Why the new government is staying silent on the City – it won’t be taking tough action on the UK financial sector anytime soon

Rachel Reeves’ first speech as UK Chancellor of the Exchequer highlighted the financial constraints facing the new Labour government. With taxes already at their highest level in 70 years as a share of national income, she reiterated her promise not to raise social security contributions, income tax or VAT.

A parallel commitment to stick to current budget rules, requiring public debt to fall within five years, is pushing Reeves to look for ways to target taxes.

The government also wants to boost its non-tax revenues by rebuilding a fleet of state-owned assets, including a national wealth fund and a new green electricity supplier, Great British Energy.

Labour’s approach is to see public spending as a catalyst for private enterprise, providing the infrastructure, skills and technological development that can encourage the private sector to produce and invest more. Its industrial strategy is based on the idea that £1 of public investment, carefully targeted, can attract £3 of private investment.

These findings are consistent with economic research suggesting that chronically low public investment largely explains the relatively slow growth in productivity and output in the UK, and that public investment in green technologies would be particularly effective in boosting them.

Over the past 50 years, governments of all parties have tended to take the opposite approach, associating public investment with economic stagnation and anticipating better private sector performance once state-owned assets are privatized.

Labour’s change of direction recognises that the UK’s financial markets, even when deregulated and encouraged to grow, have failed to mobilise the investment needed – leaving large “funding gaps” for small, innovation-based businesses, particularly in deprived regions.

Labour has good reason to be tougher on financial institutions. Its loss of power in 2010 followed a global financial crisis triggered by reckless banks and insurance companies, whose bailouts at public expense undermined the government’s record of balancing the budget and paying down the public debt.

The need to absorb these City of London losses, and then allow it to retain the subsequent return to profits, forced the Treasury into a decade of austerity that left it financially strapped when COVID struck.

Yet Labour’s pre-election plan hailed Britain’s financial sector as an “engine of growth,” describing it as “one of Britain’s greatest success stories” and promising to support its growth and innovation. This is a far cry from the party’s position half a century ago, when it envisaged a state takeover of banks and pension funds as the solution to a decade of stagnation.

The special pedestal of finance

The fear of governments to impose more taxes or regulations on the City of London, even after its costly implosion of 2007-08, is rooted in the extraordinary contribution of the financial sector to the British economy.

According to analysis of official data by its main lobby group, the financial sector and related professional services contribute more than 8% of gross domestic product (GDP) and 10% of tax revenues, and support 2.2 million jobs (7% of the total).

Its trade surplus of £63 billion contrasts with and helps offset the deficit on trade in manufactured goods. And the financial surplus it generates, by attracting capital flows from around the world, is vital to financing the UK’s chronic current account deficit, caused by spending more than it receives on current transactions with the rest of the world.

But finance’s contribution to national income and public finances may not be entirely accurate. In the aftermath of the financial crisis, experts including the Bank of England’s chief economist and the chief financial regulator suggested that the financial sector’s appetite for risky lending and short-term profits could be hindering productive businesses as much as helping them.

They also acknowledged that conventional measures, particularly those that treat the spread between lenders’ and borrowers’ interest rates as “value added,” could significantly overestimate the sector’s contribution to the economy.

In doing so, they joined a long line of researchers arguing that the City is diverting funds from productive investment to speculation that fuels asset bubbles and property price inflation.

The financial sector’s rebound from the crisis owes much to the fall in interest rates from 2008 to 2022 and quantitative easing. This additional source of very cheap funds allowed banks to preserve their “bonus culture” and increased inequality, as holders of financial assets such as stocks and bonds saw their prices rise.

---

Read more: Why central banks are too powerful and created our inflation crisis – by the banking expert who pioneered quantitative easing

---

British financial firms also benefit from an elaborate network of tax havens, undermining the tax-raising powers of the UK and many other governments.

The Conservatives have already taken steps to encourage pension funds to invest more in small, innovative firms and have created a state-owned British Merchant Bank to provide finance where commercial banks would not. Previous governments have also used windfall profits taxes to claw back public money from banks and polls suggest there is now broad support for imposing another tax on banks’ excess profits.

But Labour’s scope to redirect resources into the “real” economy, away from the financial sector, is limited by lingering doubts about the underlying health of that sector. Banks have strengthened their balance sheets since 2008 and are now passing much stricter stress tests. But this partly reflects a shift in lending to less-regulated “shadow banks”, which are not banks at all but other organisations with the capacity to offer credit.

Today, new threats to global financial stability face the rapid growth of private credit to businesses and the underestimation of climate risks.

Fears of another systemic slide – on the scale that left former Labour prime minister Gordon Brown “cashless” and more recently sunk Liz Truss – mean the government is unlikely to give financial institutions the harsher treatment that some would recommend.