When the governor of the Bank of England warns of hard times, it's time to sit up and take notice. In the bluntest of warnings to the British middle classes, Mervyn King has pointed out that higher energy and food costs are causing "a genuine reduction in our standard of living." In simple terms, we are getting poorer.
This will not come as a surprise to many people. Newspapers are crammed with penny-pinching tips and cries from middle-class professionals about how hard it's getting out there. House prices have been falling faster than at any time since 1990-92, although February is seeing an anaemic recovery.
We are not the only ones who are noticing. In the third quarter of 2007, just 38,680 Poles signed up to the government's register of migrant workers, a year-on-year decline of 18 per cent. Officials say that Poles leaving Britain outnumber those coming in. Canny workers that they are, they apparently don't like the look of our economy.
In this situation, it is inevitable that people should reach around for someone to blame. And, surprise surprise, opprobrium has been heaped on the government. So there couldn't be a better moment for Robert Peston's new book, with its demagogic, anxiety-inducing title: Who Runs Britain? How the Super Rich are Changing our Lives (Hodder & Stoughton).
Peston's thesis is that globalisation has created a new class of super-rich who have made fortunes on a Victorian scale. Some are industrialists, others are retailers, but many work in the City of London. Almost all of us have done well in the past 15 years or so, but Peston fears that this fortunate few, or their descendants, will end up wielding excessive power. They may not run Britain now, but they have "the means through the funding of political parties, the funding of think tanks and the ownership of the media to shape government policies or to deter reform of a status quo that suits them."
Worse, these people are a threat to social cohesion. The growth of the super-rich as a class has corroded "the fabric that holds together communities and the nation." Peston believes that their reluctance to pay more than the minimum amount of tax undermines the social contract, while the dizzying accumulation of wealth makes the average Briton feel that in the "casino" economy, luck—and connections—matter more than skill and effort. The rich "behave as if the UK is permanently on probation. And they would never surrender their… ability to move somewhere else should the financial tariff for staying in the UK rise above a certain threshold."
What's more, the government is cowed by this implied threat: "Gordon Brown's actions when chancellor underpinned this idea of the super-rich doing us a favour by living here, since he very carefully shied away from ever alienating them; which explains in part why the burden of tax increases has fallen on the vast majority who are not quite wealthy enough to relocate to Monaco or the Caymans."
Politics is always local; finance has become truly global. This mismatch has created an unstable situation. But what occurred in the last decade was more akin to a perfect financial storm. Let me explain.
The globalisation boom that started in the 1990s, quite independently of the policies of Blair and Brown, changed the nature of business and finance. Falling trade barriers and improved communications allowed businesses to purchase and sell goods in new countries and regions. This called into being a vast new market for financial services funding this expanded global trade. It also created huge fortunes for a small number of lucky or talented people.
The people who did well were those who spotted the opportunities first. A classic example was Philip Green, the British fashion retail king, to whom Peston devotes a whole chapter. A small player who ran cheap fashion chains until the early 1990s, Green was quick to start buying smartly and cheaply from Asia. "He discovered the manufacturing potential of China years before most British companies," writes Peston.
What's more, Green realised that the only way to lock in this temporary advantage was by snapping up his less nippy competitors. In a few years around the turn of the century, he bought Sears, a tired but property-rich shoe retailing chain, British Home Stores and finally Arcadia, a retail group that owns, among other chains, Top Shop and Miss Selfridge.
I recently talked to the boss of another British clothing retailer. When he joined the business in the mid-1990s, it had a turnover of a few million pounds and was almost bankrupt. A decade later, it was turning over hundreds of millions and earned margins of 20 per cent—fat profits for a retailer. (The company's main shareholder is turning a hamlet he has bought in the countryside into a Kennedy-esque compound.) What accounted for this turnaround?
"Simple," he replied. "The cost of clothes collapsed. And because we had a brand name, we were still able to charge £50 for a sweater even though the input cost to us had, say, halved. So we went from making no money at all to very attractive profit margins." Even better, Britain's biggest clothing retailer, Marks & Spencer, was slow to respond. For several years, it continued to pay workers in Britain to make clothes at high prices, giving its rivals a priceless advantage. M&S ultimately cut loose its British suppliers, causing a big furore in late 1999 when it announced it would no longer buy from William Baird, a Scottish textile firm that had supplied it for 30 years. Baird's was forced to lay off 4,500 people. But even then, M&S struggled to catch up and only just escaped takeover by Green in 2004.
Like any revolution in business or finance, globalisation separated the world into winners (who "got it") and losers (who didn't). What allowed the winners to clean up was access to cheap finance. From the late 1990s, not only did interest rates and inflation fall to very low levels because of the supply-side miracle of globalisation (lots of people in poor countries producing export goods cheaply and not consuming very much), but new techniques in finance vastly expanded the sources of debt funding.
Traditionally, only banks lent money (although large companies could borrow directly from institutional investors by selling bonds listed on stock exchanges). But now a new wave of investors such as hedge funds and insurance companies started to lend in the riskier, higher return end of the market through credit derivatives and other special vehicles. This allowed banks to lay off risks that they had hitherto been forced to carry on their own balance sheets. They were thus encouraged to lend irresponsibly, whether to "sub-prime" home buyers, to hedge funds themselves or to back "leveraged takeovers" (buying companies with borrowed money and paying the interest out of profits). Consequently, debt became both cheap and rather too easily available (see "The financial crisis explained," Prospect February 2008).
This allowed the likes of Green to snap up their rivals. And conventional entrepreneurs weren't the only ones to take advantage. Private equity firms, property speculators and hedge funds got in on the act. These predators found that it was remarkably easy to buy stock market companies. Because debt was cheap and plentiful, they could buy really big targets using little of their own cash. Typically, four fifths or more of the cost of these takeovers was funded with borrowed money. Bigger and bigger targets thus came into their sights—a process that culminated last year when KKR, a US private equity fund, bought Alliance Boots, the owner of Boots the Chemist, for £11.1bn. KKR put up only £932m of equity to take a controlling stake.
Meanwhile, the owners of the target companies—pension funds and other investors in listed shares—were often willing sellers. A mixture of poor governance and misguided regulation (much of it dating from the time of the Major government and designed to stop future Robert Maxwells) forced pension funds and insurance companies—the main owners of British listed companies—to sell shares and buy bonds after the dot-com crash in 2000. This helped drive down share prices and made it even easier for the predators to snap up stock market companies.
The buyers found they could pay off the borrowings relatively quickly by selling hidden assets or running the business to generate cash. What's more, listed companies could not mimic the actions of private equity because their investors—perhaps with good reason, as things have turned out—would not tolerate such high levels of borrowing.
There was an explosion of highly leveraged takeovers as a succession of well-known public companies were gobbled up: Debenhams in 2003; Allied Domecq in 2005; BAA, owner of London's airports, Associated British Ports and BOC in 2006; EMI and the AA last year—as well as a bid for Sainsbury's that was thwarted only by the credit crunch. (Not all the deals involved public companies. One of the largest deals in 2005, for instance, involved a small private chemical company called Ineos quadrupling its size by purchasing BP's petrochemicals division for £6bn—all of which was financed by debt.)
These deals exposed a flaw in the tax system. In classical finance theory, it shouldn't matter whether a company is financed by issuing shares or borrowing money, as its underlying value is unchanged. Tax, though, means the theory doesn't work in practice. Tax is paid on profits (attributable to shareholders) but not on interest (attributable to banks and bondholders). This means there is a real advantage in tax savings if a company is financed by debt. In the cheap credit conditions of the boom, this tax interest "shield" suddenly became a useful loophole. It encouraged companies to engage in irresponsible borrowing, and clever financiers to buy and sell companies—taking them private and then floating them again on the stock market.
This process eroded the tax base in two ways. Not only were the heavily indebted companies paying little or no corporation tax, which applies to profits, but the taxman could no longer be sure of taxing the interest received by the lenders. Because of the internationalisation of finance, many lenders and investors were foreign. And many of those that weren't—big private equity firms, or people like Philip Green—had arranged their affairs so they paid little or no tax in Britain.
That said, the tax leakage was only partial. British banks participated heavily in the leverage boom and continued to make huge profits that were taxed. Their returns on equity throughout this period averaged about 20 per cent, more than twice the returns earned by the average industrial company.
You can hardly blame excessive borrowing and tax leakage on the government. It inherited a flawed system and had the misfortune to see its flaws exposed by a prolonged boom. But in retrospect its inertia looks unwise. The rash of highly geared takeovers made it more likely that there would be more bankruptcies when debt became more costly—as is now happening. The tax shield simply made for extra churn on the stock market, which helped only the financiers who were arranging the deals. Meanwhile, as more companies understood the advantage of leverage, it became harder for the taxman to take his bite—meaning everybody else had to pay more.
Moreover, the tax interest shield wasn't the only fiscal come-on the tax system gave to the debt junkies in the City. One of Gordon Brown's first acts as chancellor had been to break the link established a decade earlier by Nigel Lawson between capital gains tax and income tax. In order to improve the incentives to build and then sell businesses, and to signal Labour's pro-business credentials, Brown introduced "taper relief" on capital gains tax—business assets would be taxed at a low rate of just 10 per cent once they had been held for a qualifying period (initially ten years but later reduced to just two). But in doing so, he made the tax system less fair. In particular, he restored to the rich an incentive to convert income into capital gains.
The clever clogs of the private equity industry latched on to this. They persuaded the taxman that a large part of their pay was a profit-share and hence should be taxed as a capital gain rather than as income. Their argument hinged on the way private equity organises itself. Normally, a private equity firm is a partnership between external investors and the buyout group. The investors put money into funds that are set up by the buyout group to invest in companies. These funds last for six to ten years, at the end of which the profits are split 80:20 between the investors and the buyout group. The chunk that the buyout group gets is its performance fee, or "carry." This fee, it was argued, was technically a return on an investment in equity—and hence not income but a capital gain.
At this point, private equity was one industry among many that exploited these arrangements. But in 2003, the government killed off other share-based compensation schemes by forcing employees to declare them as part of their income. The private equity industry, however, cut a special deal exempting itself from the rules. The origins of this deal are unclear, but many (including Peston) believe that Brown was talked into it by Ronald Cohen, then chairman of Apax, one of the City's largest private equity firms—and also a big funder of both the Labour party and Brown's own office. Peston's charitable verdict is that Brown didn't understand the distinction between private equity (buying mature companies with lots of debt) and venture capital (equity investment in start-up companies). The less charitable verdict is that he knowingly gave a tax break to his City pals. Frankly, it is hard to know which is the more worrying.
But the result was another bonanza for private equity—and such a huge one that one ashamed private equity boss finally admitted last year that it was wrong for him to pay less tax than his cleaner. Genuine venture capital, a much riskier game, went nowhere. Meanwhile, private equity funds became bigger and, as they did so, the value of the tax break became astronomical. In the 1980s, in the early days of private equity, the average size of funds was £50m to £100m. In recent years, the largest funds have been in the £5bn to £10bn range.
A £5bn fund might make a 20 per cent annualised return over its six-year life—turning into £15bn. Assume that all but £1m of the original £5bn was put up by external investors in the form of loans. Even after repaying these and assuming an interest rate of 8 per cent, there would be £7bn left in the pot, of which the buyout group's partners would collect 20 per cent, or £1.4bn. Had that £1.4bn been taxed as income, the government would have got a cheque for £560m. But taxed as a capital gain at 10 per cent, the taxman's take drops to £140m. In other words, the treasury has waved goodbye to £420m. That was not just lost cash to the taxman. It was an enormous financial incentive to do deals, deals, deals.
Of course, not all these deals were bad. There is clearly a place for private equity alongside the quoted sector. Buyout groups are sometimes good at reviving "Cinderella" businesses that are trapped within larger conglomerates. As Peston acknowledges: "Some private equity firms display real talent in the way that they improve the fundamental efficiency and growth prospects of a business." Yet in recent years things have gone too far.
Why did the government stand aside and allow financiers to wreak such havoc? At first, when debt levels started to grow much faster than the broader economy, the government didn't see it as a problem. Ministers persuaded themselves that rising leverage was a natural trend in a modern economy. Moreover, no one was complaining about rising house prices. And a little extra debt sloshing around the system helped consumers spend their way through the downturn that followed the bursting of the dot-com bubble in 2000.
But even when strains started appearing in the system, ministers were loath to intervene. The City was still producing big revenues for the taxman. Britain's financial industries contribute about a third of corporation tax—up from 15 per cent in the early 1980s. The City is—for all its faults—a goose that lays a prodigious number of golden eggs. And as the government jacked up spending after the second election victory in 2001, it needed the cash flow.
This desire not to mess up the City money machine also made the government wary of new taxes or regulations. Ministers and officials had learned from the US experience what regulatory overkill can do. The US government drove the international bond markets from New York to London in the 1960s after it imposed a withholding tax on dollar securities. And in 2002, a big chunk of the international equity market similarly crossed the Atlantic after congress passed the Sarbanes-Oxley Act in the wake of Enron, imposing costly and burdensome regulation on US listed companies.
You could claim that the government has pursued a shrewd and hard-headed industrial policy in the City's favour, preserving fiscal incentives and keeping a "light-touch" approach to regulation. The City has arguably become the world's dominant financial centre at a time of substantial expansion in the international capital markets. It has increased its share of international business far faster than Wall Street, its closest rival, which is both envious and fearful of its success. It is hard to judge exactly what role government policy has played in this. But compared to Labour's disastrous industrial policies of the past—in steel, shipbuilding and so on—at least it has reinforced success rather than failure.
The government has sometimes been too close to the money men—and perhaps a little too impressed by the big bucks. Blair should not, for instance, have watered down planned changes to the taxation of big pension pots simply because Unilever boss Niall Fitzgerald—who would have been adversely affected—asked him to. But it is wrong to heap the blame for everything on cronyism. As we have seen, there were sound reasons for backing the City.
But the perfect storm may not be over. The system that expanded credit prodigiously in the good times is now going into reverse. A contraction is likely, which explains Mervyn King's concern about living standards. "Deleveraging" is an unpleasant chain reaction that works like this. Assume a bank makes a big loss on some duff loans that it made to leveraged buyouts. Its bosses may call for it to increase its capital ratios, meaning it can make fewer loans to customers for the same amount of capital. So it has to call in some loans. This in turn forces some borrowers to sell assets, and asset prices fall. That undermines the value of collateral banks are holding against loans. More loans are called in, leading more borrowers to sell assets and so on.
This process may lead to a steep rise in both mortgage defaults and losses on corporate loans. It's the reverse of the good times, when rising debt gave everyone the illusion of wealth. British households will have to pay back some of the £1.4 trillion—£56,000 per household—that they have borrowed. It's hard to know how the process will work through. In Japan, the deleveraging after the 1989 bubble led to the prices of shares and property falling by between 40 per cent and 70 per cent.
If anything that severe were to happen, there would be mayhem. But even a modest slump is likely to lead to more panic and more demagoguery. There will be more talk about the evils of the City and the super-rich. The banks are not doing much to help their own cause. A recent survey showed that 80 per cent of City bankers had this year received a bonus equal to or higher than the amount they got last year. That's pretty outrageous after a year in which the world's central banks had to ride to the rescue of the financial system. The system enjoys legitimacy only if there is carrot and stick. Carrot and more carrot isn't just unseemly; it is fundamentally unhealthy as it encourages bankers to take even more risk. After all, the bigger the bet, the fatter the carrot they get if things come off. And if things go wrong, the authorities simply have to step in and bail them out. Suddenly the €50bn bet on derivatives made by Jerome Kerviel, a trader at the French bank Société Générale, doesn't seem quite so irrational.
The government can't turn the clock back. But it can learn lessons. The leverage boom has fizzled out for now. But Brown should perhaps examine those elements of the tax code that contributed to the excess. He could usefully look again at reforming corporation tax to make it less debt-friendly. If the tax shield is removed, there should be compensating cuts in company taxes so that the overall burden on industry is unchanged. Still, it's hard to change things unilaterally in the modern world. Peston holds out the hope that the credit crunch might be scary enough to forge some sort of international consensus—but don't hold your breath.
And what about the super-rich? Here, it is important for the government to disentangle genuine abuses from media outrage. Peston salivates at the thought of the billions more that could be raised from the Sunday Times Rich List. But that is unrealistic.?In 2004-05, Britain's 112,000 non-domiciles—who are an imperfect proxy for the very wealthy, as some have modest incomes—paid tax at a rate of 31 per cent on their British earnings, according to HM revenue and customs. That may seem a modest rate for the very rich, but in absolute terms it was worth about £3bn. Moreover, notwithstanding Britain's sophisticated tax avoidance industry, the top 1 per cent of taxpayers—another imperfect proxy, as it includes the merely rich as well as the super-rich—paid 22 per cent of Britain's total income tax receipts against their 11 per cent share of pre-tax income. The government needs to focus on increasing the absolute numbers rather than jacking up the percentage figure at the expense of the actual tax take. That—rather than reducing inequality by the simple expedient of driving the super-rich away—is the best way to help those lower down the scale. There is a case for reforming the taxation of non-doms. But the government's approach to date has been flawed. A system that discriminated between the super-wealthy and those of more modest means would be fairer (see Richard Sennett in this issue).
Still, while the government might need to be more thoughtful, it doesn't need to cringe. Where would the non-doms go if they fled Britain? Ireland might do, but Switzerland doesn't allow non-doms to work. Beyond that, they would have to head to the Gulf.
But just as the government didn't cause all these problems, it can't fix them all either. The banks need to pitch in too. They need to mend their battered reputations with investors and the public. It would be a good start if they could show they were serious about restraining pay in tougher times, and about reintroducing the concept of carrot and stick. Shareholders too need to put more pressure on them to run their affairs more responsibly. For if they don't, the pressure for the government to show it is not clueless—and do something possibly damaging—will mount.
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