Why the debate has gone all wrong
PART of the problem in Britain today is that public debate is taking place in a fact-less vacuum. People have no interest in what is really happening to investment bankers’ pay and prefer to ignore the regulatory revolution across all of finance, including banking, fund management, private equity, trading, accountancy and insurance.
Take pay: as we report on p1, it is expected to be down by 25-30 per cent at Barclays, 30 per cent at Citi, 26 per cent at Goldman Sachs, and so on. There is also an ongoing jobs bloodbath. This correction is easily explainable: banks now have to hold more capital and lower-yielding, liquid assets – this is slashing profits and especially return on equity, now often below the cost of capital. The only way to reverse this is for banks to slash costs (especially pay), shut low-return units and shrink balance sheets.
Some of this shift is due to a cyclical drop in revenues – but much is structural. Pay will be permanently lower in banks (though not necessarily in hedge funds, trading houses and other parts of finance). Shareholders will make sure this happens – they need to make a decent return. Pay will still remain much higher than in other industries – but the gap will be smaller than it was at its peak, when revenues per banker were artificially magnified as a result of cheap money, bubble-era rising asset prices, an artificial collapse in risk premia and vast firm-level leverage. Most of these factors are now gone. Obviously, pay (and revenues and profits) were too high during the bubble – but the system is readjusting.
An even more irritating issue is the absence of any economic explanation of the crisis – as opposed to populist nonsense confusing the human-level manifestation of the bubble (higher house prices or City pay) with its deep cause. There is a long tradition in economics – one which was mainstream in the UK until about a decade ago, before the political establishment and commentariat suddenly forgot all that it had learned since the 1970s – that argues that booms and busts are, these days, primarily caused by monetary forces and in particular an excessively low cost of money and credit.
Many classical economists believed this, as does Ludwig von Mises’ Austrian school – this was also the view of the monetarists, led by Milton Friedman, and the new classicals, led by Robert Lucas. Today, many economists believe monetary policy errors caused the bubble – and that a recession would have happened anyway, regardless of the proximate cause of the crisis, namely US sub-prime mortgages (themselves promoted by US government agencies).
This time, monetary policy errors weren’t purely caused by domestic central banks – rates were driven down by a lack of savings in the West and monetary manipulation in the East, and by moral hazard created by promises of state intervention. (The latter also caused excessive bank leverage). Shockingly, this well-respected view that excessively low rates and other errors by central banks were a key driver of the bubble and bust is mysteriously absent from the UK debate. The result: lots of emotion, insufficient reason, and a confused country.
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