Chancellor Rachel Reeves arrives at the Davos summit this week amidst a sea of back-slapping financiers, but a growing body of evidence suggests she should offer them a cool reception rather than a warm embrace.
The Chancellor's Courting of the City
Reeves has made cosseting the financial sector a cornerstone of her growth strategy. In her November budget, she notably spared banks from a proposed windfall tax. This was followed swiftly by regulators, for the first time since the 2008 crisis, loosening capital requirements—the buffers banks must hold against losses.
The Chancellor's logic is clear. In her first Mansion House speech, she labelled the sector the “crown jewel” of the UK economy. With growth stagnant, the argument runs that now is not the time to raid banks for tax revenue, and that lighter capital rules will free them to lend more to businesses and households.
The approach has won plaudits from finance chiefs. JP Morgan's Jamie Dimon cited the government's pro-growth stance as a key reason for committing to a new £3 billion headquarters in Canary Wharf.
The Academic Evidence: When Finance Becomes a Drag
However, a significant catch exists, highlighted at a recent London School of Economics conference aptly titled ‘Too Much Finance’. Academic research spanning over a decade consistently shows that once a country's financial industry grows beyond a certain size, it ceases to boost the economy and instead becomes a brake on growth. The UK's sector passed that point long ago.
Alex Cobham of the Tax Justice Network, a conference convener, stated: “The research really consistently shows that the UK is far past the point where we would maximise the benefits of finance. And actually, it’s a drag on the economy, and has been for a long time.”
This drag operates in two key ways. Firstly, an oversized finance sector makes the economy more vulnerable to catastrophic, finance-led crises, as witnessed in 2008. Secondly, it warps the allocation of the nation's brightest talent and capital.
A landmark 2012 paper by Stephen Cecchetti and Enisse Kharroubi noted that finance “literally bids rocket scientists away from the satellite industry,” diverting innovation from productive sectors. This echoes Adair Turner's famous 2009 remark that much City activity is “socially useless.”
Implications for Policy: Check, Don't Cheer
The implication for policymakers is stark. Rather than courting bank bosses, they should use tax and regulation to keep the sector in check. Critics have already attacked the decision to cut capital requirements.
Former Bank of England chief economist John Vickers and David Aikman of the National Institute of Economic and Social Research argued last week that with public finances tight and global risks high, resilience should be strengthened, not weakened. They contended the move would likely lead to higher shareholder payouts, not increased lending.
The core risk, as Cobham warns, is that the profits from finance are privatised, while the risks are socialised. When crises hit, as in 2008, the public bears the cost. As the AI boom inflates finance and private credit further, the message from experts is clear: for the health of UK plc, the Chancellor's warmth in Davos should be tempered with a much colder assessment of the sector's true economic value.
