Last Wednesday’s British budget did very little to rectify that country’s yawning fiscal deficit, but what little it did was almost entirely at the expense of the country’s high income earners, those making over 150,000 pounds ($210,000). The fascinating question is: if British governments return to their pre-1979 high-tax ways, as seems likely, what will happen to London’s financial services business?

Not content with raising the top marginal income tax rate from 40% to 45% last November, Chancellor of the Exchequer Alistair Darling raised it again to 50%. Two tax increases in one year will certainly start to convince affluent Brits that this has become a habit, as it was with previous Labour governments. Indeed, yawning future budget deficits, and the accompanying financing difficulties, are likely to lead to further such increases. Now the EU wants to impose a Europe-wide statutory limit on bankers’ bonuses.

In the 1930s, you didn’t want to own a major Manhattan office building. 40 Wall Street, for example, briefly the world’s tallest office building before being eclipsed by the midtown Chrysler Building and Empire State Building, leased slowly during the 1930s, for rents about half those projected at the time of its construction. The building defaulted on its bonds in 1935 and was still failing to cover even senior debt charges four years later, at which time it was only 81% occupied.

Brokerage firms, expected to be the building’s premier tenants because of its location next to the Stock Exchange, both went bankrupt and downsized sharply during the decade, so that even the main office of Merrill Lynch, then as later the country’s largest retail broker, took up only one of its 87 floors. Mind you, if you were a tenant the fringe benefits were great; remodeling was done at cost, many repairs were free and the building ran a free shopping service and provided embryonic IT services, fixing tenants’ ticker tapes that seized up. Fortune magazine’s superb July 1939 celebration of New York (timed to coincide with the World’s Fair) tried to put a brave face on the building’s fate, and it did much better after World War II, but for a decade or more the struggle for its owners was grim.

This time around, much of the Manhattan financial services sector has already migrated to New Jersey, where its absence will be largely hidden from general view as its offices are adapted to Mafia-run light industry and hazardous waste disposal. In any case, given the size of the US economy, at least the great bulk of US financial services will remain domiciled in the country, very largely in the New York area, so Manhattan real estate should not suffer as it did in the 1930s.

It is London whose office buildings may suffer the fate of 40 Wall Street, or much worse. Should the London financial services business relocate, the trading floors of Canary Wharf, lacking 40 Wall Street’s architectural distinction, adaptability and convenient location, would become cavernous echo-chambers, home only to bats and rodents feeding off decades-old junk food wrappers. In the City of London proper, the smaller and older buildings would readily re-adapt to small-scale mercantile operations, and only the largest and most opulent offices would lie derelict. Needless to say, petty criminals would benefit more from such dereliction than the British Exchequer or the staggering British economy.

It may be objected that the City of London survived tax rates on income far higher than Darling’s current effort, with top rates above 90% for most of the period 1939-79, and remaining higher than today until Nigel Lawson’s budget of 1988 (one of Lawson’s worst mistakes was in waiting so long to reduce the top rate from 60% to 40%, thus ensuring that the City boom of the 1980s occurred in an atmosphere of tax evasion.) Indeed in one spectacularly awful budget designed by the allegedly moderate Roy Jenkins in 1968, the top income tax rate was levied at 135%. (Jenkins, in most respects no fool, recognized the adverse supply-side effect of tax rates above 100%, so imposed the levy retroactively on the previous year’s income, legally and constitutionally disgraceful but economically less self-defeating.)

To optimists pointing out smugly that those four decades of economically suicidal top tax rates did not destroy Britain’s financial services businesses, I would respond that they came damn close. The jobbers, who made markets in British shares, being partnerships were taxed at top marginal income tax rates on their profits, while inflation rates of up to 25% eroded their capital base; consequently by 1980 they were far too undercapitalized to play their proper role in the capital market, and fell victim to the misguided “big bang” reform of stock exchange trading. The merchant banks also had their capital bases halved in real terms by the 1970s inflation and sterling devaluation, and their partners were no longer rich enough to inject additional capital. Consequently, they also were too small to compete with the US and Continental behemoths when the “playing field” was so misguidedly “leveled.”

The 1986 Financial Services Act was a bureaucratic nightmare, which left investors far worse protected than they had been under the previous “gentlemanly capitalism” and together with “big bang” delivered the British-owned houses trussed up as victims to foreign predators. However because of the decimation of British wealth caused by the taxes and economic ineptitude of previous decades, it may well have been inevitable, if Britain was not to fall behind entirely in the race for internationally-sourced business.

The merchant bankers, brokers and jobbers of 1939-79 were deeply attached to British-domiciled institutions and deeply rooted in British society; they and their senior staff had very little alternative but to remain passively in place for the Exchequer to loot. Those controlling the limited international corporate and capital markets business of those highly protectionist and un-globalized decades also had very little alternative but to transact their business in London. Even so, much investment management business migrated to Switzerland, not historically a major home for global private wealth and investment management, but free from the capital controls and intrusive regulations and taxes of London.

However New York, the principal potential competitor to London, was artificially split between commercial and investment banking, and the investment banks were undercapitalized and focused almost entirely on the gigantic US domestic market. Hence, with a considerable amount of wobbling by the late 1970s and early 1980s, London houses were able with difficulty to maintain their position, and even to regain some of the capabilities that had been destroyed by World War II and the decades of exchange controls.

Since the destruction of almost all the historic British financial institutions in 1986-2000, the picture is very different. A high proportion of the participants in the London market are foreigners, and even British participants are much more securely members of the international moneyed elite than of the decayed British aristocracy or impoverished middle class. The significant London financial institutions are almost all headquartered outside Britain, and their London staff have caused the head offices endless cost and risk over the last few years by their careless attitude to the parent institution’s risks and insatiable appetite for their own rewards.

Potential clients are themselves global, with corporations manufacturing worldwide and run by rootless MBA management, while the wealthy are almost entirely from non-UK cultures, possibly effectively without any domicile at all if their home country has been taken over by crooks, thugs or Marxists. In any international business, London is no longer without serious competition; for one thing most owners of London financial houses have taken good care to install equivalent capabilities in their home country headquarters.

In such an environment, the government appears to believe that by turning a blind eye to foreigners’ tax evasion it can preserve London’s capabilities. However this is probably wrong (although imposing full British taxes on foreigners would kill the City even faster.) British bankers will not wish to continue forever as impoverished valets to their wealthy foreign overlords; they will migrate to some non-UK jurisdiction where they are not grotesquely discriminated against by the local tax authorities. Their employers, finding London an expensive place in which to do business, no longer with any great advantages in terms of local expertise, will move London’s operations back to their headquarters, or to third country tax havens. Foreign staff, finding themselves far from home in a declining business environment where their wealth is fiercely resented by the impoverished overtaxed locals, will seek some alternative low-tax domicile.

If the EU caps bankers’ bonuses (at a level that after the next few years of inevitable inflation will seem laughably inadequate) this will merely ensure that the international financial business moves to New York, Shanghai, Dubai, the Caymans or (my guess) Singapore, rather than to Frankfurt, Paris or even Dublin.

Much of the financial glory of the past two decades is one with Nineveh and Tyre in any case; no regulator will ever again believe in bank self-management of risk, and hedge funds, the obvious alternative homes for the financially adventurous, will find it impossible to attract either equity capital from newly suspicious institutions or debt finance from newly cautious banks. However even within this duller, diminished universe, London’s market share is almost certain to shrink, as successive British governments seek to finance their overspending habits and close the resulting deficits from the resources of the ever-dwindling number of rich.

The British economy may not quite experience the traumas of the US 1930s (though Britain’s GDP has already fallen as much as in the better-managed British 1930s, without much hope of subsequent vigorous recovery as in 1932-37.) However the London office market, particularly that in the isolated and un-reusable Docklands, will almost certainly suffer a downturn that will make the grim New York 1930s market seem the epitome of prosperity.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)