The City and the Real Economy

The “City” refers to both a place in the East Central part of London and a set of commercial-finance activities, including some which are headquartered there, but like insurance for instance, may be spread physically across the whole of Britain.

The conventional view of free market capitalism as practised in the Anglo-Saxon countries is that economic value arises from the combination of invested capital (principally equipment, premises, land) and labour (both specific and unspecific to the particular business)[1].  Typically, such businesses, if they are not just warehousing or stand-alone packaging operations, will generate sales of the order of the capital invested, while labour costs will be less than half of sales, possibly for large operations like oil refineries – much less than half. Profit is what is left after labour, purchases of materials and outside services, taxes, interest on borrowed capital, maintenance of equipment and premises, and depreciation of capital have been paid for.  Again, very approximately profit may be 10% of sales – as reflected in stock-market price earnings ratios of around 8-12.  Obviously there are big variations as can be seen in the stock-market price lists in the daily papers.

Across a whole range of technologically advanced industries such as oil, chemicals, electronics, IT, pharmaceuticals, polymers, and aerospace, for companies such as Shell, Vodafone, AstraZeneca, one employee may generate sales revenues in the range £0.3 to £1.5 M and profits per employee of £50 K to £100 K.  Capital assets deployed to achieve these figures are typically in the range £0.5 to £1.5 M per employee.

If we take companies providing financial services direct to the public, such as insurance companies, for example Legal and General and Aviva in the UK, we find profit per employee in the range £30 K to £100 K, obtained at margins on sales of 4-20%, with capital deployed in the range £0.3 to £1.0M, much the same as in the industrial sectors.

Unit and investment trusts, which are the stock-market services most used by the general public, are more generous to their employees and managers by a factor of 5-10 times.  The recent sale of Gartmore Group to Henderson Group for £335 M revealed about £20 Bn funds under management, generating £300-340 M fees per annum or around £1 M of fee income per employee out of which salaries and bonuses are far and away the chief cost.

These figures are at the low end of the range of fees generated by unit trust managements.  Yet at the same time performance for the purchasers of unit trusts has not been very good.  A recent survey suggested that in the 10 year period 2000 to 2010, three quarters of funds surveyed did not do better than the principal London stock-market index FTSE of 100 leading companies.  The FTSE itself ended the decade where it began at around 6000, meaning that in capital terms most unit trust investors lost money, and in revenue terms received less than a building society or bank deposit over the period.

Nonetheless there is no shortage of individuals offering unit or investment (mutual) funds to the public.  At the last count there were around 10,000 funds listed in the London Financial Times, all doubtless attracted by the £1 M-£10 M salaries they can generate for the managers and their immediate staff, comparable in fact with the salaries and bonuses which the directors of the major retail banks and the managers of the retail banks’ investment divisions are awarding themselves.

Investment banks and hedge funds are arguably the most prominent of the institutions in the wholesale sector of the financial business.  Here rewards to individuals go up by another factor of 5-10 times.  The largest hedge fund in Europe, Brevan Partners, shows in its accounts for the year to March 31 2010 profit per employee of £1.97 million, at a profit margin on revenues of 93% and negligible capital.

How did Brevan Partners make its money?  Clearly not by the meticulous combination of long-term technological capital, skills and expertise of the companies and industries of the real economy, referred to in the first three paragraphs of this post.  Fundamentally Brevan’s results disclose massive betting on bonds and currencies.  In fact hedge funds bear about the same relation to the real economy of goods and services as betting shops do to the blood-stock industry.  However, unlike the general public’s betting on horse racing outcomes, personnel in hedge funds and some similar activities in the investment banks are protected from failed bets, ultimately by the workings of limited liability (Ltd and plc) status.

While every investment of capital in the real economy carries risk, most people see the difference between prudential investment and gambling.  Investment in the real economy is designed to generate new economic value: on the City scale, betting is basically about the involuntary transferring, through the wholesale loans mechanism, of huge sums of money from a large number (millions) of people  – customers of the retail banks – to a small number (tens of thousands) of employees in the hedge fund and investment bank businesses.  This broadly accounts for the nearly two orders of magnitude (100 times) difference in the levels of remuneration which we see between the real economy and these businesses.

In the British government-rescued banks – Lloyds, Royal Bank of Scotland and the collapsed bank Northern Rock – the source of their collapse was simply gambling with other people’s money, and  the individual gamblers concerned have been financially completely protected from the failure of their gambles.

Does it have to be like this?

Indeed it does not, but it will take legislation, comparable in scope with the 1880’s Factory Acts in Britain and the Bretton Woods Agreements in 1944 between the three soon-to-be-victors in the Second World War.  Bretton Woods introduced fixed exchange rates with respect to the US dollar – with some changes until 1972 – and also set up the International Monetary Fund – still with us.

However, pending a comparable redesign of the international monetary and banking systems, we in Britain and other countries, can make a start on creating a financial system to serve our citizens rather than the other way round.  First we can restrict limited liability status to companies in the real economy (which it was originally set up to do) and specifically require investment banks and hedge funds to be partnerships, limiting their liability if they so choose by taking out commercial insurance.  Second we should separate the investment bank functions completely from the retail banking and building society sectors (which follows from the first measure).  Thirdly we should require loans to and from the retail bank sector from and to the wholesale sector above a certain level to be reported directly to a bank’s shareholders, and at some level of loan, subject to their prior approval.  A major effect of this measure, which would be strenuously opposed by City interests, would be to slow the financial system down – but this is precisely what is needed to stabilise it.  Other slowing down measures are needed too, which we will present for discussion in a later post.

Does it matter?

We shall return to the consequences of the present system (including senior executive pay), but for the moment two consequences in particular can be seen.  First we can observe that foreign exchange deals by investment banks and hedge funds at some trillions of pounds sterling annually exceed foreign exchange dealings for international trade and inward and outward investment by at least 30 times, depending a little on the scope of the word “investment”, i.e. most foreign exchange dealings are pure gambling; with derivative instruments created to spread the risk away from the individual gambling firms.  Ultimately though the risk is put on the general public through the banks.  Because the annual sums involved are so huge, comparable over a year with the whole US economy, it means that a buyer or seller of a currency can create his own self-fulfilling prophecy: the more you buy (sell) the more the price of a currency rises (falls) in the short term so the buyer (seller) can make a profit if they move quickly enough – which computer-based buy (sell) systems are primed to do.  This has absolutely nothing to do with adjusting prices (of currencies) to reflect real changes in the international economy which moves on an altogether much longer time scale, but are often claimed as justification for the whole futures markets.  It is pure diversion of cash away from the real value-creating economy.

The second consequence is by contrast micro-economic, but of huge importance to the West.  The sheer scale of the rewards to individuals in the wholesale financial businesses in Western countries, which we have highlighted above, is diverting a whole generation of talented young people from productive economic activity, into what is in effect valueless gambling.  This effect is very visible in the graduating classes of the engineering and science departments of the leading schools and universities in the USA, the UK, Australia and Canada and is spreading to Continental countries which have until recently been relatively immune from the effect.  That this should be happening as the BRIC countries (Brazil, Russia, India, China), not to mention Indonesia and the Middle East, are gearing up to challenge the West in every industrial sector and source of raw materials, is of the gravest import for us all.  So even in these two respects only, redesigning the financial system matters hugely.

[1] In the unspecific labour category are to be found cleaners and at the other end of the pay scale many of the directors of large corporations.  In the specific labour category are to be found the engineers, operators and maintenance technicians in businesses producing tangible goods or sustaining a whole variety of systems and services from airports to zoos.

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One Response to “The City and the Real Economy”

  1. The Manager says:

    Robert Peston’s searching examination of the banks’ behaviour (BBC2, 9 pm, 18 January) echoed some of the key points in this post. Sir Philip Hampton, current chairman of the 85% state-owned Royal Bank of Scotland, was moved to say that banks’ activities highlighted in the programme (the enormous increase in their lending, the scams employed to get round the capital requirements of the Basel I accords, and the factor of 10 increases in bankers’ pay in the decade leading up to the collapses in 2008) “hadn’t benefited the ordinary consumer very much”; surely the understatement of the new decade so far.

    In the programme there was little or no recognition from the various contributors that apparently the bankers and traders and the politicians never stopped once to think why in Britain and America there was no increase in goods and services value remotely commensurate with the colossal increases in Bankers’ pay and investment bank profits. Your post gives the answer – loss-free gambling with other people’s money.

    Are there not prosecutions to be brought under the 2006 Companies Act, which explicitly holds directors to account over “reckless behaviour”? Managers of real economy companies are certainly held to account under the Health and Safety Act 1974, and there is now a new offence of corporate manslaughter.

    I only ask.

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