Adrian Hamilton: Now was not the time to pick a fight with the City

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While it is generals who are usually accused of fighting the last war rather than the next, politicians are far more guilty of the charge. Particularly when it comes to tax, they're forever reacting to last year's headlines just as the circumstances are entirely changing. Four months ago duty increases on fuel seemed just the ticket to show firmness on global warming. Today, with the price of oil doubling to well above $100 per barrel, they have proved positively otiose.

So it may prove with the proposed tax on non-domiciles and the changes in capital gains which are so incensing the City. When they were first mooted last autumn, they may have looked a splendid wheeze to take the wind out of the Tory sails. Today they look just the wrong battle to fight with a City engulfed by the biggest financial market crisis in a generation, bigger perhaps than any since the war.

The Chancellor in his speech yesterday took due note of the financial storms moving in from across the Atlantic, but it was only to present them as a foreign threat which brave little Britain would never allow to divert it from its economic course.

It was in Darling's interest to play up the foreign pressures, over which he could claim no responsibility, while playing down our own part, for which he was responsible. But the degree to which the Treasury, and for that matter the Bank of England, refuses to recognise the scale of the potential threat posed by the crisis in the financial markets or its implications for London and the financial services industry here is truly staggering.

The US Federal reserve, together with the European and Swiss central banks, did not agree to pump nearly a quarter of a trillion dollars into the credit markets on Tuesday just because of a little local difficulty to American mortgage lenders. For the past six months and more the central banks have consistently and persistently pumped in funds to give the market liquidity and stop a growing freeze-up in lending.

As central banks, of course, they can afford to do so. But each time these injections have failed to do their task. After an initial surge in confidence, the interbank lending rate (the rate at which banks lend to each other) has climbed up again, making irrelevant any action by. the central banks.

So this week we have seen an injection of liquidity double anything that has gone before. We have also seen the US Fed for the first time agree to swap its own bonds for the troubled mortgage-backed securities, which have been the primary source of the problem. The stock markets surged in response, here as in the US, and the interbank rate fell. But the question still remains: will it work this time?

The trouble with this crisis as compared to previous problems with the fringe banks and Third World debt is that no one knows the full scale of the crisis. All sorts of figures have been produced in the US about the size of the losses should the US housing market decline by, say, 30 per cent (not an outlandish suggestion). The falls then would be large enough to overwhelm even the US Fed. But, given a reasonable degree of stabilisation of the markets, the US sub-prime crisis could be manageable.

But the fear is that the crisis could spread – is indeed already spreading – through the derivatives market, where every bank is deeply involved. In which case you are faced with problems without end, and quite possibly without bottom. It was fear of defaults among the biggest banks that partly caused the present panic in the markets. If it were just a matter of a reluctance to extend credit to uncertain borrowers, then pouring central banks funds into the market might work to loosen the log-jam. But if the reluctance derives from the fear of lenders that their own position may be strained, then no amount of extra liquidity will help.

The obvious concern to the British authorities – and to the Chancellor yesterday – is the impact of a credit crunch on consumer spending, business investment and growth here. We may think of this as an American problem, but we have in many ways a similar reliance on housing values and consumer credit and could be next in line for the pain.

But Britain's other problem is its reliance on financial services as the mainstay of its economy, and indeed its employment. Banking and related legal and accounting services provide some 20 per cent of our economy and together with oil and energy, by far the biggest source of government taxation. If financial institutions start to fold, then the effect on Britain could be catastrophic. Already the taxpayer is involved in a rescue of Northern Rock that has tied up nearly £80bn in public funds. And that is just for a local building society. If a major bank went under, the ramifications would be incalculable.

Even without this crisis, the plus points of London as a centralised global finance centre were starting to diminish. Add to that personal tax and yesterday's budget may look what the City fears it to be – the wrong fight, at the wrong time in the wrong place.