Market Update: Where did the money go – we offer some answers – Full Analysis

Our politics is dominated by concerns about affordability. The Chancellor, Rachel Reeves, announced a budget in which she raised taxes to subsidise prices. An economic crisis becomes a political issue: voters struggling with energy costs and higher food prices tend to vote incumbent governments out of office. Even the price of eggs became a noisy theme in the last American presidential election that Trump won, promising to bring prices down.

There are short-term reasons for the current price rises: energy costs climbed because of the Russia-Ukraine war, although this was worsened by Britain’s energy regulation regime. Food prices are being affected by climate change and, in the case of eggs, by bird flu. These factors all helped to create the cost-of-living crisis.

Taking the long view

But there is a long-term story as well. The reasons for Britain’s economic stagnation over the past 15 years can be explained simply, even if the underlying story is more complex. The simple version is captured in a well-known chart from the Office of Budget Review – the arms-length body that monitors the government’s economic analysis.

In short, in the wake of the 2008 global financial crisis, the underlying performance of Britain’s economy jumped tracks downwards to a lower level of productivity performance. This didn’t happen in any of the western European countries that Britain usually compares itself against, or the United States.

The dotted line shows what would have happened had productivity growth continued on its pre-2008 track. The gap now is not a small one. Without this decline, the British economy would be about 14% richer, and earnings per household around £11,000 a year higher.

Blame George Osborne

The simple version of the story can be summed up in two words: George Osborne. Unlike Treasury ministers in other countries, the British Chancellor of the Exchequer decided that austerity was the best economic strategy in response to the financial crisis. Intellectual cover was provided by a 2010 economics paper, ‘Growth in a Time of Debt’, by two US influential economists, Carmen Reinhart and Kenneth Rogoff. The paper demonstrated that when government debt went above 90% of GDP (national annual income), then economic growth stalls.

But the paper was able to show this only because of a series of spreadsheet errors. When these were revealed three years later, by a University of Massachusetts graduate student, Thomas Herndon, British economic policy didn’t change. Austerity was always a political project.

Increases in productivity essentially come from a combination of public-sector investment and private-sector investment. Austerity killed off public-sector investment, so also dampened the confidence of the private sector, and its willingness to invest.

There is now a substantial body of academic research that shows that people’s experience of living in a stagnating economy with squeezed local services created the conditions both for UKIP’s surge in popularity and was then enough to tip the Brexit vote from Remain to Leave. This acted as a further dampener on private investment.

Long term financial decline

Opportunities to tank an economy don’t just appear as if by magic. The Global Financial Crisis was the last in a line of financial shocks that had snaked through the 1990s. These, in turn, had their roots in four deep-seated and inter-connected factors:

• A long decline in global growth rates that started at the end of the 1960s
• The rapid rise of Asia’s share of the global economy from the 1980s
• An increase in the level of debt in the international economy
• A steady rise in the financialisaton of everything from the 1980s, as investors chased returns in a lower growth world.

“The great unremarked class struggle that happened in the 1970s and the 1980s”, writes Dan Davies in The Unaccountability Machine, “was between capitalism and managerialism. The managers lost this struggle, pretty comprehensively.”

Financialisation took multiple forms. The notion of “shareholder value” as the lodestar of company purpose was framed by the conservative economist Milton Friedman and put into practice by influential chief executives such as Jack Welch at the American company General Electric.

Another is the rise of privately held capital – particularly private equity firms – that attach themselves to anything with a steady income stream – from water companies to care homes to Manchester United – then saddle them with debt and extract revenues from them for investors.

And then there is the rise of financial instruments such as derivatives that are essentially sophisticated forms of betting that exist at least in part so people can extract a margin from each transaction in spreads or fees.

When finance overtakes the real economy

The world economy is worth around $105 trillion at the moment, but the annual value of the financial derivatives that sit on top of this is around $667 trillion. As John Lanchester said recently in the London Review of Books, “What modern finance does, for the most part, is gamble. This doesn’t mean all financial instruments are dangerous, but the balance has tipped heavily towards speculation.

It speculates on the movements of prices and makes bets on their direction.

This was amplified by the design of the Quantitative Easing [QE] schemes that were invented to keep the global banking system afloat after the financial crisis, which had the effect of making asset holders wealthier at the expense of the rest of us by inflating, for example, the value of property. A different design could, instead, have accelerated investment in green infrastructure. It was an opportunity missed.

The result of all of this is that the rich have got richer and wealth inequalities have ballooned.

Complex problems with deep roots whose outcomes benefit the rich and powerful tend to be hard policy problems to fix. In political terms, many of the levers that might create change in the short-term are within the financial system, which politicians tend not to understand.

A ‘finance curse?’

The UK financial services sector is also over-developed compared to most other countries, which brings its own problems. Much of what the sector claims is economic value added is simply extraction from other parts of the economy. The research organisation New Capital Consensus argues in its report, Effective Investment, that “The UK’s investment system routinely diverts financial flows away from the real economy… the expansion of financial services – beyond a certain point – produces lower, not higher, productivity and fails to deliver for the real economy in which we all live.” Britain, said the author Nicholas Shaxson, suffers from “a finance curse”.

Some of the ways to address these issues are technical. The former Bank of England economist, Dan Davies, proposes changing company law to stop private equity companies loading their acquisitions with debt. Tax tweaks to secondary transactions such as derivatives could reduce the gains from short-term speculation in these kinds of financial instruments.

But if we’re serious about making the British economy more productive, the place to start is with the pension system. Pension funds invest our money – currently some three trillion pounds – to ensure long-term returns, but don’t act in our long-term interests. Instead, they behave in the same short-termist way as the rest of the financial sector.

There’s no shortage of ideas on how to make them both take a longer-term view of investment and to invest more for the public good, going back at least to the Kay Review in 2012.

No one is going to be on the streets any time soon chanting “WHAT DO WE WANT? NEW RULES FOR PENSION TRUSTEES”. But if we want to start feeling better off again, a public campaign about the role of the destructive elements of the finance sector is the place to start.

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