How financialization broke Britain We bet the house — and lost

The grim forecasts just keep on coming. Only last week, EY Item Club warned that the economic hit of the Iran war on the British economy could be the worst since Covid — even as Deloitte predicted that 250,000 British workers will lose their jobs by the middle of 2027, bringing the unemployment rate up to 5.8%. Once again, the country is at risk of recession. In truth, of course, Britain’s economic troubles far predate the Iran war. Despite Keir Starmer and Kemi Badenoch’s claims to the contrary, something about the country’s political economy seems fundamentally broken. On key economic indicators, the United Kingdom has deeply underperformed relative to its peers: real wages saw zero growth in the 15 years following the 2008 Great Financial Crisis, while productivity has been sluggish for over a decade. Public services, from the NHS to local government, are visibly straining under a legacy of chronic underinvestment. 

Andy Burnham, who might yet succeed Starmer, has issued his own diagnosis of Britain’s predicament: the “four horsemen” he proffers are deindustrialization, privatization, austerity and Brexit. The first two are simply shadows cast by the elephant trampling across the room; the latter are misguided reactions to the damage it left in its wake. The grey behemoth in question is finance.

Just how broken is Britain, then, and what role did finance play? The “too much finance” argument has fallen somewhat out of fashion since the crisis. But “financialization” — that is, the extent of the growth of the financial sector and financial asset accumulation — remains the central cause of the country’s malaise. It broke the link between corporate profits and productive investment, inflated asset prices and living costs, and hollowed out manufacturing and investment into research and development (R&D), thus leaving the economy structurally vulnerable to the policy disasters that followed the crisis. Now that geopolitics and trade fragmentation have exposed the vulnerability of lacking a domestic manufacturing base, it is worth re-considering finance as the main culprit.

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The United Kingdom’s relative economic decline and its attendant political dysfunction can be understood as the outcome of several self-reinforcing trends — what economists might call a bad equilibrium — with finance at the center. Where underperformance has been starkest is in the growth of productivity and wages. Data from the Office for National Statistics reveals that, between March 2008 and June 2023, the United Kingdom saw zero growth in real average weekly earnings. By contrast, cumulative real wage growth in France and Germany registered 10% or more during the same period. This astonishing gap is partly the result of a similar trend in productivity growth, which has been poor in both historical and comparative terms. Among the UK’s larger peers, only Italy, bedeviled by deep structural problems and policy failures of its own, performed worse on these measures.

The primary driver of long-term growth is investment, specifically investment into productive assets as well as research and development. This is known as fixed capital formation and includes investment by businesses, households and government. The country’s economic future, principally its growth trajectory and the sustainability of its national debt, depends on present levels of investment being sufficient to drive productivity growth over the long run. And investment decisions depend principally on the expectation of profits. This profit-investment nexus — complemented by public investment in key areas like education, research and infrastructure — forms the beating heart of a healthy market economy. But in Britain, more than almost anywhere else, it appears to have broken down. 

Since early 1989, private investment has declined dramatically. As a share of gross domestic product, private fixed capital formation and net investment (which accounts for depreciation) are down by 30% and 76% respectively. These are extraordinary figures. The more narrow measure of business investment (which excludes investment by financial corporations, non-profits and investment into housing) is down 51% as a share of GDP from its peak in mid 2000.  

Yet there was plenty to invest: the total surplus in the corporate sector (gross operating surplus, a broad measure of profits that includes the value added after compensating labor but before rent, taxes, dividends and depreciation) has increased fivefold since the mid-Eighties. Where did those surpluses go? The short answer is that finance absorbed them, channeling capital and resources away from productive investment and into financial asset accumulation, shareholder payouts and property speculation.

To understand how this process unfolded, it helps to trace two interconnected stories. The first concerns the deregulatory reforms of the Eighties that unleashed the financial sector. The second concerns the consequences of that expansion: how it distorted the relationship between profits and investment, contributed to the decline of British manufacturing, and left the economy vulnerable to the shocks that followed. Together, they provide a stylized account of how “too much finance” took its toll on the economy.

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Starting in 1980, Margaret Thatcher and her cabinet enacted a series of deregulatory reforms, beginning with the removal of the credit-rationing “Corset” to allow banks to create credit freely. Other reforms such as the Housing Act 1980 (which included the infamous Right to Buy) and the Local Government, Planning and Land Act 1980 created a large surplus of public land that could be privatized and transformed into financial assets. If 1980 created the flow of money and assets, 1986 created the mechanism to intermediate it. The “Big Bang” in October of that year was the watershed moment: the reform of the London Stock Exchange resulted in the removal of fixed commissions, the introduction of electronic trading and the opening up to foreign banks. It also changed the nature of the domestic financial system in a way that would prove highly consequential. 

By the late Eighties, London had already become the center of the global “offshore” dollar market, acting as the neutral and lightly regulated clearing house for international capital. This sat at odds with its hamstrung banks and exchange: Japanese or American banks in London couldn’t trade equities with the same ease with which they could trade currencies. This was despite the fact that there was no formal separation of commercial banking and merchant banking as there was in the United States. Previously, British banks were prevented from acting in both capacities by tradition, the Bank of England’s “eyebrow” — and by the very rules that were amended in 1986. The liberalization of the domestic market allowed banks to act in “single capacity” and enabled the City to accommodate and integrate the rapidly expanding presence of global finance. The decades after 1986 would see foreign owners continue to pour into UK financial assets: above all, housing.

The reforms were enacted to arrest the City’s declining competitiveness relative to Wall Street. But they were also, implicitly, a bet on a particular model of growth: one that prioritized financial services over the country’s traditional strengths in manufacturing, which was already under severe pressure from global competition and the recession of the early Eighties. The reforms’ architects, chief among them Nigel Lawson, chancellor between 1983 and 1989, expected that a larger and more dynamic financial sector would reinvigorate the British economy. Indeed, the reforms turned out to be highly consequential — just not in the way Lawson expected. “I didn’t give it a great deal of thought at that time,” he would later say about 1986 and its consequences. 

Whatever was left of manufacturing at this point was walloped by the subsequent exchange rate consequences: the capital inflows into sterling assets strengthened the currency, making sterling-denominated goods exports uncompetitive. The other immediate consequence was a build of catastrophic financial risk, resulting in the aptly-named “Lawson Boom” later that same decade, and, ultimately, the 2008 crisis. More consequentially for the real economy, however, the reforms produced a set of incentives that made holding and trading financial assets consistently more profitable than investing in productive capacity. In a financialized economy, simply sitting on assets, such as property, equities or financial instruments, could generate higher returns than expanding production lines or product innovation. The result was a stagnation of the productive sector. 

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In the years leading up to the 2008 crisis, the financialization of the British economy had a direct and measurable impact on the relationship between corporate surpluses and investment. That is: when companies made a profit, much of that profit went straight into finance. The share of the private sector’s surplus that accrued to financial corporations grew from 7.7% in 1986 to 16.9% in 2007. This change in the sectoral composition of the economy reflected an enormous misdirection of resources and misallocation of capital. Since British equities were volatile during the period, property became the favored asset class from the mid-Nineties onward. The financial sector itself facilitated this process. The composition of bank lending shifted dramatically: the mortgage share of total lending rose from around 30% to 65%. Instead of supporting productive investment, credit growth largely financed the acquisition of property assets.

How did this process unfold over time? In the early Nineties, the returns gap between financial assets and productive capital was reinforced by the poor economic conditions that followed the Lawson housing bubble and the European Exchange Rate Mechanism crisis. Household demand was crushed and unemployment climbed to over 10%. Real wage growth across the decade slowed to 1.6% annually, from 4.4% in the Eighties. With domestic demand and therefore profits weak, the incentive for productive investment was further diminished. At length, the recovery of both property prices and real wages after 1997 started to close this returns gap. Nonetheless, the profit-investment relationship did not reassert itself. The gap had been large enough for long enough to cause a structural break, permanently altering the incentive structure of the British economy. So, even when conditions improved, the structural malincentives created by financialization remained. As a result, the economy-wide share of private net investment continued to fall. 

It was not just financial asset substitution. Firms increasingly used profits for share buybacks, to pay out dividends and to hoard cash — extracting value from the productive economy rather than reinvesting in it. The extent of shareholder value extraction is remarkable: dividend payout ratios (the share of net income distributed to shareholders) rose from 30-40% in the Seventies to 60-70% by the 2000s. This was devastating for precisely the kinds of long-term spending on which future growth depends. R&D is the easiest budget item to cut when shareholders demand short-term returns, and Britain’s R&D intensity suffered accordingly. Masking the underlying weakness were “wealth effects” — rising property prices made households feel richer — and an expansion of household debt to sustain consumption. This mask of credit-fueled growth slipped off in 2008. After the crisis, the financial sector’s size and returns on financial assets more or less flatlined.

But the damage had been done — and the underlying problems persisted. Financialization had shifted the composition of total surplus towards finance, a sector with inherently low capital investment needs compared to manufacturing. In relative terms, this reduced both the overall level of fixed capital formation and R&D spending, which is overwhelmingly concentrated in the manufacturing sector. The result is that Britain lags relative to peers like Germany, where manufacturing still comprises just under 20% of economic value creation. Every year of stagnant R&D spending makes this gap wider and harder to close; the cumulative damage to the country’s future potential to innovate is enormous. Britain’s financialized economy also misallocates human capital: financial workers capture 60% of top income decile gains while comprising just 5% of the workforce, drawing talented individuals away from engineering, research, medicine, education and public service. 

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In this way, the economy’s resources — capital, labor and institutional attention — have been directed away from productive activity. This redirection explains the long-term structural trends in the British economy. But to account for the drastic worsening of the productivity and wage growth trends after the crisis, we have to look at policy. Burnham was correct to identify austerity and Brexit as two of the apocalyptic horsemen. But the reasons they belong on the list have to do with how they worsened the structural obstacles to investment created during the financialization era. Whatever industrial growth might have been possible after the eclipse of finance’s dominance was wrecked on the shores of these grand and unforced policy errors.

The fiscal consolidation program of the Cameron-Osborne era consisted almost entirely (80-85%) of spending cuts, and disproportionately hit public investment, infrastructure and R&D-enabling spending. In the first three years, capital spending was cut by nearly a third in real terms and public investment was pushed down to its lowest levels since the Sixties. By any measure, this was one of the most sustained, and in its cumulative effects severe, austerity programs in modern history. What sets it apart is that it was voluntary: the UK had its own currency, its own central bank, ultra-low borrowing costs throughout and faced no market pressure whatsoever to consolidate at this pace. Yet it did so in a front-loaded fashion between 2010 and 2013, just when public spending was most needed and cheapest to finance.

This matters not just for demand. Public investment is not a substitute for private investment but complementary to it: spending on infrastructure, education and research all raise the expected returns to productive investment in the corporate sector. At the same time, average real wages experienced their longest sustained fall since at least the Victorian era. Why would firms expand if there is not much growth in demand from consumers? And why should they invest in labor-saving (that is, productivity enhancing) processes and technologies in the absence of sustained wage growth? The broken profit-investment nexus, already weakened by decades of financialization, was now further undermined by deliberate policy choices.

The pressure on both real wages and investment started to ease in 2013 and 2014: austerity tapered off while a lower oil price and a stronger pound lifted some of the cost pressures. Brexit snuffed out this nascent recovery halfway through 2016. Since then, the net investment share of GDP reversed course and has not found its way back. It remains well below its 2007/08 levels. By some estimates, Brexit accounts for something like a third of the total growth shortfall that has accumulated since 2016, with the investment channel accounting for the largest single component. Real wages recovered only during the pandemic, when labor shortages and a churn in hiring restored the long-term trend.

The answer to “who broke Britain” must therefore include the governments between 2010 and 2016. Austerity seems to have been informed by the notion that the drag on competitiveness and productivity was the size of the welfare state, whereas Brexit assumed the panacea was remaking Britain’s trade and regulatory relationship with Europe. What these policies reflected was a failure to diagnose what was actually ailing the British economy and a thoughtless, almost frantic administration of the wrong treatments. This is strangely reminiscent of actions of Britain’s elite in the Eighties: overreacting to their own post-imperial decline by defenestrating industrial production, betting the house on finance — and losing.

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The extent of the mess is such that Britain will likely not be restored to the ranks of the world’s great industrial countries. That privilege belongs now to the late industrializers in East Asia, all of which kept finance in check. But a plan to fix Britain does not require reindustrialization to that extent. Manufacturing’s share of economic output has declined across all advanced economies, who also underwent varying degrees of financialization. What distinguishes them from the UK is the extent to which this process has taken hold and to which it has created a reliance on financial services. Apart from gradually cutting this sector to size, it is not clear how this process can be reversed without a large public concerted investment program: in infrastructure, in education, in the energy transition — all designed to raise aggregate demand and the expected returns to private capital formation. 

But given the British economy’s unusual tendency to generate inflation, as well as the sensitivity of sterling and government borrowing costs to fiscal signals, any sizable public investment program would require a more accommodative central bank, one willing to support larger fiscal commitments rather than reflexively tightening against them. The Bank of England, however, seems more concerned with the interests of the financial sector, which favors stable prices and fiscal prudence. The policies of successive British governments too have reflected these priorities: the financial sector’s weight in the British economy is not just an economic but a political fact. It shapes the incentives of policymakers, the structure of the tax base, and the terms on which Britain engages with the rest of the world. 

It won’t be easy to eradicate the pro-finance bias. But starting with the right diagnosis is crucial. The intensity of Britain’s economic malady relative to that of its peer countries is not about trade relationships or welfare spending or European regulations. It is a particularly unfortunate child of the neoliberal turn, whose main macroeconomic legacy has been the rise of finance and the steady erosion of productive investment despite burgeoning profits. It would be politically expedient to point out that countries who have been able to insulate themselves from the worst effects of this era, chief among them China, are in a position to determine their external affairs autonomously. In the “post-neoliberal” era, then, the first step to “fixing” Britain should involve accepting that the City of London’s status as a global financial center, far from being the crown jewel of the British economy, has come at an enormous cost to the country’s productive capacity and, ultimately, to its sovereignty. 

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