Labour’s affair with bankers is to blame for this sorry state

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The crippling consequence of inability to admit error is the impossibility of learning from past mistakes.

In Wednesday’s Budget statement, Alistair Darling acknowledged that even on his optimistic assumptions a decade was needed to repair Britain’s public finances. The UK government’s reputation for economic competence was already in tatters; the chancellor of the exchequer has now laid it definitively to rest. How did the New Labour project end in such disaster?

The answers lie not in unpredictable global events but closer to home. The government failed to deal effectively with the reform of public services and conducted an indecent love affair with the financial services industry. These two apparently unrelated errors, allied with hubris, proved to be a fatal combination.

When Labour came to power in 1997, dissatisfaction with public services such as health, education and transport was widespread, and justified. For two decades not enough money had been spent, particularly on capital projects. This underspending had contributed to weak and demoralised management, reservations about which led to a fear that simply allocating more cash would provide poor value for money.

There were two possible directions of reform. One – it might be described as Blairite – decentralised management authority and financial responsibility. The other – it might be described as Brownian – tightened centralised control and imposed performance targets on managers, with associated sticks and carrots. Both approaches were pursued, inconsistently, but overall with more Brown than Blair. When, by 2000, there was little to show in the way of beneficial results, the decision was made to spend lots more anyway. There were some service improvements, but the concern that the extra money would not be well spent proved largely justified.

The reasons targets do not work are evident from any study of the failure of planned economies. You can require people to meet goals, but that is not at all the same as encouraging them to meet the objectives behind the goals. By emphasising targets you undermine both their motivation and their ability to achieve these more fundamental underlying goals. In a delicious irony, a major victim of this process would be the Treasury itself. Here is how it happened.

The government’s principal fiscal target was to balance current expenditures with revenues over an economic cycle. This makes sense as a generalised objective: but not as a binding constraint. The financial services sector boomed from 1998 to 2000 and the government benefited from a surge of revenues. The tide then receded. But by mechanically averaging spending and receipts over the cycle, earlier revenues could be used to offset the later splurge in spending. When this resource started to run out, the Treasury redefined the economic cycle to claim compliance with the target.

This is where the two stories become linked. We now know that many of the banking profits of that period were illusory. But they generated substantial revenues from corporation tax and income tax on bonuses. The real funding gap was wider even than it appeared.

But the illusion was at its most influential at the highest levels of government. Investment bankers had become the most powerful political lobby in the country and there was no vestige of political support for action to restrain City excess. Light touch regulation was not just a matter of policy but a matter of pride.

What would have happened if the Financial Services Authority or Bank of England had sought to block the competing bids from RBS and Barclays for ABN Amro – a contest which, we now know, would bankrupt the bank that won the race? The phones in Downing Street would have been ringing insistently and it is easy to imagine the government’s response.

Little has changed. The government continues to see financial services through the eyes of the financial services industry, for which the priority is to restore business as usual. For a time in 2008, it seemed possible to argue that a package of temporary support for the banking industry, combined with substantial recapitalisation of the weaker players, might stabilise the financial sector and prevent serious knock-on effects.

But the problems of banks are much deeper than were then acknowledged and the destabilisation of the real economy has happened anyway. Government now provides taxpayers’ money to financial services businesses in previously unimaginable quantities. But there is no control over the use of the money, no insistence on structural reform or management reorganisation, no safeguarding of the essential economic functions of the financial services industry and no accountability for the damage that has been done.

It is as though the teenage children and their friends were to wreck the house and then demand that the grown-ups clean up before the next party. Their parents are too intimidated to do anything more than ask Uncle Adair to keep an eye on them and excoriate the hapless Fred who made off with some of the silver.

On Wednesday, Mr Darling gave the impression of an honest man who would have much preferred to have been somewhere else, as befits someone caught in a trap not of his own devising. We need a comprehensive reappraisal of both the fiscal framework and the economic and political role of the financial services sector. The crippling consequence of inability to admit error is the impossibility of learning from past mistakes.

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