Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 13 October 2016

Did the Bank of England cause Brexit?

Suppose that by the mid-2000s, immigration from the EU (and the potential for additional immigration) had led to an important shift in the UK labour market. The possibility of bringing labour from overseas meant that old relationships between the tightness of labour market and wage increases no longer held.

You might think that was bad for workers, but that is not so. It would mean what economists call the natural rate of unemployment (or NAIRU) has fallen. Unemployment can be lower without leading to wage increases that threaten the inflation target, because workers fear that the employer can resort to finding much cheaper overseas labour. It reduces the power of workers in the labour market, but also leads to overall benefits. (This is just an example of the standard result that reducing monopoly power is socially beneficial.)

But it is only good news if the Bank of England recognises the change. If they do not, we get stagnant wage growth and unemployment higher than it need be. The obvious response is that the Bank will know there has been a change because wages will start falling faster than they would expect based on previous relationships. However that effect may be masked by the well documented employee and employer reluctance to actually cut nominal wages. Add in the shock of the financial crisis, and this change in the way the labour market works might well be missed.

Here is the big leap. Suppose the above had happened, and the Bank of England did not miss the change. Monetary policy would have been much more expansionary, bringing unemployment well below the 5% mark. Nominal wage growth would have been stronger, and a buoyant labour market would have generated a feel good factor among workers. With more vacancies and less unemployment, concerns about immigration would have begun to fade. The Brexit vote would still have been close, but would have gone the other way.

You may say how could monetary policy be more expansionary given how close we are to the Zero Lower Bound? If that was the case the Bank should have said they were out of ammunition, and placed responsibility with the government and austerity. But for the last two years at least, the Bank could have cut interest rates and has not. You could blame the relentless expectation in the media and financial sector that rates would increase, but the Bank should be able to rise above that.

Of course the Brexit blame game is easy to play when the vote was so tight. The most speculative aspect of this chain of thought is the initial premise about a shift in the NAIRU created by immigration potential. While the possibility makes sense, whether the data backs it up is much less clear. Yet there is some evidence of a structural shift in the UK labour market in the mid-2000s, as Paul Gregg and Steve Machin report.    


  1. I quite agree that central banks should be more assertive in telling politicians when CBs think they are out of ammunition – or at least out of conventional ammunition. As for unconventional ammunition (QE and negative interest rates), they have undesirable side effects (increased inequality in the case of QE).

    CBs telling politicians to do more fiscal stimulus could be construed as entering the POLITICAL arena. I’d construe it as CBs giving politicians impartial economic advice, which is part of a CB’s job.

  2. I understand the point you are trying to make but in a referendum where one side drove around in a bus that said 'We send the EU £350 million a week / let's fund our NHS instead' and revoked that 'promise' with an hour of winning... well I think there are bigger culprits than the Bank of England.

    P.S. you should change the title of the post because at some point in the future somebody is going to claim you were really questioning the Bank of England and not just working through a thought exercise.

  3. "(This is just an example of the standard result that reducing monopoly power is socially beneficial.)"

    I take issue with that. It has to be a seller's market where labour is difficult to get hold of and business has to compete to get it. Then you get labour to capital substitution and an improvement in productivity.

    Perhaps if we were to turn the result of the referendum around, we might begin to understand how difficult it is reconcile the positions of both camps. If Remain had won by 52% to 48%, how would they have accommodated the wishes of the Leavers, going forward?

    The NK "solution" of trying to change the price of lending and hope bankers lend for good reasons — we already know that doesn’t work.

  4. "If that was the case the Bank should have said they were out of ammunition, and placed responsibility with the government and austerity. But for the last two years at least, the Bank could have cut interest rates and has not."

    It needs to do more than that. They should leave rates permanently at zero and regulate the banks on the asset side.

  5. The above blog is a case where a more formal model might help to clarify the points I am currently undecided upon. Alternatively, perhaps either S. W-L or another person's comments could provide an intuitive explanation of these points.

    1. In a simple demand-supply model, treating the labour market as a whole,an increase in the supply of labour would lead to lower real wages not just to a lower rate of increase of nominal wages.

    2. If so, would those who would have been employed anyway, be better off after the increased migration?

    3. What does all this imply about the labour market behaviour of UK workers who would have been unemployed without the fall in the NAIRU?

    4. If the overall unemployment rate falls after the increased migration, can we be sure (as was assumed in the previous points) that the number of unemployed UK workers will fall? The overall unemployment rate will fall, but the denominator of the rate has increaaed (the total labour force now includes UK workers plus immigrant workers).

    5. Can we be say if the total real income from employment has increased? (More people employed, but a lower real wage each). It may depend on an elasticity of labour demand and supply condition. What about the total real income of UK employees?

    6. Finally (I have more queries but the list is already long enough), how do the answers to the above points change if we realistically allow for labour markets segmented by occupation, industry and location, some of which may include Manning-type monopsonistic segments?

    I'd be grateful for comments which help me think these points through.


  6. «You may say how could monetary policy be more expansionary»

    I can only admire our blogger's boundless faith in monetary policy. As he has remarked previously it is fiscal policy that has been tight, and as he has not remarked enough it has been tight in the recent past, in a highly differential way, generous towards the affluent middle-income classes and severe towards the low-income classes. The mix of extraordinarily loose monetary policy and selectively tight fiscal policy has been boasted of by Cameron and Osborne in no uncertain terms.

    As the the overall stance of monetary policy since 2000, both before and after the 2008 crisis it has been indeed exceptionally expansionary; currently we have a 6% government deficit and a 7% trade deficit that testify as to how wildly lose, plus of course the really big deal, ever bigger property prices in southern England, and this usual map of property prices 2005-2015 by regions shows how amazingly expansionary monetary (that is, credit) policy has been for southern England:

    The same map and data show that property prices have been falling significantly in real terms in the other regions, some of which like the north and Wales have voted overall for "Leave", but some of which like Scotland and Northern Ireland have voted overall for "Remain". Still perhaps if credit policy had managed to push up property prices in the north there could have been a "Remain" win.

    «we get stagnant wage growth and unemployment higher than it need be»

    First wages in 2005-2015 have not been merely stagnant: lower-half by income wages seem to have dropped 10-20% in real terms, and underemployment has significantly masked unemployment.

    But anyhow lower wages and employment than otherwise would have been the case seem popular "advantages" of tighter fiscal policy rather than monetary policy: these boost significantly business profits and reduce the costs of the NHS and of retired affluent voters who rely on hired help for personal care, gardening, cleaning, nursing, ...

  7. NAIRU ― a folk psychological hallucination
    Comment on Simon Wren-Lewis on ‘Did the Bank of England cause Brexit?’

    Simon Wren-Lewis argues with regard to the UK labor market: “It would mean what economists call the natural rate of unemployment (or NAIRU) has fallen. Unemployment can be lower without leading to wage increases that threaten the inflation target, because workers fear that the employer can resort to finding much cheaper overseas labour.”

    Clearly, this is a psychological argument about what might go on in the heads of workers and employers and, clearly, the speculation about the inner workings of other peoples’ minds can go on until everybody is blue in the face without ever reaching an empirically testable conclusion. Folk psychology and behavioral speculation is simply the wrong way to tackle the employment problem. There is NO such thing as a NAIRU.*

    The fact of the matter is that employment is OBJECTIVELY determined by the structural employment equation which consists of measurable variables and is absolutely FREE of folk psychological assumptions. The basic version of the SYSTEMIC employment equation is reproduced on Wikimedia:

    The bottom-line of the employment equation is that overall employment (in the world economy) INCREASES if the average wage rate W INCREASES relative to average price P and productivity R. This is the OPPOSITE of what folk psychological labor market theory has always preached, and this goes a long way to explain why economists ― and NOT the Bank of England ― are the ultimate cause of unemployment/deflation/depression.**

    Egmont Kakarot-Handtke

    * See paper ‘Keynes’ Employment Function and the Gratuitous Phillips Curve Disaster’

    ** See post ‘The very serious blunders of very serious people’

  8. Labour inflows from the Eastern bloc are infinitely elastic. Any loosening of macro-economic policy would have just seen further inflows. Jobs would be created, but not for natives; and if they were they would be of low quality.

    This is a Marxian world, not a neo-classical one. The predictive power of this theory is astonishing - on the surface. The theory says opening up labour flows would create a dependence on those flows which would lower the value of native labour - with equally adverse effects for the source country of that labour. I say on the surface because the problems in UK society that led to Brexit are deeper than immigration - although Marxian theory can surely handle that well as well.

    A big cause of Brexit was also bad economics. In particular relying on an econometric model which said there would be no increase in immigration with the opening up of the eastern bloc (which was used to argue for EU expansion without transitional controls), and where there obviously was a huge influx, the playing down of the implications until it forced a political crisis - and hence Brexit. I agree immigrants are not to blame for the problems, but it was naive of the establishment (including mainstream economists) not to think that such a surge in immigration would lead to to a political fall-out and to encourage rapid EU expansion and take unnecessary risks.

  9. I do think the economic story is probably a huge part of the answer. And maybe the BofE had a part to play, but I'm skeptical of how useful monetary policy tools are in a liquidity trap scenario.

    The bigger blame, to me, goes to the political establishment and their embrace of fiscal austerity almost across the board. There's no question that adequate fiscal stimulus could have been effective in getting the UK's economy back on track.

    If the Labour and Lib Dem parties had had sufficient courage and insight to go for a large stimulus package right out of the gate, the economy might have recovered to the point that by 2010, they may have found themselves increasing in seats. If the Conservative party, upon taking power in 2010, hadn't gone so hard for austerity, the UK economy would have recovered much more significantly by now.

  10. Good point. I'm surprised no one has mentioned this. In some ways Brexit helps compensate for the BoE's reticence, inflation expectations are rising. Shame Brexit's also going to reduce real GDP. Real yields on long-term gilts have dropped to -1.75%, which surely indicates a permeant economic depression?

    Are you going to follow this up with a post on the ECB and Trichet specifically?

    Reminds me of Solow - “Everything reminds Milton Friedman of the money supply. Everything reminds me of sex, but I try to keep it out of my papers.”

  11. Does this highlight the tension inside the bank about protecting independence? To go expansionary would be to publicly set the bank against the government's policy.

  12. That's fascinating - another line of argument in favour of expansionary monetary policy, and one that relates directly to those 'legitimate concerns' about immigration (and suggests that some of them actually were legitimate, at least locally and temporarily).

    The lesson seems to be that Marx was a cock-eyed optimist - not when he foretold revolution, but when he described the state as "a committee for managing the common affairs of the whole bourgeoisie". If it worked like that we might not be in this mess.

  13. We were already living in an unsustainable credit bubble.
    I am not sure that expansionary monetary policy would have improved the situation.

    The shift of manufacturing out of the UK and the influx of migrant workers may not have been bad things to happen to the economy, but they had consequences. One of which was the financial crash. Another was Brexit.

  14. OK but could it not be retitled did UK business and MNCS cause brexit. Did their profits increase more than wages. Nearby to yourself is a major think tank which suggests that the recent decline in sterling has been partly used as a cover by UK exporters to increase the sterling price and not output. They report this in connection with the recent poor figures in manufacturing and exports. It is unlikely that there will be a corresponding increase in wages for the staff unless it is for the chief executive.

  15. I am not an economist, so I wish economists who say we should have an expansionary monetary policy would explain what they mean. What would we see the CBs doing that is different from what we see them doing now? I also wish I could see an economist explain why they think lower interest rates will increase demand when people have insufficient disposable income. When I took Econ 101 back in 1960, the received wisdom was that interest rates were like a string. You can pull on the string by raising rates to slow down an overheated economy, but you can't push on a string to boost a stalled economy.

  16. If you watched the testimony of Michael Saunders (of the MPC) before the treasury committee last week, you would have seen that he said that the Bank of England now believes that the NAIRU has fallen due to structural changes in the UK economy (more immigration, busted unions, etc). He also said that the Bank is going to keep rates low because for now, it sees the medium-term inflation rate (post-2019) falling back below 2% (it will be above target as prices adjust to the devaluation in Sterling).

  17. Not sure if my earlier comment posted, but Michael Saunders (newest member of the MPC at BoE) said that the bank does recognize a decline in the NAIRU just last week in testimony to the Treasury Committee. I watched on parliamentlive.


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