Hamish McRae: Like or loathe them, big City bonuses keep London at the top of its game

It is City bonus time again. To most people outside the world of financial services the idea that anyone should get a multiple of their salary just for doing their job seems a strange aberration. That these bonuses in the case of Goldman Sachs should average over £300,000 for every employee will seem stranger still. So what is happening?

There are three strands to this story. First, international financial services are the global boom industry. Second, London has been gaining market share in this business. And third, human skills have become scarcer relative to other forms of capital, so variable pay - the bonus system - is spreading into most industries, as employers bid for the best. A word about each.

Finance does very well out of the present burst of globalisation and sustained global growth for a number of reasons. As most industries become more global in their outlook and activities they need to buy the services that enable them to invest outside their home base, raise investment funds for expansion and so on. That creates demand. As the pool of global savings rises, with a particular surge in Middle East petrodollars, the owners of those savings need to allocate them. That creates supply.

There are a couple of further factors at work. The surge of liquidity created by the low interest rates policy of the world's central banks over the past five years has further promoted the size of the industry. And the ageing population of the developed world requires ways of investing for pensions, even if most countries have under-invested on this.

The second strand is what has been happening in London. It has a number of advantages over everywhere else, going right back to the 1960s when it created the eurocurrency markets - that is, dealing in currencies other than the home one. Advantages include the English language and legal system, being in the middle of the three time zones, the size of the pool of skilled labour and relatively light but effective regulation.

In the past five years these advantages seem to have increased. There is probably some advantage not being in the eurozone, contrary to the expectations of the pro-euro lobby. New York's difficulties post 9/11 and Enron have encouraged business to shift here, and the rising importance of the Middle East as a source of funds helps too.

You can see the effect of some of these points in the graphs and table. Employment in financial services has been rising, with some shift from the "old" City to the new area of Canary Wharf. When compared with other countries, the UK leads in international bank lending and foreign exchange, in derivatives that are not traded on a formal exchange, and in international equities. It lags behind the US in hedge funds, but has been clawing back some ground, and it lags behind Germany in exchange-traded derivatives. The figures are not complete yet but this year it looks as though more money will be raised in initial public offerings (IPOs or what we would call flotations) in London than New York, which will be another first.

Subjectively London's position looks like advancing further. I saw a headline in the ChinesePeople's Daily last week: "London tops NYC in global appeal". The gist of the story was that one of the key reasons why London was pulling ahead was that it was easier for employers to find, or import, highly skilled people into the UK than the US. America was creating barriers to talent.

This has a huge impact on global firms such as Goldman Sachs. They recruit world-wide. If they can get their key non-American staff into London but not New York, they have to do the business from London.

That leads to the third point: the global fight for talent. Bonuses in finance go back a long way. Typically, firms in securities business experience fluctuating earnings and in the past many were partnerships. So the obvious way to cope was to pay people a relatively low basic salary and then share out the profits at the end of the year. In a good year you got three times' your salary and in a bad one, nothing.

Now most are no longer partnerships but the fluctuations continue, influenced by financial market conditions. So the bonus system would make sense. Alongside this, and this is common to many other forms of activity, has come a "star" system. People who are stars, who generate a lot of business, earn an increasing premium. This is happening everywhere - NHS managers even qualify for bonuses - but in some forms of finance it is particularly easy to identify how much people bring in.

For example, fund managers who regularly get into the top quartile should be paid more than those who don't, and you can measure how good they are. With dealers, it is even simpler: you just give them a portion of their profits.

You reward people who bring in new business, though since they are sometimes incapable of actually doing the business they win, you have to balance the rewards of the stars with those for the sloggers.

But are these talents really so rare? We understand that footballers' and entertainers' talents are rare because we see them at work and figure out that we couldn't do as well ourselves. We don't see investment bankers at work so we don't know what they do.

There is a real question as to whether there is some market failure. This can take many forms: people become, for example, journalists instead of City lawyers without fully realising the difference in their lifetime earnings that will result from that decision. Or people do languages at A-level instead of Maths in the mistaken idea that being able to speak French will be a more valuable skill than being able to analyse a spread-sheet. Or people simply bunk out of school without realising the extent to which that closes off their chances of a well-paid job.

At any rate, you would expect these stories of City bonuses to suck more talent into financial services and that is clearly happening. However, a lot of the talent, in London at least, seems to be coming from abroad, particularly from Europeans who have free entry to the jobs market here. Yet the scale of the bonuses suggests that there is still an unsatisfied demand for skills. No employer willingly pays more than the market clearing rate for people's services.

What happens next? Bonuses at this level are a function of a bull market - and that will not continue forever. London will find it hard to gain much more ground vis-à-vis other centres simply because the business is so profitable that other places, particularly in Asia, will try hard to pick bits off. My guess is that it will continue as before, gaining ground in some quarters and losing in others, maybe slightly increasing global share.

And bonuses? Look, this year is exceptional. Next year will probably be fine, but this bull run is quite mature and at some stage things will turn down. So don't spend all the bonus just yet.