8938 laws of unintended consequences itemid 127

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Unintended Consequences

Written by Paul Amery

  
April 10, 2013 17:41 (CET)

In today’s Financial Times there’s an excellent column by John Plender (subscription required) on the long-term effects of the liberalisation of the City of London undertaken by Margaret Thatcher’s conservative government in the 1980s.

Plender reminds us that landmark events, such as the 1984 privatisation of the UK phone utility, British Telecom, were less the result of Thatcherite, free-market ideological fervour than a pragmatic and short-term fix intended by the government to land the costs of updating a run-down phone network on the private sector.

The BT privatisation was the first of a series of sales of controlling UK government shareholdings in utilities, running from 1984 to 1997.

These large public share sales, combined with the “Big Bang” that took place in 1986 (when demarcation lines between the UK’s share brokers and traders were eliminated, fixed commissions were abolished and the UK’s informal version of “Glass-Steagall”—a split between commercial and investment banks—was relaxed), set UK securities market trading on a rapid upwards trajectory and marked a big shift towards the overall “financialisation” of the British economy. Other European countries soon followed suit.

An anonymous commenter on Plender’s column (“non-exec”, at 12.44pm) argues that the upturn in the City of London’s fortunes (and the beginnings of the financial market money-making machine that arguably hit a peak in 2008) actually began two decades earlier than Thatcher’s reforms, in 1964.

In that year, says the commenter, the then UK Chancellor (finance minister), James Callaghan, took a decision that led to an inadvertent boom in the fund management business.

“The Chancellor introduced capital gains tax (CGT), to close off escape from his penal taxes on investment income. But he left a loophole for defined benefit (DB) pension schemes, which were spared both CGT and investment income tax,” writes the commenter.

“Boards of directors everywhere set up employee pension schemes and capital flooded in. By the 1980s, assets in UK DB pension schemes exceeded the rest of Europe’s put together. The companies with pension schemes did not have the skills to invest them. Hence the second unintended consequence: institutional fund management flourished.

“At the same time, inflation made investing in fixed income bonds calamitous. The third unintended consequence was therefore to boost whichever investment firm gave the highest allocation to equities. This happened to be Mercury Asset Management.”

According to this version of events, the great post-war boom in the UK fund management industry happened largely by accident.

And, following this logic, one could argue that the increasing interest in index-based investing is a further, fourth consequence of the 1964 UK tax change. After all, it was the growing realisation that active fund managers could not, collectively, add value, that led to the focus on costs that’s been behind the indexing boom.

If all this seems far-fetched, it’s easy to forget that the leaders of investment banks in the 1960s and 1970s viewed asset management as a peripheral, even disreputable activity.

In the latest issue of Global Custodian magazine, editor-in-chief Dominic Hobson writes that:

“As recently as 1977, the total assets under management of the entire American mutual fund industry were worth just $50 billion (they are now $15 trillion, 300 times more).

“That same year Siegmund Warburg told Peter Stormonth Darling to ‘get rid’ of Mercury Asset Management, the investment management subsidiary of SG Warburg (an investment bank) that rode the 1980s bull market in equities successfully enough to become the largest and most successful independent fund management business in the United Kingdom.

“Yet Warburg tried repeatedly to close, sell or give it away, because he regarded investment management as unprofitable, a distraction from his primary business of giving disinterested advice to top-class companies and governments, and an activity almost as disreputable as stockbroking. It was called Mercury because he refused to allow his name to be associated with it.”

But Warburg, widely viewed as the brightest and most talented London banker of his generation, got it wrong. Fortunately for Warburg shareholders, his subordinates ignored the command—or managed to convince him otherwise.

“By the late 1970s, investment management was on the cusp of a period of such explosive growth that Mercury Asset Management eventually fetched a price four times that of the whole of SG Warburg, Hobson reminds us.

And Mercury is of course now part of BlackRock, the world’s largest asset manager and the biggest player in the index-tracking ETF business.

No one knows how the financial markets will look in thirty years’ time, but much of what happens will surely be dictated by current changes in regulation—which, as usual, are being driven by the desire to mend perceived flaws in the previous rules.

And a key area is tax. The current deliberations on Europe-wide financial transaction taxes are almost certainly the most critical debate of the moment.

Charging a levy per transaction on trades in shares, bonds and derivatives threatens to render whole areas of financial activity—from algorithmic trading to repo and securities lending—marginal or uneconomic. ETFs will suffer knock-on effects if the costs of secondary market trading rise, although traditional index funds may see a renewed period of popularity.

And, whatever happens to plans for a Europe-wide FTT, we’re surely on course for several years of reversal of the previous decades’ expansion of the financial sector.

But it won’t be bad news for everyone. Just as the UK’s fund management business was set on a path of huge growth by the attempted closure of a tax loophole half a century ago, so current reforms are surely setting the stage for new activities and services to flourish. It’s just that, given the unintended consequences of rule changes, only the far-sighted or the lucky will be able to place the right bets.

Dominic Hobson got in touch with IndexUniverse.eu to tell us that it’s a mistake to play down the ideological component of the 1980s push for privatisation of state assets in the UK. He says:

“John Plender is not quite right about BT. I was present at the creation of the privatisation programme in 1982-3, and it would be a great mistake to underestimate its ideological dimension. Certainly, getting the BT investment programme off the public sector balance sheet was a consideration (they looked at “Buzby bonds” first), but giving public companies unrestricted access to financial markets is a large part of the point of privatisation. Breaking the Post Office trade union stranglehold on labour costs (and so telephone prices to consumers (as a measure of the absurdity, the government had looked at price-capping BT) were also considerations, as was evolving technology (I remember the first mobile phone networks being presented to the backbench committee I serviced in the Commons in 1981 or 1982).

“Bear in mind the market for supplying  telephones was liberalised in 1980 as a first step (up to that point you could only get a phone from BT)  and the first real competitor (Mercury, owned by Cable & Wireless) was licensed in 1981 (it had to build its own network, and BT did its best to scupper its success by denying it interconnection). The initial plan was actually to break BT up (the first idea was that BT would be forced to lease capacity to third parties). It was George Jefferson, BT’s chairman at the time, who insisted it stay in one piece as the price of his support, like Denis Rooke at British Gas – much to the fury of Margaret Thatcher.  Privatising BT was not an accounting gimmick – it was a genuinely revolutionary idea at the time, diluted in terms of competition by the incumbent management, not the government.”


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