What Comes Next, After North Sea Oil?

Mrs Thatcher's government's economic and social policies were made viable only by the fact that her era coincided with the United Kingdom being able to exploit the oil and gas reserves that had been found under the North Sea over the previous couple of decades. The tax revenues derived from those resources largely funded the welfare state, enabled the government to give redundancy pay and early pensions to unwanted employees from the nationalised industries, and maintained the nation's defences. The material fact of having sufficient gas to meet the national need, and a significant oil supply that diminished the need for imports, enabled the country to shut down the coal industry almost completely. 

Those were the material conditions in which the financial revolution of 1986 was facilitated: and the financial services [with their related activities like the courts and arbitration services] were opened to the international community and became a significant earner of foreign exchange. The loss of the textile, crockery and steel industries was mitigated by the sale of financial and related service globally. In particular, Britain's membership of the European Economic Community as it went through the transition to the European Union enabled London to become the unchallenged financial hub of the Union. It will be interesting to see how far President Macron, as an ex-banker, is able to steal business for Paris in the coming years; but that will be a side-show compared to the issue that is being considered here.

The key fact is that material assets - oil and gas - enabled the immaterial activities of 'the City' to become established as major export markets. Simultaneously, the incomprehension of successive governments as to what was happening in the domestic financial services market was building up to the crash that almost brought down the entire economy in 2007-8. New forms of contract, most particularly securitisation, enabled the domestic financial sector to grow in an unprecedented ways to an extent that was way beyond the regulators' power to comprehend or to control it. Securitisation was developed simultaneously in the USA and the UK, as a means whereby borrowing by some firms and most individuals could be lifted off the books of the banks and building societies that made the original loans, and sold on as new forms of security to suddenly emerging 'wholesale' traders and investors. This meant that the retail banks reduced the amount of lending in their books, and could lend more again; which loans could then be securitised: and so on. The debts owed to their banks by small and medium-sized firms largely remained with the banks, because they were recognised to be too risky for securitisation. But the mortgages and credit card debts owed by millions of ordinary people were seen as safe debts to be securitised. Thus when the crash came, the banks faced the fact that they had many billions of pounds of debts from smaller companies on their balance sheets, most of which the companies could not settle in the depressed condition after the crash. So the debts were kept on the books, the Bank of England allowed the banks to cash in government bonds in sufficient volume and value to make those books look balanced, and a huge problem for the future in the form of 'zombie' companies was created [and it now seems almost permanent: impossible in the near term to resolve].

Meanwhile the financial institutions collectively have carried on lending pretty freely to house buyers with reliable incomes, fueling a boom in property prices for the sectors of society than can afford to maintain their repayments and causing a major social division between those who can 'buy' homes and those who can not. Juggling money to keep the mortgage market expanding, largely by expanding the money supply through the Bank of England's 'quantitative easing' trick, has maintained the illusion that 'owners' of property are asset-rich: and this has kept the economy buoyant with regularly reported 'growth' of the Gross Domestic Product of the economy. This is all based on a bubble of credit; about which the Bank of England is becoming increasingly concerned.

Meanwhile, the 'real economy' of goods made and imported and exported and consumed has shrunk to a minor proportion of the domestic economy. The country has become import dependent: to a degree that ongoing sales of financial and related services to the rest of the world will not enable he country to pay its way. Departure from the European Union, even if the UK is able to retain its status as the financial hub within the European Economic Area, will make this situation worse.

It is usually condemned as old-fashioned and uncomprehending to stress the overriding importance of the material economy. But the success of Germany as a material-exporting country [of high-value-added products] is the living demonstration of the point. The reckless use of North Sea assets to finance a material standard of living that the country can no longer afford, and to fund a finance sector that has exacerbated the nation's problems, is a horror story which will haunt economic reality for at least a generation to come: and no politicians are preparing to cope with it.

Bonkers About Bankers; Wet About Water

The British media are currently commenting both on the future regulation of the water industry and about the report of a Parliamentary Commission that has been discussing the changes in banking regulation that the Treasury is likely to bring forward following the Vickers Report which proposed the saparation of retail from wholesale banking.

The common thread linking the OFWAT licensing package to the Vickers proposals is the attempt in each case to crystallise an illusory distinction between 'wholesale' and 'retail' operations. Behind both follies lies the Economists' dogma that 'competition' is a good thing; which in the crazy world of contemporary politics is pitted against the bureaucracy's recognition that a failure either of the domestic and industrial water supply or of the accessibility of cash to households and firms would be both economically and humanly cataclysmic in its consequences.

If the supply of water or of 'retail' bank accounts was left to rampant open competition with no restraints, some firms would grow by using both fair and unfair tactics; while others would be driven to bankruptcy. A failed bank or water company could leave its customers destitute or dying; so retail competition in banking and in water trading must be underpinned by a system that would ensure continuity of supply to the customers of failed suppliers. Hence the appearance of retail competition is pursued, by the politicians who hold the ring between ideologues and bureaucrats; who have some inkling of the extent of the damage that was done to the economy by the near-collapse of banking in 2008 and who are desperate to avoid being blamed for another ruinous cock-up.

At present both the water business and so-called banking are vertically integrated. Banks deal with every sort of financial transaction from managing children's saving accounts to ensuring that their whole complex pattern of operations has sufficient liquidity at all times. Water companies convey the fresh water supply from lake, river or aquifer to the kitchen sink [and Water-and-Sewerage companies carry the process forward to the point where the cleaned waste is returned to the environment]. Dogged Economists have come up with suggestions that in both cases 'retail' operations should be separated - or, at the least, 'ring-fenced' - from the risks and costs that are incurred in the 'wholesale' sectors if the industry; and that a show of competition, albeit closely controlled by regulators, should be fostered in the retail market. All this complex bureaucracy would be paid for by the users of banks and of water so that Economists would be able to claim that suppliers would be pushed a few metaphorical inches towards the nirvana of marginal cost pricing [a fantastical concept that any non-economists can pursue on Wikipedia if they have a few days to spare.

It is generally conceded by all observers except currently-orthodox Economists that water supply is a natural monopoly. So much capital is invested in securing abstraction points, purification plant, water mains, distribution pipes, customer connections and meters [where they are in use] - and in providing the energy to pump the water around the system - that it would be unimaginably expensive to install a second, third or fourth supply network simply to provide competitors for the incumbent company. The prices that customers would have to pay to finance the construction and maintenance of the unnecessary additional infrastructure would be prohibitive: to which must be added the maintenance costs for systems would be used at significantly less than their capacity. The nutters who propose 'competition' simply because that is the ideal of Economic Theory would love to be able to ignore the material realities of of water supply. The coalition government appears to be content to leave the physical infrastructure in the hands of geographical monopolists; albeit expressing some pious hope about eventually making it easier for new companies to take over access to raw water. This could only be achieved by changing the pattern of abstraction licenses, whose award is in the scope of the Environment Agency: not of OFWAT, and would almost certainly require the expropriation of some of the assets and contractual rights belonging to the incumbent companies. Economists argue that provided the new entrants could offer water at source at a 'wholesale' price that was competitive with other sources, the distributors would be compelled to buy a proportion of their supply from the new competitors. Alternatively, the distributors would be compelled to receive the water into their systems, and pump it around to the connection points at which the competitor's [or an associated business's]  customers would be billed by a 'retail' water company that would be a separate entity from the delivery company.

Anybody who pretends that cost to the customer would not increase with the creation of a raft of new companies that employed chief executives and nonexecutive directors on the usual terms, bearing the advertising and other costs of competition should look across at the energy sector, where boards are highly-paid, where competition is ritualistic under a fanciful regulator, and within which absurdly expensive green objectives are met by compelling customers through their bills to throw enough subsidy to constructors of windmills and nuclear power plant - and even converting coal-fired power stations to using biomass [which is increasingly challenged on ecological grounds]. The cost of capital for all the companies will also increase with every increase in the uncertainty of the companies' income flow that follows from fake competition and from the appropriation of upstream assets from the companies.

With sulkily expressed threats that they will return to the government's preferred agenda of legislated pseudo-competition as soon as possible, in the face of near-unanimous opposition from the industry, OFWAT has withdrawn a recent threat to change the basis of remuneration for shareholders within the price review due in 2014. It is still threatened that the regime will be changed to fit Economists' models; but the danger is deferred for an indefinite period.

Meanwhile the banking business gets massively more coverage in the media than does water; partly because editors and journalists do not recognise the immense difference between unconditional human needs, represented by water,  and the availability of convenient services, such as banking: and also in recognition of the fact that finance is under much more obvious scrutiny as the Economics editors and commentators try to elucidate the debate around the 'Vickers proposals'. Vickers has proposed, and the Establishment has rallied around the concept, that a 'retail-wholesale' bifurcation of banking should take place. The UK Treasury policy is said to be that the corporate structure of the post-2008 financial conglomerates should not be changed; in line with the pretence that the amalgamated banks will eventually expose 'where all the bodies are buried' and hygienically dispose of the remains. Meanwhile it is proposed that operating divisions within those massive entities - and in  the immensely smaller niche firms that operate as specialists in that sphere  - should manage 'retail' banking on the assumption of being underwritten by the government: while 'wholesale'  areas of the agglomerated leviathans would be allowed in theory - to fail. Even if this were practicable - which it is not - it would not address the basic issue. Very simple tests can confirm that a colourless liquid is or is not water; and more-complex tests can verify whether identified water is potable: equally simple tests can verify whether a passage of credit through a succession of bank accounts is financing a real-world transaction that supports material business [or business with a material objective, such as insurance or investment for pensions].

But just as a water company could not guarantee the current high level of service to British consumers if it did not control all the processes in the supply sequence, so a 'retail' bank needs to operate knowledgeably in the wholesale arena to ensure the best returns on investments for its shareholders and to give assurance to all its customers that they can receive their deposits - in cash - on demand. To concentrate on the wholesale-retail issue is nonsense. As has been argued previously in this blogsite and in thousands of pre-blog, pre-twitter era discussions I have argued - and asserted - that in finance the essential distinction is not between retail and wholesale but between categories of 'products'. In terms of the flow of business in this millennium, transactions to fund the movement of goods around the world and to support material industry - including investment - are swamped by contracts [and by the consequential notional flows of money] that are outstanding in the betting games of derivative and futures trading, short-selling and the multiple other forms by which 'banks' hove been institutional gamblers. Far from ensuring the liquidisation-on-demand of their retail depositors' assets, they made the whole banking business.insolvent: compelling already-bankrupt governments in the US, Spain and the UK to raise massive financial packages to rescue the complex banks. The logical split is that of finance from gambling: with banks that have retail operations being unconditionally forbidden to gamble. That simple measure would massively increase the stability of banking, and would set a tight cap on the losses that governments and central banks could be expected to bear in the peculiar event of the fortuitous failure of a retail bank.

As Britain's retail banking inescapably passes under EU regulatory control, the innovative and globally significant high gambling business could flourish even better than before if it was pushed wholly outside the banking regime. It could grow in importance as an employer, an export earner and a source of taxation.

Four London Markets

Until the so-called 'big bang' in the middle of the nineteen eighties there was a complex of specialist markets: retail and wholesale insurance, retail and business banking, building societies, pension funds, investment management, stock broking, stock jobbing, bond trading, bill trading and several others. Some merchant banks covered a range of these functions; but they all kept clear of retail banking and of all categories of insurance. After the bang most of the non-insurance functions were pretty quickly subsumed into large conglomerates: as a general rule, only the firms that remained under the control of families stuck to a selected range of specialist functions, while the majority leapt into a spectrum of activities that was so broad that the central board of directors could not possibly hope to maintain adequate oversight.

That all came unstuck in 2007-8 and now there is mounting tension between the City of London, weakly 'supported' by the UK government, and the Commission of the European Union who want to impose common methods of regulation and taxation over all finance sectors in all EU member states [and not just the eurozone]. The press is slowly becoming cognisant that insurance will became increasingly expensive if absurd rules of reserving - which may be relevant for banking - are imposed on insurers, More recently feature articles and leaders have been written on the crazy proposal that pension funds should similarly be undermined; shrinking the value of all past and future pension contributions and building up a huge increase in old-age poverty for the future.

It is now urgent and vitally important that the UK government - and, in this, the Labour opposition should declare complete support for the position - declares unconditionally that they will protect the interests of investors, savers [including contributors to pension funds] and those who wish prudently to insure their assets in a rational and affordable system.

It is also crucially important for the survivial of the economy that the international earnings of the financial industries are at least maintained. Assuming that the irrational and irresponsible system of giving traders bonuses proportional to turnover [however risky] rather than on the basis of achieved real profits is replaced by a more rational system of remuneration, it is likely that the income-tax yield from the City will decline hugely; and alternative sources of government revenue will urgently be required if the national deficit is to be diminished. If the historic and entirely rational requirement for reserving by insurers is maintained [and if the daft actuarial preference for bond over equity investment is set aside] that sector can remain the world leader. The Vickers Commission's recommendation that 'retail' banking should be separated [in regulatory terms, if not by separation of ownership - though that would be desirable] from 'wholesale' has been accepted by the government and should be implemented: though fears of the government compromising and thus undermining the separation  are mounting. Given that Vickers will, to some limited extent, be implemented, attention should then be focussed on driving genuine wedges between materially useful merchant banking and the huge mass of activity that is appropriately called 'casino banking'.

Before the intrusion of modern Economics in the eighteen-seventies, Political Economists had tought - correctly - that a distinction should be draen between 'productive' and unproductive investment. Productive investment laid down the basis for more production in the future; unproductive investment provided products that were consumed in ways that did not put anything into future economic activity. That distinction should be restored, and those wholesale financial activities that conduce to the facilitation of productive investment should be in one category [let us call it merchant banking] and those that manage purely speculative finance or hedge financial deals unrelated to material economic capital formation [casino finance] should be in another category. Merchant banking should be regulated and taxed as banking is managed by governments all over the world. Casino finance should be registered, regulated and taxed for what it is: betting. Just as appropriate regulation and taxation have made London casinos popular among global high rollers, and the retail British betting industry has been highly successful, so both face-to-face and online finance gambling in futures, derivatives, short-selling [of shares not owned by the sellers] should be legalised and regulated and taxed as a great British business. Before anyone else does it, the City should develop on its great tradition as the magnet for an expanding global trade in bets, which is what most of the turnover was before the crunch. The credit crisis has arisen largely because governments mistakenly adopted and monetised the so-called "banks'" gambling debts; and part  of Britain's way out of the mess can be speeded by optimising on the existing City expertise.

In due course, real productive investment must enable industry [including creative industrial sectors] to grow and provide an increasing part of the national product; but for a quick fix the opening of the casino finance business - on an open and honest basis - is the primary feasible option.