A new romance blossomed today in London as Conservative leader David Cameron stepped out for the first time as British Prime Minister with the leader of the Liberal Democrats, and Deputy Prime Minister, Nick Clegg at his side. Is this a match made in heaven or hell for the urgent task of economic reform? The first clues come from the parties’ coalition agreement.
The Conservative view seems to have won out on the delicate balance between fiscal stimulus and deficit reduction, with a commitment to cut public spending by £6 billion ($9 billion) this year, yet the agreement includes the important caveat that the final decision to cut or not will depend on advice from the Treasury and the Bank of England. This is the right approach. Cutting too early could send the economy sliding back into a Japanese-style stagnation: the decision needs to be made on the basis of the numbers, not political calculations that lean to getting the hard decisions out of the way as early as possible in the government’s time in office.
The longer term challenge of making the biggest public spending cuts in more than half a century is going to be settled by a public spending review, although Stephanie Flanders of the BBC has noted that one price of the coalition seems to have been various new spending commitments. Watch this space.
On the big question of financial reform, the coalition partners were already united in their commitment to charge some sort of levy on the banks to recoup the costs of government bailout, so it is no surprise to see this as a central plank of the new government’s banking platform. Even so, the problem remains that a new tax on the banks will really only be viable if other countries also agree to implement it. The new government also offers warm words about uncontroversial ideas like promoting more competition and diversity in the banking sector and getting the nationalised banks to lend more (as well as a commitment not to join the Euro during this Parliament: must have been a tough decision that one!).
In pre-coalition days, the Liberal Democrat’s economic guru, Vince Cable, had turned himself into a national celebrity with his anti-bonus and ‘break up the banks’ rhetoric. As an MP for the junior partner in the coalition, however, Cable has had to accept the lowlier role of Secretary of State for Business rather than Chancellor of the Exchequer, which has gone to the Conservative George Osborne (whose reputation, in turn, is lowlier than Cable’s). As a result, most of the meatier issues around banking reform have been pushed off for further consideration. ‘Unacceptable’ bonuses will be tackled, says the coalition agreement, but there is an interesting rider that the proposals must be “effective in reducing risk”, which rightly shifts the debate from how to punish bankers to how to incentivise them to behave in the economy’s long term interests.
Cable’s cherished idea of a British ’Volcker Rule’ to split retail banking from investment banking is now destined for consideration by an independent commission. It will be interesting to see if the terms of reference will ask the experts whether this is a good idea (we suspect not) rather than simply how to make it happen.
In the end, the one big idea on financial reform that did make it into the coalition agreement is handing financial regulation back to the Bank of England, winding up the Financial Services Authority (FSA) in the process, which was a Conservative idea. There is some sense in doing this – since systemic risk was the problem, creating regulators with an oversight of the entire financial system has an obvious appeal. (America, for example, could certainly do with a big integrated financial regulator rather than its myriad of small, uncoordinated regulators.) Yet it is less than evident that the Bank is going to be any good at this role. Indeed, the FSA was born out of concerns that the Bank was better at managing macroeconomic trends than overseeing the financial services industry.
All in all, it seems that the new coalition government will make plenty of changes to the financial system. It remains to be seen if this benefits the British economy. Even less clear is what it will do for the City of London. The Labour government made it a priority to promote the interests of the City, as a booming finance industry in London was a huge source of jobs and tax revenues (as well as donations to Labour Party coffers). Since the financial crisis, the Conservatives have indulged in populist bashing of the City, and espoused policies that many experts thought would drive mobile financial capital away from london to friendlier locations. Yet many observers suspected this was a ruse to hide from voters the fact that the Conservatives had lots of wealthy friends in the City, and that once in office they would again promote the interests of the City. By contrast, the Liberal Democrats seem genuinely affronted by the activities of the City. Will one unexpected consequence of the coalition government be that the populist banker bashing of the election campaign actually becomes policy, rather than merely a broken promise?