Welcome to the Square Mile workers' republic

The City as a workers' republic seems a concept almost too ridiculous to be worthy of serious consideration, for without question the City is one of the most viciously free-market, competitive meritocracies ever to have graced the face of planet earth. Yet in the sense that it is also a place which exists purely for the purpose of enriching those who work there, the City as a workers' cooperative seems a perfectly reasonable way of looking at it.

Compelling new evidence of this long-suspected truth emerged this week in the shape of the Stock Exchange's annual analysis of the financial performance of its 250 member firms. In the year to last June profits of the securities industry more than tripled to well over pounds 700m. More significantly, however, staff bonuses leapt by nearly a half to pounds 315m. Assuming markets maintain their present buoyancy, this year looks like being even better.

Remember, these numbers do not refer to the City as a whole, but just to equities, equity derivatives and bonds. Factor in the bonuses also being paid in foreign exchange, other derivative markets and corporate finance, and it is no wonder that working in the City is rapidly becoming the equivalent of winning the National Lottery. Forget utility fat cats; they've got nothing on this lot.

When people are paying themselves on this scale, it might reasonably be assumed they are also earning pots of money for their owners, for gone are the days when the City was dominated by a collection of closed partnerships. Most big London securities firms are now part of much larger, generally international concerns. The bizarre thing about what is now going on, however, is that on the whole they are not; despite buoyant market conditions, return on capital is still generally poor. Traders and corporate financiers may be enjoying an orgy of excess, but those they work for, those who provide the capital, the systems and own the brand, are generally not.

There is nothing particularly new about this. It has always been notoriously difficult to earn good returns out of investment banking. The highly volatile nature of capital markets is only part of the cause. The other is very high rates of pay and on this front there is absolutely no evidence of getting to grips with the problem, rather the reverse. The trend in staff costs in these organisations is up and up. Other costs go down and down, staff numbers are cut back and back, but salaries, bonuses and the proportion of profits taken by pay, climb steadily. Nor are low rates of return any apparent deterrent to new entrants. With the Germans now fully awake to the delights of Anglo-Saxon capital markets, a whole new wave of competitive salary increases has set in.

Since top traders, analysts and corporate financiers are often "locked" in to their organisations by rolling three-year bonus schemes, these have to be bought out by the new employer if he is going successfully to poach anyone. Hence the guaranteed bonus, which to all intents and purposes becomes part of a flat-rate salary. On top of that then comes the real bonus or the profit share. Even Sir George Parr would have difficulty exaggerating the reality of pay escalation in the City, so transparently ridiculous is the process.

There is no obvious solution to the problem, for City pay is not determined as in most industry and commerce by the pressures of the real domestic economy, but by internationally accepted yardsticks and measures. A proprietary bond trader, or a good one at least, will have his pay determined not by the profits and return on capital of his organisation, but by the going rate for the job in New York and Tokyo. Investment banking thus becomes the reverse of what happens in virtually all other businesses (I exaggerate only a little here), a producers' monopoly, a business which is run by and for the benefit of its employees, not its shareholders.

Here is just one example, and actually a relatively modest one. Bill Harrison, the new chief executive of BZW, has reportedly been recruited on a package worth pounds 6m over five years. That will be lower in all probability than some of his traders are earning, but it is also considerably more than the chief executive of BZW's parent company, Barclays Bank, makes. Now there is no way Mr Harrison can ever hope to justify such pay, however talented he is, however hard he works, for in the end, it is the organisation, BZW, which makes him, not he the organisation.

At such rates of pay people are in essence working for themselves, not the organisations which hire them. Indeed, the effect of such excess is to undermine the organisation by reducing its profits. And yet this is the going rate for a top investment banker. What we are looking at in City pay then, is a sophisticated, talent-based, modern-day version of union power. It might even be argued that the effect of this is as damaging to the real economy of Britain and elsewhere as ever the unions were, for the extreme rates of pay that lie at the heart of the City are reflected in excessively high charges to industry and commerce for capital and services.

The harsh truth is that the City is a Square Mile of pure undiluted hypocrisy, in this regard at least. The free market principles and disciplines that it applies so ruthlessly to commerce, industry, and yes, governments too, are nowhere to be seen when it comes to its own backyard. Perhaps it was the City that Tony Blair was thinking of when he talked of "stakeholding". But then again, perhaps not.

I am no Eurosceptic but I found it hard to disguise my glee on seeing that an attempt by Karen Van Miert, the European Competition Commissioner, at empire-building in the field of mergers policy had been stamped upon, not just by Britain, the outsider, but by France, Germany, Spain and everybody else of importance.

The Competition Commissioner had wanted to lower the threshold at which mergers qualify for examination by the European Commission to a level which would have roughly doubled the number of deals being vetted in Brussels. Led by Germany, member states have dug their heals in. It seems that in M&A activity, if nothing else, national sovereignty will always reign supreme.

The pound is back at its highest levels since Britain was so ignominiously pushed out of the ERM. Is this no more than a flash in the pan caused as much by the possibility of higher short-term interest rates as anything else, or is it the sea change, flight to quality dreamt of by the true patriot? I'd dearly like to think the latter, but for the moment I'm afraid I don't quite buy it. In part, sterling's strength is being driven by the possibility that the mark will get diluted in European Monetary Union by the inclusion of the Italian lira and the Spanish peseta. But is this really enough on its own to reverse a 30-year record of inflation and devaluation? Somehow I doubt it. It is going to take more than three years of Kenneth "Lucky" Clarke to convince markets that things have indeed changed for good, even if Germany does commit itself to a half-baked version of the euro.