions are very different. The financial crisis of the last five years has revealed the significant risks associated with having a large financial sector. This has led to a more sympathetic hearing for those who criticise finance and financialisation: the increased role of financial institutions, markets and agents in the economy. This report weighs up the arguments put forward by the financial sector’s supporters and detractors and analyses its role in the economy. The results of this analysis have some important implications for current debates about the future of the financial sector. The UK does indeed have a comparative advantage in many areas of financial services, but particularly in investment banking. This advantage has its roots in the long history of the City and survives because the infrastructure of financial markets and the support industries that surround them have been continually maintained and upgraded. The City is an important source of overseas earnings for the UK and of revenues for the Exchequer. Official statistics suggest it was also an important source of growth in output (though not employment) in the decade up to 2007. However, this growth does not appear to have greatly benefited the rest of the economy. There is no evidence that a much bigger financial sector, relative to the rest of the economy, has led to an improvement in resource allocation or to better returns for savers and investors. If anything, the opposite appears to have been the case. The financial sector has grown because it is extracting larger rents from the rest of the economy. This is a cause for concern, not for celebration. 2 IPPR | Don’t bank on it: The financialisation of the UK economy Financialisation has also been accompanied by – and almost certainly played