Economics

Why Osborne can't support hedge fund restrictions

May 14, 2010
Ready to cut
Ready to cut

The new British government is kicking and screaming because next week the EU expects to adopt stringent regulations on hedge funds. Funds that comply will get a “passport” and be allowed to trade within the EU. Others, whether based in Europe or offshore, will be locked out of the continent.

George Osborne is not happy. 80% of European hedge funds are based in London, and industry spokesmen tell us these new rules will hinder their ability to find the most profitable international opportunities. The government has been frantically negotiating for watered-down regulations, but right now, only the UK and the Czech Republic are planning to vote against it.

The growth of an unregulated shadow-banking sector, advocates of the bill insist, is one of the causes of the financial crisis. Having just authorised a 750-billion-euro bailout, no wonder Merkel and Sarkozy want to ensure they don’t have to do it again. The proposed rules on the shadow banking sector seem sensible enough—limiting leverage, forcing greater transparency, and insisting assets be held in European banks—but they will reduce banking profits.

Back before the crisis, when economists and central bankers congratulated themselves on having overcome the business cycle, they called our era “the great moderation” and they thought they had the macroeconomic tools to prevent any major economic slowdown. Most establishment thinkers maintained that a large and free financial sector was a benefit to the general economy. Their logic was that a big financial sector, even if it was only peripherally engaged in productive investment, added liquidity, making trading easier.

This crisis has revealed the hollowness of that claim. The liquidity was more apparent than real. It evaporated every time it was really needed, forcing governments to add it themselves. Now, more and more distinguished economists are realizing that our economies grew faster and with fewer financial crises back when we had a small financial sector. New regulations in Brussels and in Washington may well shrink the overgrown shadow banking system, and that will probably be good for the rest of us.

But it won’t be good for London. Britain is no longer dominant in ship building, in steel manufacture and in textiles, the industries that powered its growth since the 19th century. It is, however, still one of the world’s great financial centres. During the boom, profits from banking swelled tax revenues, stimulated demand, and raised house prices in Mayfair and Fulham. Much of the reaction against Lord Turner’s proposed Tobin tax (also known as the Robin Hood tax) was focused on its negative effect on London’s economy. Few disagreed with the global benefits of an infinitesimal tax restricting spurious speculation but all agreed it would be bad for the financial sector and thus for the British economy. Osborne’s dismay vis-a-vis the new hedge fund regulations is a bit reminiscent of North Carolina senators’ views on tobacco legislation. No one denies that cigarettes are bad for you, but they are good for North Carolina.

A few years ago, in Takhar province in northern Afghanistan, I asked a grizzled mujahedin what Afghanistan produced for export, other than opium. He scratched his beard and muttered optimistically, “lapis lazuli.” Please forgive the comparison, but hedge funds in London are a bit like poppy producers in Afghanistan.

It has proven very difficult to limit poppy production in Afghanistan. Farmers and warlords alike see no alternative crop that will make them anywhere near as much money. It is becoming clear that a bloated financial sector has been detrimental to the world economy, but it remains London’s biggest moneymaker. A smaller financial sector will hurt the UK, whose global competitive advantage is in finance, media and little else. If the new regulations do indeed limit financial sector profitability, we will need to find our own lapis lazuli.