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Right-Sizing the Financial Sector in Post-Brexit Europe

The bidding for London’s financial sector is a game where there is much to be gained by losing.

The vote in the UK to leave the European Union (EU) has set off a race among major European financial centers like Paris, Frankfurt and Milan to capture much of the financial industry that is now located in London. As a result of EU rules, it will be difficult to conduct many of the transactions which now take place in London if the UK is no longer part of the EU. This means that a large part of London’s financial industry will soon be looking for a new home.

While the temptation to pull in an industry with a large number of high-paying jobs (some very high paying) is understandable, a larger financial sector will not necessarily be a boon to the winner’s economy. It is worth thinking more carefully about what the financial industry is.

To some extent the financial sector fills the textbook role of transferring money from households who want to save to businesses, governments and individuals who want to borrow. This is a necessary and important economic function. If a country can win more of this business, both to meet its own needs and those of other EU countries, it will clearly benefit in the same way that it would benefit from having a larger tech or manufacturing sector.

But the modern financial industry goes well beyond the story of bankers lending money to businesses and homebuyers. In the United States, the narrowly-defined financial security (securities and commodities trading) has almost quintupled as a share of the economy since 1970. It went from just over 0.4 percent of GDP to more than 2.1 percent of GDP in 2015. This difference of 1.7 percentage point of GDP corresponds to $290 billion a year in the US economy in 2016.

This $290 billion is the additional amount that the rest of us have to pay to the financial industry because it requires far more resources to allocate capital than it did back in 1970. This would be fine if we had reason to believe that we were getting something for this money, but after the crash in 2008 it is difficult to make this case.

After we saw the growth of massive housing bubbles in the US, UK and elsewhere, is there any reason to believe that the financial sector is doing a better job allocating capital to productive businesses now than it did four decades ago? Do families feel more secure in their savings today?

If the financial sector is not doing its job any better today than when it was far smaller four decades ago, then the additional resources devoted to the sector are largely wasted. We are in effect paying people, and often paying them very well, to do nothing. This is one reason a financial transactions tax makes so much sense, it will eliminate a vast amount of wasted resources in the financial sector while raising a huge amount of money for the government.

With this understanding of the financial sector, does it make sense for France, Germany, Italy and other EU countries to try to develop the same sort of bloated industry we have in New York and which now sits in London? In effect, it would mean that the sector would divert resources from the rest of the economy to pay them to play complex financial games.

Some people outside of the industry will gain in this story. For example, people who own real estate in the next big financial center will see their property values rise. The people who provide services to the industry may also gain from increased demand. But the case for the rest of the country is far less clear.

The public school teachers, firefighters and custodians in San Francisco are not winners as a result of the city’s tech boom. They have been priced out of the San Francisco real estate market and many have multi-hour commutes each way between their homes and work.

If Paris or Frankfurt wins out as the next big financial sector we should expect to see a similar story. As real estate prices skyrocket, those who don’t already own their house or apartment will be pushed to distant suburbs.

There is also another important, although indirect, way in which the prosperity of the financial sector will hurt the rest of the economy. While inflation is not a serious concern at the moment, it likely will be at some point in the future. When that happens, the spending generated by the wealthy in the financial sector will be a negative for the rest of the economy.

In the context of an economy near full employment, big spending banker types will be putting upward pressure on prices. This will cause the European Central Bank to raise interest rates to slow the economy. That will mean job losses for manufacturing and retail workers and downward pressure on the wages of the less-privileged sectors of the labor market.

This is a big part of the story of inequality over the last four decades. The financial sector is a big part of the reason that the UK is second only to the United States in its level of inequality. The bidding for London’s financial sector is a game where there is much to be gained by losing.

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