Britain Leaving the EU Might Help Tame Its Financial Sector Leviathan

Boris Johnson declared in an interview last month that London would continue to thrive whether the UK was in or out of the EU.  He believed that infrastructure issues would be more influential in determining the capital’s future prosperity.  Within days, Sir Gerry Grimstone who is Chairman of TheCityUK, a group lobbying for a ‘Yes’ vote in the referendum on continued UK membership of the EU, said it would be ‘disastrous’ for the country and for its financial industry if there were a vote for Brexit.

Meanwhile, Mark Boleat, Chairman of the City of London Corporation’s Policy and Resources Committee, judged that Brexit would lead to considerable uncertainty for the City’s business prospects but there would be no stampede of international banks and traders to other financial centres.

At a time when Greece’s chances of staying in the euro zone and possibly the EU have been a focus of concern in financial markets, the bookmakers’ odds on Brexit have been shortening.  It is of more than academic interest, therefore, how the UK might fare if it were to quit the EU.  There is a general sentiment that the UK financial sector might be among those parts of the economy facing the stiffest challenges in adjusting to the new conditions but no consensus on how well it would succeed.  The difficulty in projecting how the UK might fare in hypothetical circumstances is well illustrated by the national debate some fifteen years ago over the UK’s adoption of the euro in place of sterling.

The shock to the UK economy from the global financial crisis was massive, In Part Because of the importance of financial services There is scarcely anyone now who, whether economist or politician, would argue in favour of the UK replacing its national currency with the euro.  As we watch nightly on our TV screens the people of Athens scavenging for food around dustbins, we might well reflect that could have been us, if Tony Blair had fulfilled his crowning ambition and persuaded the British people to embrace the euro.  The shock to the UK economy from the 2007-09 global financial crisis was massive.  Because of the importance of financial services to overall UK business activity, it could hardly have been otherwise.  However, the flexible sterling exchange rate helped insulate the UK economy from the pressures the crisis generated.  Those international investors who believed the UK’s prospects had been materially damaged were able to go on selling the pound until the exchange rate reached a level that seemed to reflect the risks.  That safety-valve would not have been open if the UK had been locked into the euro.  As it was, the pound weakened 27% between 2007 and 2009 and fell 28% against the euro over the same period. By staying out of the euro zone, the UK had also retained a measure of discretion over fiscal policy.  The UK government did not have the EU Commission breathing down its neck, urging swift compliance with the terms of the Stability and Growth Pact.  Still less did it have ‘troika’ representatives dictating the detailed terms of a bailout that would have been inevitable if, unlike in 1992, there had been no key to release the UK banking system from the prison of a fixed exchange rate regime.  Instead, Mr Osborne had the freedom to allow the fiscal ‘automatic stabilisers’ to kick in during 2012 when it seemed the UK economy might be slipping back into recession.  In 2014, the UK general government deficit was still running at 5.7% of GDP.  Of EU member-states only Cyprus, in the first year of adjustment after a banking crisis, ran an appreciably wider government deficit, a sobering fact for all those who took issue with the Cameron Coalition’s ‘austerity’ policy.  Economic adjustment could have been far more painful in the UK as, indeed, it has been in several countries that found themselves trapped in the euro zone.

balance sheets of institutions in the UK financial system in 2013 Were equivalent to 11 times national outputThe damage that a distressed UK economy might have inflicted on the euro, given the scale of capital flows into and out of London, is beyond reckoning.  Leaving aside the UK’s extreme exposure to shifts in international financial sentiment, its GDP in 2010 was 8% larger than the combined GDP of Greece, Spain, Portugal, Ireland and Cyprus.  (By 2014, it was 37% larger, such was the effect of bailouts.)  If the UK had been inside the euro zone, it seems inevitable that the bailout mechanism would have blown up long ago.  Indeed, the Eurocrats in Brussels and Frankfurt owe a debt of gratitude to those in the UK who campaigned against adopting the euro.  Perhaps they recognise this.  It is a long time since any of them warned of the dire fate that might befall the UK if it did not fall into line.

It might have been useful if those in the UK who, all those years ago, advocated entry into the euro zone had analysed why their arguments had been so disastrously misguided, and if they had published their findings.  What went wrong with their forecasts?  Was it a failure of imagination on their part, an inability to envisage economic conditions any more hostile than those that prevailed through the lotus-eating 1990s?  They could not picture events that would ever disrupt the even tenor of economic progress.  Rather, they feared that the UK, if it remained without the euro, would miss out on most of the benefits of the new world order.  But this cannot be the full explanation; after all, Gordon Brown resisted the euro even though he believed he had abolished ‘boom-and-bust’.  Possibly, the euro-enthusiasts were beguiled by academic theories seeming to support the view that the UK and the euro zone constituted an ‘optimum currency area’.  More likely they were imbued with idealism towards the European project or else with disgust at anything as traditionally British as the pound sterling.  However, with many of the euro’s champions, the most likely motive was probably concern for the economic well-being of narrow sectional interests. Whatever progress they have made in their analyses, and it is not at all clear how far they have advanced, it is easier to discern why, for the most part, they have maintained silence over their past errors.  They hope the euro debate has been long since forgotten because they intend to come back with much the same arguments during the forthcoming referendum battle.  They are concerned not to undermine their own credibility at the outset.

the UK financial system’s balance sheet was, as recently as 1968, About the sames size as annual economic output and was not much higher in 1978For those dependent on the City and on financial services for their livelihoods, anxiety over London’s future as a financial centre if the UK were to find itself outside the EU is bound to be uppermost when weighing the pros and cons of EU membership.  Whether  Boris Johnson or Sir Gerry Grimstone is presenting the more plausible view of the risks will be the crucial question.  For the country at large, though, the paradox may be that Mark Boleat’s greyer, and perhaps rather more realistic, vision may well appear to provide stronger grounds for leaving the EU than for staying inside.  Arguably, the UK economy is already unbalanced on account of the gross over-development of the financial sector.  A scenario where growth in the UK financial sector slows or even reverses might, provided the change is gradual, offer the best hope of avoiding serious threats to the UK’s future economic stability.

The problem was illustrated in a chart which appeared in the Bank of England’s latest Quarterly Bulletin in an article that sought to map the UK financial system. This showed the aggregate balance sheets of institutions in the UK financial system in 2013 amounted to some 1100% of the country’s GDP, that is, 11 times national output.  This is a far higher multiple than for other advanced economies.  For example, the corresponding proportion for the USA was slightly less, and for France and Japan slightly more, than 500%.  Somewhat disingenuously, the authors comment that the size of the UK financial system is ‘comparable to other countries with a historic specialisation in financial services such as Switzerland’.  In fact, their chart shows the UK multiple is higher even than Switzerland’s 900%.  We might also note that, according to World Bank figures, Switzerland’s per capita GDP in 2013 was almost 50% higher than the UK’s.  Consequently, the impact on the average Briton, were there to be a blow to financial confidence, would be almost twice as painful as for the average Swiss.  We do not have to look in the crystal ball when we can read the book. Even with the UK authorities using the policy flexibility that an independent currency afforded them, real household disposable income was still 1% lower in the first quarter of 2012 than it had been in the fourth quarter of 2007.  And it is possible to imagine shocks to the financial system more severe than that which befell the UK in 2007-09.

Policymakers too readily assume that because London has historically been an important international financial centre and the UK economy has, until recently, survived without serious mishap, there is nothing to worry about in the present imbalance.  That is a complacent view. As the Bank of England’s chart shows, the UK financial system’s balance sheet was, as recently as 1968, equivalent to only 100% of GDP and this proportion was not much higher in 1978. The massive expansion in financial liabilities came after Big Bang reforms, which in turn were a necessary condition for the growth of financial capitalism on a global scale.  London’s success in attracting a substantial slice of the massive expansion in international financial business is often celebrated but the downside, in terms of increasing the vulnerability of the UK economy to financial shocks, was not even recognised until 2007.  To be sure, it is easy to point to the economic benefits flowing to the UK from the hypertrophy of its financial sector.  A research report published by the City of London Corporation in 2013 suggested that around 20% of total government revenues were generated in the financial sector (including taxes on the incomes of those employed in the sector). To have such a significant proportion of revenues stagnating or shrinking might present a challenge to fiscal policymakers.  However this is a challenge they may have to confront anyway if, as seems probable, more of the fruits of financial business accrue to capital and less to labour in the years ahead. This is a likely scenario with the further computerisation of banking operations and the application of Artificial Intelligence to many currently high-grade and highly-paid functions. The government may well need much more effective restrictions on cross-border profit transfers if it is to retain the revenues it has hitherto enjoyed from the financial sector.  Seeking to impose those restrictions might well drive financial business away from London, whether or not the UK is in the EU.  Being outside the EU might at least leave the UK government free to sponsor development of new cutting-edge industries offering hope of replacing the shrinking tax revenues and employment from the financial sector.

A wider question is raised by the huge expansion of financial services in the UK over the past thirty years.  Even if some of this activity were to migrate to other centres, the risk would remain of severe economic strain resulting from any future financial shock.  If, as perhaps seems most plausible at first glance, financial business were to move from the UK to the euro zone, it might appear the size of the euro zone’s economy could better absorb shocks than the UK’s because it is so much larger.  However, as recent events have shown, there is not the degree of fiscal integration in the euro zone to allow the costs of a shock in one centre within it to be spread across the zone as a whole. Alternatively, if global financial business were to concentrate in the USA, we might well doubt whether the US economy alone were large enough to absorb all the losses stemming from a global financial shock. What would be needed to sustain confidence in a global financial system is worldwide fiscal integration that allowed the burdens of financial bailout to be spread equitably across the whole world.  Any national economy, even the USA’s, would stagger under the bailout burden if it had to bear the potential losses from all the financial business transacted within its boundaries.  Since the world is very far from achieving such a high degree of fiscal unity, it seems it must remain exposed to shocks as long as the financial system is as overblown as it has been in recent times.  There are more powerful historical forces acting on the City of London than will figure in the EU referendum debate.

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About the author

Stephen’s career spanning five decades has made him one of the most respected and unique voices in the City of London. Disclaimer regularly publishes a selection of his elegant and thoughtful essays on the global economy, which he has been writing regularly since he founded Fifth Horseman Publications in the late 1980s. As well as an economist, Stephen serves as Treasurer of the Forum for European Philosophy and was elected to the Royal Institute of Philosophy.

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