By Martin Hutchinson

Contributing Editor

Money Morning/The Money Map Report

Think about Michigan or about Ohio’s Mahoning Valley in the 1980s. Both were famous for industries that were world leaders in their time. Yet, once those industries decayed, large parts of both areas became wastelands of home foreclosures, crime and alcoholism.

The decline of the global financial services industry from its unsustainable 2006 peak may produce a similar effect in a once economically thriving country – Britain.

Thirty years ago, Britain had its own rust-belt problems. The British automobile industry, a shining star until the Morris Motor Co.’s Lord Nuffield died in 1963 (remember 1959’s hot new model, the Mini?), was subjected to a series of government-directed merger deals in the 1960s, and the resulting mess, British Leyland, was nationalized in 1975, amid appalling losses.

The steel industry was nationalized in 1950, denationalized in 1954, and nationalized again in 1965; not surprisingly, the political football became a byword for high costs, strikes and inefficiency. Even Rolls-Royce Ltd., Brian’s premier high-tech company and maker of both luxury automobiles and aircraft engines, was effectively bankrupted and forced into public ownership in 1971.

In 1979, however, Margaret H. Thatcher became prime minister. Whereas her American contemporary, U.S. President Ronald Reagan, had little direct effect on U.S. industry, Thatcher had a huge direct effect on the shape of the British economy – she had little option, since the government owned so much of it. She forced British Leyland to shrink drastically, privatized British Steel, British Telecom and Rolls-Royce, and dramatically downsized British Coal after a yearlong face-off with the miners union.

At the same time, she deregulated the City of London’s financial-services business on a supposed “level-playing-field” basis, allowing foreign banks to dominate it and effectively putting the 200-year-old London merchant banks out of business.

Thatcher’s restructuring of British manufacturing, together with her tax cuts and government spending restraint, put Britain on a growth path that lasted a generation. Even after her Labour Party political opponents under Tony Blair gained power in 1997, growth continued, although government spending began creeping back upwards, and is now slightly above its 1970’s peak as a percentage of the economy.

Her restructuring of the City of London brought immense wealth to London itself, as huge global banks deployed increasing amounts of resources to growing their London-based international finance businesses. By 2006, London was rivaling New York as a financial center, even though the base of British domestic business was a fraction of that available from the giant U.S economy.

Traders, hedge fund managers, private-equity managers and dealmakers in general were paid fabulous sums. Since London residents were not liable to British tax on their non-U.K. income, the city also attracted footloose glitterati of all kinds, from the Indian steel billionaire Lakshmi Mittal to the seedier but immensely rich top members of the Russian mafia.

In the United States, financial services doubled its share of gross domestic product (GDP) and trebled its share of Standard and Poor’s 500 Index profits between 1980 and 2006; in London, the growth was even greater and its dominance of the economy more extreme. House prices, too, became far more overblown in Britain than in any but the most speculative areas of the United States.

The 2006 celebrations of the twentieth anniversary of the Financial Services Act of 1986, Thatcher’s deregulatory bombshell, rejoiced in London’s newfound wealth, sneered at the relative impoverishment of Britain’s provinces and missed one key weakness of the economy: Almost none of the major institutions generating such fabulous wealth were owned or headquartered in Britain. When London-based “masters of the universe” wanted to speak to those controlling the huge amounts of capital they deployed, they had to pick up the phone to New York, Frankfurt, Paris, Tokyo or Dubai.

Now, the financial services business is in trouble. What’s more, the parts of the business in which London specialized are in most trouble. Securitization and derivatives were the two immediate causes of the credit crisis, while the 50% declines in the emerging-market stock markets have made the exorbitant fees of the private-equity and hedge-fund managers seem extortionate.

It is now abundantly clear that the financial services sector has incurred gigantic losses and that even when those losses have been subsidized by some unfortunate group of taxpayers, the sector is likely to end up being far smaller than it was. In fact, as a share of the economy the sector will probably end up being only a little larger than it was back in the 1970s.

For Britain, this has three appalling costs.

First, the assets of its financial services sector are around 400% of its GDP, below only the much smaller Iceland, Switzerland and Ireland and twice the U.S. ratio (and most Swiss banks were notably cautious in the bubble). Because of the importance of Britain’s financial sector, its bank bailouts need to be nearly as large as those in the United States, yet its tax base is only one quarter the size.

Second, the downsizing of financial services will produce an immensely damaging decline in British asset prices, particularly those of London and southeast England housing, in which so many middle-class Britons have invested their entire life savings (investing in the stock market is much less embedded there than it is here in the United States). That will have a further unpleasant effect on bank loan portfolios, pension and insurance assets and the British tax base, which will deepen the economic downturn.

Third, and most serious, since the British financial services sector is almost entirely controlled from overseas, there is very little long-term reason why it should remain in Britain. After all, it’s not as if London’s climate is particularly attractive except to aficionados, while its infrastructure is appalling. The product areas in which London-based houses appeared to have a particular expertise have mostly been shown to be over-elaborate Ponzi schemes.

Even if the top management of a German, American or Japanese bank wishes to keep its stable of overpaid London financial whiz kids, it will have to deal with enormous shareholder and political opposition to do so. The Lehman Brothers Holdings Inc. (LEHMQ) bankruptcy, in which money was remitted at the last moment to the United States, so that London-based employees and creditors fared far worse than those in New York, is symptomatic of the “hollowing-out” process that is likely to continue for several years. Even the Russian mafia may find it prefers somewhere warmer.

Eventually, probably after a steep decline in the value of the British pound sterling and a major reorganization of the British economy, and at the cost of an enormous increase in British government debt, the inventive and entrepreneurial British will no doubt find new ways to make a living. In the meantime, I wouldn’t put my money there.

[ Editor’s Note : As the financial crisis continues to sweep the globe, it’s clear that “uncertainty” will continue to be the watchword for at least the first part of the New Year. That's really no surprise, given that the global financial crisis continues to whipsaw the U.S. financial markets in a manner that hasn't been seen since the Great Depression.

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