Hamish McRae: Can London emerge from financial crises with its reputation intact?

How damaged is the City? As the decision about Northern Rock is gradually absorbed by the markets, people are switching attention to the secondary effects. Sir Howard Davies thinks that the combination of Northern Rock and the non-doms tax saga has indeed been damaging. He deserves to be listened to. He is now director of the London School of Economics but formerly was director-general of the CBI, deputy governor of the Bank of England and the first head of the Financial Services Authority.

It is difficult, this one, for a host of reasons. One is that "reputation" is such an ill-defined concept. Sometimes it matters enormously, as when Northern Rock's slipping reputation led to a run on the bank. But sometimes it seems hardly to matter at all. You might have thought that China's reputation as a stable country making steady progress towards a more liberal society would have been devastated by the Tiananmen Square riots. Yet the willingness of foreign companies, including US ones, to invest in China was as far as one can see completely unaffected; in fact it gathered pace afterwards.

There is also a distinction to be made between the short-term and long-term effects. There must be some damage for this Government. I gather that a lot of foreign people working in London have been shocked by the change of mood between the Blair and the Brown governments. I heard a series of foreign business leaders heaping praise on Gordon Brown at a Treasury seminar when he was still chancellor. I would be astounded if they would do that now. But that is a short-term effect. They know that this government won't be there for ever and they will recalibrate their opinion as and when the other lot get in.

So while there may be some short-term damage, things will adjust. If, as I expect, the non-dom tax changes end up with the exchequer getting less tax revenue in total, not more, expect policy to change pdq. The trouble is that no one knows the effect of a change in tax policy until after the event. What matters is not what people say; it is what they do.

The longer-term effects are decided by bigger economic forces. China continued to attract inward investment because the economic case for using its vast supply of cheap labour was overwhelming. So the crucial question facing London's financial service business is whether the underlying reasons that attracted it in the first place will continue to have their magnetic influence. Could the business really shift elsewhere?

We don't have up-to-date figures for the industry's output and will have to wait until the summer for 2007 ones. Two things, however, are absolutely clear. One is that this is a London industry. Roughly half of the country's output is generated there, as the pie-chart shows. The other is that until the middle of 2007 at least, financial services were gaining their share of national output and that if you add in associated professional services, such as accountancy and the law, they are now larger than manufacturing (other chart).

So there is mass. But why, you might reasonably ask, does the industry have to be so concentrated? The costs of operating in London are huge – with the partial exception of New York, higher than anywhere else in the world. Yet the business is almost entirely electronic. True, much of the trading has to be done in dealing rooms and the dealers need to be in the same place. But the dealing room is a factory and that factory could, in theory at least, be located anywhere in the world.

The evidence is that while some functions can move – investment management seems to be reasonably mobile – most cannot easily shift unless there is some catastrophic military or political event. Beirut's financial business disappeared after the civil war and now has eventually shifted to Dubai. Shanghai's fin-ancial services were destroyed by invasion and the communist revolution and were eventually rebuilt in Hong Kong. So London's niche financial service businesses can move to Dublin and Geneva. If the Dutch authorities were smart, they might shift to Amsterdam. It may well be that new businesses will choose to locate elsewhere, just as new car assembly plants are built in low-cost Slovakia rather than high-cost Belgium. But more than any other industry in the whole world, finance needs to be concentrated. Why?

The best explanation I have seen comes in the new book on economics, The Logic of Life, by Tim Harford. He argues that human beings need to cluster together with similar people to exchange ideas and that these intangible relationships and connections enable people to do their jobs better. This does not apply to all occupations but it does apply in communications, higher education and finance. Mass matters.

There is some small evidence that this may be weakening: that improved communications may be reducing the need for physical proximity. Some work at the London School of Economics that looks at the citations of patents suggests that res-earchers are citing new patents registered in other countries more swiftly now than they were a generation ago. That makes sense. Given the speed and ease of email, you would expect new ideas to move across national boundaries more easily than they did before the internet age.

However, this is consistent with the notion that better communications increase the relative position of large financial centres because they enable those centres to deliver their services more widely. Thus London can use the new technologies to sell services to the world, whereas it used to face more local competition.

What we will have is an interesting experiment. London has deliberately made itself somewhat less attractive to foreign talent. So people will have to decide. I heard yesterday of one person, a Briton who was living abroad, who had reluctantly decided that he had to return to the UK because of the new regulations on the number of days he was allowed to come here to work. But others may jump the other way and relocate their businesses offshore. This is a separate issue from the change in non-dom status but may prove just as significant and, as with the non-doms, we simply don't know whether the tax revenues will rise or fall as a result.

The worrying thing is that people like Sir Howard Davies are worried. It may be that London's great run of growth is drawing towards a close. It will not suddenly disappear because momentum, like mass, also matters. But it is quite hard now to recall the shabbiness of London in the 1970s, when population was falling and businesses were moving out. It took a long time to recognise the turnabout that started in the early 1980s but if Sir Howard is right, we may notice a swifter change now, in the other direction. I hope he is wrong.

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