Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 31 August 2017

Why Brexit has led to falling real wages

This might seem easy. The depreciation immediately after Brexit, plus subsequent declines in the number of Euros you can buy with a £, are pushing up import prices which feed into consumer prices (with a lag) which reduce real wages. But real wages depend on nominal wages as well as prices. So why are nominal wages staying unchanged in response to this increase in prices?

Before answering that, let me ask a second question. Why hasn’t the depreciation led to a fall in the trade deficit? Below are the contributions to UK GDP from the national accounts data. Net exports are very erratic, but averaging this out they have contributed nothing to economic growth since the Brexit depreciation.

The belief that the depreciation should benefit UK exports is based partly on the idea that exporters will cut their prices in overseas currency terms, making them more competitive. Yet at the moment UK the majority of exporters seem to be responding to the depreciation not by cutting prices but by taking extra profits. If they keep their prices constant in overseas currency terms (from currency denomination data almost as many exports are priced in overseas currency as imports), sales will stay the same but profits in sterling will rise.

While this helps account for the lack of improvement in net trade, it increases the puzzle over why nominal wages are not responding to higher import prices. If exporting firms profits are rising because of the depreciation, why not pass some of that on to their workers?

One perfectly good answer is that the labour market is weak, and what has stopped real wages falling further is that firms do not like to cut nominal wages. In these circumstances there would be no reason for exporters to share their higher profits with their workforce. So the immediate impact of the depreciation has not been a decline in the terms of trade (export prices/import prices), but instead a shift in the distribution between wages and profits. But many people believe that, with unemployment falling rapidly, the labour market is not weak.

There is another reason why exporters might be increasing profits but not sales, and not passing higher profits on to higher wages, which goes back to a point I have stressed before. We need to ask why the depreciation happened in the first place. To some extent the markets were responding to lower anticipated interest rates set by the Bank of England, but there is more to it than that. Brexit, by making trade with the EU more difficult, will reduce the extent of UK-EU trade. Furthermore there are two reasons why Brexit is likely to reduce UK exports by more than UK imports.

The first is specialisation. Because countries tend to specialise in what they produce, they may not have firms that produce alternatives to many imports, making substitution more difficult. The EU produces many more varieties of goods than the UK, so they are more likely to be able to substitute their own goods to replace UK exports. The second is the importance for UK exports of services, and the key role that the Single Market has in enabling that. On both counts, to offset exports falling by more than imports after Brexit we need a real depreciation in sterling. Exporters will have to cut their prices in overseas currency terms, and a depreciation allows them to do this.

Of course Brexit has not happened yet. We still get a depreciation because otherwise holders of sterling currency would make a loss. So firms do not need to cut their prices in overseas currency yet, allowing them to make higher profits. But these higher profits will be temporary, disappearing once Brexit happens. It would therefore be foolish to raise wages now only to have to cut them later when Brexit happens (no one likes nominal wage cuts). To restate this in more technical language, when Brexit does happen the UK’s terms of trade will deteriorate as a response to export volumes falling by more than import volumes. Firms are in a sense anticipating that decline in the terms of trade by not allowing nominal wages to rise to compensate for higher import prices.

So before Brexit happens we are seeing a distributional shift between wages and profits, but once Brexit happens profits will fall back and we will all be worse off. For Leave voters who think this is all still just ‘Project Fear’, have a look at the national accounts data release that the chart above came from. It shows clearly that UK growth in the first half of this year has been slower than that in the US, Germany, France, Italy and Japan by a wide margin. What Leave campaigners called Project Fear is real and it is happening right now, but do not expect your government or some of your newspapers to tell you that. 


  1. "Yet at the moment UK the majority of exporters seem to be responding to the depreciation not by cutting prices but by taking extra profits. If they keep their prices constant in overseas currency terms (from currency denomination data almost as many exports are priced in overseas currency as imports), sales will stay the same but profits in sterling will rise."

    Apologies, Simon, I'm not sure I follow why this would be the case. Isn't the logic behind the ↓currency value, ↓price of exports in foreign currencies that by cutting the price of your exports, you capture more of the market, increasing profit? If so, I think we need more explanation for why British firms are choosing not to drop the price of exports than 'they want increased profit', since that motive ought to see them at least fractionally reduce prices to capture a larger share of foreign markets.

    1. If prices are set in the foreign currency, a weaker pound boosts sterling revenues. You don't need to lower prices and increase market share to grow profits.


    2. From my own experience I would suggest short term incentives as the reason. When people are rewarded for quarterly performance, taking margin today rather than share tomorrow is too tempting,

  2. Thanks for the technical update. As a layman I have never been happy with the idea that a sterling depreciation will fix all our problems. Its always felt like a first order reaction to a more complex issue.
    Surely what is more important than the value of sterling is that we as a nation add value to our products and services so that they are sought after and traded.
    This adding value requires a highly skilled and educated and active population.
    Unfortunately as children we are taught the value of money and so obsess over it.
    Maybe I am missing something obvious but I believe sterling's value is not that important and definatly not worth shooting yourself in the foot to cause it to depreciate. There is no easy answer just hard work.

    1. A good observation. This idea that the answer is to devalue currencies is very MIT-centred -which has a close relationship the IMF. Dornbusch and others used to say (using Model) that East Asian economies kept their currencies 'undervalued' and maintained large surpluses. But historians will tell you that their currencies were 'overvalued', evidenced in low black market rates.


  3. Interesting argument as ever, however I feel like this may attribute too much foresight and rationality to businesses. From my own experience of working in a multinational manufacturer, the idea that management would link higher profits to higher pay is simply unthinkable. I do not believe that the link between higher profits and higher wages exists anymore, certainly in big manufacturing. Higher profits mean higher profits, and nothing else.

    1. Higher profits typically induce more production/investment, which often requires more labour and in turn higher wages to entice them. That said, there are lots of caveats to this story (market power, not full employment, etc)

  4. Alexander Harvey31 August 2017 at 19:49

    The ONS Paper (Michael Hardie, Andrew Jowett, Tim Marshall & Philip Wales) covers some of this in relation to the exchange rate decline between Q3 2007 and Q1 2009.

    Search for:

    Explanation beyond exchange rates: trends in UK trade since 2007 (22 August 2013)

  5. No need to publish this - mainly comments/suggestions regarding language.

    1st para, second sentence - "Euros" - change to euros; "a £" - sterling; change first "which" to "that", and put a comma before last "which".

    3rd para, second sentence - "Yet at the moment UK"

    5th para - comma after "In these circumstances"

    6th para, 3rd sentence - comma after "To some extent"; last sentence - comma after "Furthermore"

    7th para - "Single market" - all lowercase

    Wages have fallen in real terms since the referendum, but many employees have not seen real terms increases for many years before that. I think the economy is failing millions of people - there are too many jobs that are insecure (gig economy, zero hours), and many people are desperate for more hours (underemployment), or better pay and conditions and a career with progression. Many companies do not want to spend money training people. Perhaps worst of all, government is clueless about upskilling and training people (jobcentres are decades out of of date and these days are only there to process so-called 'benefits'). We need a government that is dynamic and can set up institutions and pathways that enable people to retrain quickly, but be flexible and smart enough to work with various industries to identify new jobs/roles and make training available to prepare people for entry-level roles.

  6. This pretty much accords with my experience. There is an extra factor - suppliers who would previously have accepted £ are now demanding € or $, and using the necessary adjustment to nudge prices up at the same time.

  7. The clearest indication of the poor health of the UK economy is that it is failing to respond to the widespread strength in the rest of Europe this year.

    GDP growth is surprising on the upside not only in the euro area, but in all economies around it with strong economic links - from Sweden, to Poland, to Turkey. But there is no such surprise in the UK, which is entirely consistent with your point. Stronger demand in the UK's main export market, a sterling depreciation and no noticeable economic boost!

  8. A few points come to my mind.

    1 if local (e.g.€) prices have not been cut then surely export values (in £) will be rising if volumes are the same. If £ export values aren't going up to match depreciation someone is losing market share.

    2 due to the multi national integrated nature of so much business then a lot of exports will be set using transfer prices, and the importing company will not want to upset their finely balanced tax calculations by introducing currency risk in to higher taxed jurisdictions. Certainly no short term transfer price changes would be considered.

    3 like few other commenters I think the link between profit and wages may not be straight forward. A single company, family owned firm may be transparent enough for profit rises to be identified nad passed on eventually but in multi-nationals no single division or plant is going to identify its profits.

  9. It is refreshing to read this. Most mainstream economists do not talk about terms of trade effects (eg Krugman and many others saying ad nauseum that the answers to problems like those in Greece would be simply solved if it could just devalue its own currency). An important discussion about the substitutability of imports (Marshall-Lerner). I think if people can now start thinking seriously about this they would understand better why many countries, despite enormous hardships, prefer staying in the Eurozone.


  10. I wonder whether part of the problem is that firms are anxious to hoard as much profit as possible in order to validate elevated stock market valuations (elevated as a consequence of QE) AND to offset pension fund deficits (which are suffering from the want of compounding attributable to very low interest rates); indeed, the demand for elevated stock valuations is also part of the pension problem: fund managers must have increasing returns via stocks in lieu of the compounding that they would have obtained had interest rates remained positive. If firms were not hamstrung by unaffordable promises to past pensioners there would be less of a need to fixate on hoarding profits. What current and future workers - defined benefit pensioners - must realise is that their wages are stagnating or falling in real terms (and their opportunities are shrivelling in consequence) as a function of the need to keep their predecessors in their defined benefit entitlements.

    The only consolation for workers re Brexit is that, over time, it might create such a scarcity of labour in certain sectors that it will force firms to increase real wages and/or invest in long-overdue productivity improvements.

    As to the failure of import substitution, this seems to underscore to me that need for a state-funded investment bank, as recommended by John McDonnell and others. If I recall, the likes of Godley, Cripps, etc. in the old Cambridge AE group were looking seriously at import substitution in the early 1980s.

    I agree with all the comments made about the insufficiency of retraining and the need for the state to concentrate carefully on labour market dynamics.

  11. Were real wages not falling long before Brexit? And, as you say, Brexit hasn't happened yet? Does this imply you believe in a strong version of the efficient market theory?


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