Should the MPC tighten monetary policy?

 

The general expectation is that they will, but is this the right thing to do?

Inflation in August was above target at over 3% (total or core). UK earnings are estimated to be back to their pre-pandemic levels, despite GDP being well below pre-pandemic levels. Chris Giles forcefully puts the case for some tightening.

It is tempting to argue against any tightening by drawing analogies with the US. Their inflation has been running at around 5%, yet the Fed has not yet started tightening, despite a far stronger fiscal stimulus in the US compared to the UK. One argument for ‘seeing through’ current inflation is that it stems from temporary shortages following the end of the pandemic. Latest data for core inflation suggests inflation rates are now beginning to fall.

This applies to the UK, but we also have to add in the impact of Brexit, and more specifically the exodus of EU workers during COVID which is either unable or unwilling to come back. We also need to add in higher gas prices. But these too should be short term effects. Wages in occupations where labour demand exceeds supply will see higher wages, leading to higher prices. This will lead to higher real wages in shortage sectors, and lower real wages everywhere else. That process of adjustment should not take that long.

Of course it is possible that other workers will not accept lower real wages, and they will attempt to avoid that by raising their nominal wage demands. That could lead to a return of stagflation. The headline here is a more polite version of what I actually said, which was that talk of stagflation is dumb. There are two reasons for that. First, workers just do not have the power they had in the 1970s to set wages. Second, a credible central bank with an inflation target stops inflationary shocks leading to higher inflation expectations, and therefore persistent inflation.

So both the ‘end of pandemic’ inflation shock and the Brexit inflation shock should lead to only temporary increases in inflation. During a recovery period my view, and the view of US policy makers, is that good central banks should ignore such temporary increases in inflation. But is the UK still in the recovery period, or has our recovery finished?

While UK GDP has faltered in the latest month, it is still 2-2.5% below its pre-pandemic peak. I don’t buy estimates of the permanent damage from the pandemic that amount to that large a gap, just as I don’t believe that the Global Financial Crisis was bound to reduce trend GDP by over 7%. The US is likely to soon show that there has been little to no permanent damage there from the pandemic.

There will, however, be some permanent damage to GDP as a result of the exodus of EU workers. The size of that is very uncertain because of the unreliability of the statistics. ONS statistics for labour utilisation are more reliable.

All these series have recent trends, which makes interpretation tricky. But in no case is there even the suggestion that in the early summer the UK had exhausted available labour.

At first sight, the aggregate vacancies data suggest a different picture. However they are strongly influenced by shortages in particular sectors, as the IFS notes here. They estimate that for the majority of workers, competition for relevant new job openings is at least 10% greater than pre-pandemic. Hours worked are also still significantly below pre-pandemic levels, and the number of self-employed workers has fallen substantially (perhaps partly because of recent court judgements).

In summary, the data is consistent with temporary shortages, particularly caused by Brexit, and not an aggregate economy returning to trend. Why is the UK recovery incomplete? There are two important factors. First, the level of fiscal stimulus is modest, and measures like reducing universal credit and future national insurance increases will dampen demand. Second, the pandemic is not over yet in the UK, and some caution may still be present among some consumers.

There seems no case, therefore, for monetary tightening.

What the Bank may well do is to bring their QE programme to a premature end. The direct impact of that is zero, and it’s sufficiently small to have little impact on expectations. What the Bank says may matter more. Again I expect a lot of talk (as here, for example) about monitoring inflation carefully, but if they indicate that a rate rise may be quite soon that would be a mistake. The argument that the Bank’s credibility will fall if they don’t do something is rubbish, equivalent to the idea that expectations may become unhinged. As 2011 showed, it is perfectly possible to ignore temporary increases in inflation and retain credibility.

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Neoliberalism, Corporations and Wealth Inequality

 

These thoughts have been inspired by reading James Meadway’s fascinating essay on the future of neoliberalism, and Terry Hathaway’s article entitled “Neoliberalism as Corporate Power”, both of which I strongly recommend. Needless to say both authors may strongly disagree with what I say here, which as ever is ‘untutored’.

Neoliberalism and Corporations

If I had to offer one piece of evidence to those who are sceptical about the concept of neoliberalism, I would look at Investor State Dispute Settlement (ISDS). These entities are set up as part of trade or investment deals, and essentially allow a corporation to sue governments if governments do something to disadvantage the corporation. For some examples of cases brought by companies against governments see here. These actions are often used against smaller states, but companies have also sued Germany (for ending nuclear power) and Canada (for banning a dangerous chemical).

The motives for corporations for having such agreements are straightforward, and amount to de-risking investment. The motives of governments in signing them is presumably to facilitate investment or trade. But the idea that a government can be sued by a corporation because the government has banned a dangerous substance that this corporation is using seems very odd. If nothing else, it sets up completely the wrong incentives for that government and corporation.

I chose the example of ISDS because it illustrates a case where corporations have legal powers over governments. I think enhancing the power of corporations is at the heart of how to understand neoliberalism in practice. That may involve using the law to sue governments, as here, or it may involve using governments to enhance corporate power.

This description and my choice of example may surprise many, because it is often said that neoliberalism is all about the primacy of markets. This is certainly how many of what Mirowski calls the Neoliberal Thought Collective, and many commentators on neoliberalism, see it. I would argue the distinction is between neoliberalism as a theory or ideology, and neoliberalism in practice. Of course each influences the other, but they are distinct. In many if not all cases of neoliberalism in practice, neoliberalism has strengthened the power of corporations and large companies.

The clearest example of that for me is unionism. Everyone would agree that what was central in the arrival of neoliberalism in the US and UK was an attack on the union movement. What has this got to do with markets? The standard response is that unions interfere with the operation of a free market. But for an economist, so does monopoly, or any form of imperfect competition among firms. On this, neoliberalism in practice seems silent.

Colin Crouch talks about market-neoliberals and corporate-neoliberals to deal with this problem, but it hardly resolves it. You can see the contradiction being resolved in favour of corporations in Will Davies’ fascinating paper on how ideas about the virtues of competition, and the need to break up monopolies, changed within the University of Chicago from the 1930s until the 1980s. (I talked about this and other aspects of the problem here.) You could describe this period as a good example of where interests influenced ideas. As I noted here, I don’t think this is the only case where neoliberal governments are prepared to ignore the market in the interest of large companies.

This apart, it is fairly clear why corporations should like the idea of the primacy of markets, as long as its position in markets is unchallenged. Markets, after all, are how a corporation makes money. It is natural that it should want to avoid anything that interferes with this, like market regulations of any kind. Equally some corporations would want to extend the scope of markets into areas that might previously have been undertaken by governments.

On page 22 of this paper, Mirowski lists eleven ideas associated with neoliberal thought. I don’t think any of them go against the interests of corporations. Indeed number 9 is “Corporations can do no wrong—by definition”! This is at least compatible with viewing neoliberalism as an ideology that protects and enhances corporate interests and power. Of course this doesn’t mean that neoliberalism is only about enhancing corporate interests, or that neoliberalism as ideology is not capable of unwittingly acting against corporate interests (see below).

Of course the advent of neoliberalism was not the first time corporations had been politically powerful. The Polanyi-like tussle between corporate power and labour or democratic power began in the 19th century with the advent of corporations. The ‘Gilded Age’ in the US or the military industrial complex may be examples of strong corporate power before the ‘neoliberal era’. Corporations in the post-war period, in contrast, were relatively weak, which no doubt helped inspire neoliberal ideology.

Neoliberalism, Wealth Inequality and Crisis

One of the important acts of the neoliberal pioneer governments of Thatcher and Reagan was to reduce the tax on high incomes. I have talked about elsewhere how that may have encouraged CEOs to bargain harder, leading to ever growing CEO pay. But lower tax rates on high incomes would also have another effect, which is to incentivize corporations to divert money to dividends, which of course go to the shareholders who are the owners of corporations. Here is the share of dividend income in GDP for the US.

Towards the end of the 1980s, after the 1985 cut in the top rate of income tax from 90% to 50%, the share of US dividends in national income began increasing. (The share in GDP is low, but the share of corporate profits is of course greater.) This increasing share has continued through to today. Of course shareholders as a collective do not choose dividend levels, but the tendency that began at the same time to reward CEOs partly through stock options gave those who did choose dividend levels an interest in raising them.

A higher permanent share of dividends will mean the return from stocks will increase, and that in turn will raise stock prices. A recent study by Daniel L. Greenwald, Martin Lettau and Sydney C. Ludvigson is particularly interesting in this respect. They showed that over the period 1952 to 1988 the growth in the stock market could all be explained by the growth in output. In contrast from 1989 to 2017 a massive $34 trillion of real equity wealth (2017:Q4 dollars) was created by the U.S. corporate sector, and 44% of this increase was attributable to a reallocation of rewards to shareholders. In turn, a higher stock market price increases the wealth share of the 1%.

It gets worse. They also estimate that most of this reallocation was at the expense of labour compensation. Not only was the stock market booming because dividends were rising, but workers wages were lower as a result. In contrast to the 1952-88 period, output growth accounted for just 25% of the stock market rise. (Playing a more minor role in stock market growth were a lower risk price (18% contribution), and lower interest rates (14%) due to secular stagnation.

It is perhaps not surprising that an ideology that enhanced the power of corporations would lead to an increase in the income and wealth for the owners of corporations. However I have also argued that it led to a crisis for neoliberalism in at least the two countries where the influence of neoliberalism was strongest.

In the UK, the biggest blow to corporate power came not from unions or left wing governments, but from forces created by neoliberalism itself. High incomes and wealth generate a demand for innovative forms of financial investment, which because of financial deregulation were allowed to multiply. If you look at who helped Brexit by providing finance or, in one case, directly helping to win votes, we know of two very wealthy hedge fund managers (Robert Mercer and Paul Marshall). Critical to persuading people to vote for Brexit were very wealthy newspaper owners. More than 40 per cent of the Leader’s Group of top Conservative donors (who meet the PM and ministers regularly) owe their wealth to investment firms – a combination of finance, hedge funds, private banking and private equity.

In this sense Brexit was where one form of capital, the personal financial wealth of a few, helped set back the interest of another form of capital, a large number of corporations in the UK. The Conservative party that had previously always supported business interests in general became a populist plutocracy. Donald Trump in the US departed from the neoliberalism playbook by messing with free trade and by restricting immigration, neither of which were in the interests of corporations as a whole. [1] Whether this is a hiccup in the forward march of neoliberalism, or is a more fundamental challenge, we will see.

[1] From the early days of the Labour government the Conservative party has talked the talk on reducing immigration. However once in power, the pre-Brexit Conservative coalition and then government was very reluctant to take effective measures to reduce it. That changed with Brexit and the ending of EU free movement.

Three myths about Johnson’s Social Care package

Most of the controversy around the extra spending for the NHS and social care announced last week focused on the higher rates for national insurance. As Rachel Cunliffe explained here, national insurance contributions are a tax just like income tax or VAT. The misconception that they are payments into some pot of money that you get back later helps explain why this was the tax of choice for Johnson, although the fact that it is not as progressive as income tax (excluding, in particular, rent or interest income) probably helped too.

I'm not going to talk about why national insurance is a very bad way to fund this additional spending because that has been covered elsewhere. However my first myth is that this unfairness has something about ‘generation wars’. When the post war Labour government introduced the state pension in 1946 I don’t know whether anyone said that because money was being taken from the young to give to the old (true) it was unfair on the younger generation, but if they had it would have been nonsense. It is difficult to get your head around, but with that kind of scheme, the old at the time it starts gain a huge amount, but there is no corresponding loser if the scheme continues forever. Some things are about generational transfer (like higher house prices), but schemes where the young will benefit when they are old are not. [1] The reason to oppose the use of national insurance is on normal equity grounds considering who benefits, rather than anything intergenerational.

The second myth I want to talk about is that this package shows that this government is not Thatcherite, or Osbornite, but instead favours a bigger state (and therefore it is more left wing). This myth is believed by a number of Tory MPs, some journalists (the Telegraph’s editor even called it the triumph of socialism) and some on the left. The reality is that it shows no such thing. Instead it is just bowing to the inevitable consequence of having a state funded health service.

The fact of life that few journalists are prepared to admit, and many Tory MPs pretend not to understand, is that in economies such as ours the share of health spending in GDP rises over time. This is something I have talked about for some time, ever since Osborne pretended that he was ‘protecting the NHS’ which journalists parroted. Here, for example, is a post from 2015 that shows a graph of the share of NHS spending in GDP rising from 3% of GDP in the 1950s to over 7% in the 2010s.

There are a number of reasons for this. As our incomes rise our wish to spend money on our health rises faster than our income, while our spending on food (for example) rises less. Doctors are finding better ways (or sometimes ways that didn’t exist previously) of treating us, which often seems to involve expensive drugs or capital equipment. But perhaps most important of all, we are on average living longer but the age our bodies start needing attention has not been rising so rapidly. This point applies to social care as well as the NHS. 

The inevitable consequence is that taxes need to rise to match this rising spending. [2] This was masked for a long time by an opposing trend: falling defence spending as a share of GDP. That however came to an end certainly by the turn of the century, which is why the Blair/Brown government increased national insurance to get the NHS to a reasonable level of operation. In contrast Cameron/Osborne were able to run the NHS into the ground again not just because they ran a right wing, small state government, but because they used the false excuse of a runaway government deficit which most of the media and the public believed and because their squeeze began from a fairly good position.

This chart, of how many cancer cases were treated within the target number of days, shows what happened clearly.

This chart is one of many that show a gradually deteriorating health service since 2010: see here for more information.

This deterioration has stepped up substantially in 2020 because of the COVID pandemic. No government, whether left or right, could have failed to react to this, if it wants to survive in office. So Johnson had to put additional resources into the NHS to clear the backlog created by COVID, and that is what the higher national insurance increase is initially about. It does not make him left wing, it does not raise the scope of the state (which is what really matters politically), and it certainly doesn’t herald a victory for socialism.

At this point we do need to ask whether permanently higher taxes make sense for what is a temporary problem - clearing the COVID backlog of cases. Just as most of the costs of COVID have been paid for with borrowing, why not this? It makes no macroeconomic sense to raise taxes now to cover transitional spending. The obvious answer to this puzzle is that nothing has changed since Osborne, in that we still have a Chancellor who is distorting economic policy just so he will meet some arbitrary deficit targets. This, in turn, is why it is so inaccurate to describe this as a left wing, big state government. Talk to those in local authorities, or in criminal justice, to see that Sunak (whatever Johnson’s wishes) continues to be a small state Chancellor.

But there might be another reason why the government chose to permanently raise taxes? This brings us to myth number three, which is that this package is about improving the quality of social care, even in the longer run. In the short term most of the money raised by the new tax will go to the NHS. What is left for social care will have to cover the cost of reducing the amount the elderly need to pay for their care (but not their living costs). As the IFS says, this aspect has not been costed by the government, but “can be expected to be several billion pounds a year.” Not much if any will be left over to improve the quality of care for the next three years.

Thus the IFS writes

“While the precise path for spending – and hence for the availability and quality of care – is unclear, it is clear that the extra funding will not be sufficient to reverse the cuts in the numbers receiving care seen during the 2010s. Thus, while more people will become entitled to financial support as a result of the reforms planned, many people with care needs not considered severe enough will continue to miss out.”

Even the cap on personal social care costs will not necessarily prevent some people having to sell their homes. If your only asset is a £200,000 flat or house you still have to find the 86,000 that is the cap on payments. The government responds by talking about a growing insurance market, but that market is small at present for obvious reasons (adverse selection) and that will not change much with these plans.

What will happen in the longer term, once the pandemic backlog has been dealt with? Here we have to come back to the state of waiting lists before COVID. The NHS does not just need money to catch up with the backlog caused by COVID, it needs money to stop (and even reverse) the deterioration in waiting times that began under austerity.

There are other pressures on NHS budgets too. One is pay. It is not sustainable to keep funding the NHS by decreasing the real value of nurses’ pay. Another is privatisation. The bill currently going through parliament gives ministers the power to circumvent normal procurement rules (competitive tendering), and their past actions suggest they favour giving contracts to private sector friends rather than allowing the NHS to do work in-house. Whatever these private sector companies may claim, that means higher cost to the public sector to fund the profits these companies need to make. [3]

The risk therefore is that after three years not much, if any, of the money created by the national insurance tax increase will end up in social care. As Graham Atkins of the Institute for Government says, “There is a risk that the funding for the NHS to tackle backlogs goes into the baseline NHS budget and the funding never ends up going to local authorities to reform social care.” This risk will be intensified if the government continues to squeeze local authority budgets, which in the short term at least seems likely to happen as Sunak tries to meet his deficit targets.

If higher taxes were really for social care, then it would have made sense to give the NHS temporary money to cover costs arising from the pandemic by borrowing, and direct the funds from higher taxes to social care immediately. Better still delay the tax rise but increase funding straight away to give the economy the boost it clearly needs. One of the reasons this didn't happen is that the NHS needs more money on a permanent basis, and Johnson is a Prime Minister who knows further deterioration in NHS waiting times beyond 2019 levels will risk losing power. Thus the tax increase says very little about the ideology of this government, and instead reflects the continuing desire of Conservative Prime Ministers to retain power. .

[1] The young could lose a bit if they could do better saving themselves and then investing in social care insurance, but when that insurance is scarce and expensive because of adverse selection it seems unlikely.

[2] This is a red flag to twitter MMT, who will say you could borrow or create money instead. But doing so year after year will overheat the economy, so if we are talking about several decades it’s not a very helpful remark. I talk about the immediate short run below.

[3] The usual counterpoint to this is that the private sector have more of an interest in improving efficiency. While that may be true in some areas, it seems highly unlikely for the NHS. The inefficiencies in the current NHS largely stem from a lack of public sector investment.

Is creating worker shortages by restricting low paid immigration a good idea?

 

The combination of Brexit, Covid, and an immigration policy that favours skilled (in practice higher paid) workers has created severe shortages of some lower paid workers. We are seeing that today among lorry drivers, crop pickers, food processors, butchers and other occupations. There are two, seemingly compelling, arguments for why this might be a good thing.

The first is straight supply and demand: a worker shortage means employers raise wages to attract workers. The second is that shortages increase productivity, as firms seek labour saving machines that will reduce their demand for labour. If, like me, you think reducing low pay and increasing low productivity are good things, what is there not to like? Few should begrudge the wages in some of the industries discussed by John Harris or Sarah O’Connor rising.

There are many caveats to these arguments. The most obvious caveat is that it would be far better to have much more modest shortages, which would have the same effect on productivity and wages but which wouldn’t disrupt the wider economy. It should be possible to allow some immigration on a short term basis, without diminishing employers’ knowledge that wages will have to be higher. So far the government has refused to do this. The result is significant damage to the economy as a whole. The rest of this post is about those more modest shortages.

Another caveat is that some of these workers, like those working for the NHS or in social care, are paid for by the state, and it is highly unlikely that their pay will be allowed to rise under this government. A consequence will be permanent shortages unless the government adjusts its immigration rules to allow these workers in.

A third caveat is if workers are working in industries that produce products that can be easily produced abroad, another response to worker shortages is to take production overseas. Production may no longer be able to compete with overseas production if domestic wages rise. But this caveat obviously does not apply to goods that cannot be traded, like social care or, after Brexit, lorry drivers.

A fourth point to never forget is that there are clear losers from ending immigration - immigrants themselves. They are prepared to undertake the considerable costs of working in a foreign country because they are much better off financially from doing so. If you think in global terms rather than from the point of view of natives alone, there are large global benefits to be gained from immigration. One economist argued that barriers to immigration were Trillion Dollar bills on the sidewalk. 

The fifth caveat, which is often ignored when talking about immigration, is that we are ignoring one side of what has happened. Immigrants leaving has created labour shortages in many industries, but it has also reduced the overall level of aggregate demand. [1] We cannot have one without the other. As a result, there is going to be less employment in all the industries unskilled immigrants didn’t work in. Not enough unemployment to fill all the jobs immigrants used to do, but enough to question what the macroeconomic impact of reduced unskilled immigration will be.

This is a crucial question we need to answer before we can accept Larry Elliot’s claim that Brexit has solved a problem (low wages in some industries) created by free movement. We need to look at the economy as a whole, not just workers in a particular industry.

To do this I want to suggest a thought experiment. Imagine a country where (for simplicity) there is no foreign trade. Jobs are either ‘good’ (high wage because they are relatively productive) or bad (low wage that are relatively unproductive). All the good jobs are taken by native workers, while all the low paid jobs are filled by immigrant labour. Although the jobs done by immigrants were badly paid, they still want to do them because they are much better than wages in the countries immigrants came from. Goods produced in the country are consumed by both native and immigrant workers, and both groups have similar preferences.

Now suppose this country sent all the immigrants home. Suddenly the demand for good jobs would fall (because immigrants were not buying them), and there would be many vacancies for bad jobs. Filling the vacancies comes partly from the unemployment caused by high wage workers losing their jobs, but also an increase in the wage of low skilled workers relative to high skilled workers.

Now consider who is better off. Former immigrants are worse off because they have been thrown out of jobs they wanted to do. How about native workers? Whereas before all had been working in high wage jobs, now some of the native workers are working in low paid jobs (although not as low as they once were). As you would expect high paid jobs to be better than low paid jobs, it would seem that no one in the economy is actually better off.

How is that possible? The economy has shrunk because immigrants have left, but the mix of goods produced is unchanged. Without immigrants, some native workers have to be low paid. From native workers’ point of view, some have lost good jobs and are doing worse jobs. Average income per head is unchanged, but whereas before native workers were in the better part because immigrants were in the lower part, now some native workers are in the lower part. 

This was the point of an earlier post, which argued that restricting ‘low skilled’ (aka low paid) immigration would mean more native born workers doing lower paid jobs. True, they might not be as low paid as they were when immigrants did them, but I doubt if anyone would call them ‘good jobs’. [2]

What about low paid jobs getting higher pay stimulating productivity? Again from a macro perspective we need to look at the higher paid jobs, where wages have fallen, reducing the incentive to innovate. I have for some time argued that the best way of increasing productivity is to run the economy hot. Giles Wilkes argues the same in the context of an interesting discussion of worker shortages. In general creating shortages is definitely an inferior way of inspiring productivity growth, because excess demand is a stronger motivator of new investment than higher costs. One of the problems of worker shortages is that it may lead to inflation, which encourages fiscal or monetary policy makers to deflate the economy.

Of course the UK is not like my thought experiment in many ways. In particular, native born workers work alongside many immigrants in low paid jobs. They clearly gain from restricting immigration. But this doesn’t change the result from the thought experiment that on average the position of native workers will get worse. This is a very similar situation to free trade agreements, which often increase overall welfare but where some workers lose out. [3]

Considerations like this mean that economists tend to think low skilled immigration is a good thing from a purely economic point of view. Focusing on those who gain from reduced immigration is misleading, because it ignores those who lose out. Now there may be good social or political reasons to limit immigration as a whole, but if you want to improve the position of low paid workers a better policy is to increase the minimum wage, or in some industries enforce restrictions in hours worked and ensure better pay for working unsocial hours (bring back and extend the agricultural wages board).

Labour shortages among workers deemed to be unskilled by this government are damaging to the majority of workers in the UK and damaging to those overseas who are prevented from filling the shortages by immigration rules. It will improve the relative position in the income distribution of those working in the industries immigrants have left, but there seem to be better ways of achieving redistribution that do not reduce average incomes at the same time. If you still think the redistribution is worth it, remember you have also made the global distribution of income more unequal.

[1] Expansionary fiscal or monetary policy are good at dealing with temporary demand shocks, but not permanent ones.

[2] A simple numerical example may help. Suppose the economy is initially made up of 10 million immigrant workers, and 90 million native workers. Native workers are on average paid 10 units a week, although that is a distribution where some will be getting much less. The immigrants get paid on average 5 units a week (also a distribution). Total national income is equal to 10*5 + 90*10 = 950 units, where 10 is the average income for native workers.

The 10 million immigrants now leave. Immediately aggregate demand falls by 50 units. The demand for native jobs is now 900/950^th of its previous level, which makes just over 5% of native workers redundant (just over 5 million). But because preferences are the same and assuming no economies of scale, our new economy must have just under 9 million native workers moving over into the jobs immigrants used to do. So relative wages have to move until we attract just under 4 million native worker to do the work immigrants used to do. These assumptions imply that, once relative prices have adjusted, the new economy is just a scaled down version of the old one, where total income is 950*9/10=855 and average native income has fallen from 10 to 9.5.

[3] Another thought experiment can illustrate this. Suppose wages are low in a particular industry not because of immigration, but because of foreign competition from low wage economies. Let’s say the industry was textile production. Would we think it was a good idea to create shortages of textiles domestically by restricting imports of textiles? That would lead to more domestic production and therefore almost certainly higher wages and prices in the domestic textile industry. But equally, more people would work in the textile industry, and less in other industries which were more competitive internationally. Productivity in the textile industry might improve, but in the economy as a whole it might fall because workers had been diverted to a relatively low productivity industry.

Economic policy in most countries for decades has been to do the opposite of this thought experiment, by reducing barriers on trade. By specialising in producing the goods we are relatively good at producing, we increase productivity in those industries. Not everyone in the economy gains from this (e.g. domestic textile workers), but average incomes rise.