Immigration and Real Wages: Reality and Perceptions

Reality

Robert Skidelsky’s recent piece applies a textbook model to the question of immigration, which implies real wages do fall for some time. The story goes like this. There is sudden increase in labour supply because of a wave of immigration. Immigrants compete for jobs, which forces down real wages, encouraging firms to switch to more labour intensive forms of production (automatic car wash to hand car wash), which reduces labour productivity. However as firms respond to higher profitability and invest, everything including real wages and productivity goes back to where it was, the only difference being that the economy is now larger. So immigration leads to lower real wages for as long as it takes firms to invest.

Did the large increase in EU immigration that started in 2004 have this effect? There is no noticeable change in the rate of increase in nominal or real aggregate wages until after September 2007, which was when the Northern Rock crisis happened. Everything from 2008 onwards is dominated by the recession. But we have emerged from the recession with an economy with low productivity and low real wages, and as yet firms are not investing. Is this the model working, and has the second stage involving more investment somehow stalled for some reason? Do we need to cut immigration so we can have increasing real wages again?

There are many problems with this textbook model. First, there was a large increase in work related immigration from non-EU sources in the second half of the 1990s, but no associated decline in real wage growth. Second, the model treats immigration as an exogenous shock, by which I mean immigrants just turn up and start competing for jobs. If that was the case, we would expect to see a temporary increase in unemployment associated with immigration inflows. You do not see that in the late 1990s, or immediately after the start of EU migration in 2004. And third, econometric evidence suggests immigration has no noticeable impact on real wages (see also here. Results are similar in the US).

There is a simple explanation for all these difficulties: we are using the wrong model. An alternative model is one where firms find it advantageous to produce in the UK, but have problems getting workers, a problem that is solved by recruiting from overseas. It is very telling that under Theresa May the Home Office commissioned many studies designed to show how immigration was holding down real wages, and all were suppressed because they could find no evidence. In this production led model, there is no reason for real wages to fall. The additional employment, investment and output go hand in hand.

What about the experience of low real wages after the Global Financial Crisis (GFC)? The first point to make is that there is nothing about real wages that a combination of productivity growth, higher indirect taxes (in 2011) and exchange rate depreciations cannot explain. We have not seen a significant shift in the distribution of income towards profits. So any immigration effect would have to come through via lower productivity. As I explained here, you can tell a story where poor UK productivity performance since the GFC is the result of (a) a global productivity slowdown (b) poor UK investment in R&D and new technology (c) unexpected negative shocks: first the recession, then the lack of recovery (austerity) and finally Brexit.

I would say at the moment the evidence strongly suggests that real wages are not noticeably reduced as a result of immigration, but I remain open to seeing contrary evidence. We should also note the undisputed fact that immigration provides more resources to the public sector, so workers are better off via this route. But if this is the case, why on earth do the public believe the opposite so strongly?

Perceptions

To many, in all social classes, it is obvious that immigration reduces real wages. The logic appears watertight. If more people with skill X come into an area, that reduces what the existing workers with skill X can charge. For the self-employed plumber, it means more competition for a fixed number of plumbing jobs, so quotes for any job will have to fall. For workers being paid a wage, it means they can be more easily replaced if they or their union asks for a higher wages.

The same thing happens in reverse when people point to Brexit leading to shortages in labour in some sectors because immigrants are no longer coming. Are, they say, that will raise wages in that sector, which is bound to make the remaining workers in that sector better off.

Telling people that econometric evidence suggests that there is no evidence that immigration lowers real wages cuts little ice on its own, because the logic above seems so clear. There is also no point in telling them that immigrants will increase demand, because it is obvious that immigrant plumbers will do their own plumbing, or immigrant workers producing X will demand far less X than they produce.

The mistake people are making is right at the beginning of this thought experiment. By talking about real wages, people immediately think about themselves as workers. As a result, they imagine a world where there are more immigrants doing the kind of work they do. And, understandably, they keep everything else constant. But immigration controls are never about one group of workers, or the immigrants that have just appeared in the neighbourhood. They are about workers across the economy, influencing not just their nominal wage but the overall level of demand in the economy. 

How do we get over the failure to generalise? One way is to ask people to imagine the opposite of most people’s implicit thought experiment. Ask what would happen if there was more immigration in every trade except their own. They should realise that immigrants would require the services that this person provides, so the demand for their trade would increase, allowing them to increase their quotes and raise their standard of living.

Another mistake some people make is to assume that because many EU immigrants are from poorer East European countries, and immigration happens because of differences in standards of living, we have to get some kind of equalisation of living standards as a result of immigration. To see why this is the wrong way of thinking about it, imagine if workers were forced to move the other way, from rich to poor countries. Would this raise real wages in poor countries? Of course not: they would be paid the same as domestic workers producing the goods the poor country does.

A far better way of thinking about EU immigration is that it is allowing production in the UK to happen which would otherwise go abroad. Of course there may be a small number of cases where overseas workers are exploited by restricting their ability to leave their employment, but domestic laws and resources should exist to stop that happening.

One way proponents of less immigration play on these misleading perceptions is to talk about just controlling unskilled immigration. That is clever, because it diverts people away from thinking in terms of a labour shortage model. The best response to that is to suggest various occupations that are not classed as skilled, and ask people whether they really want less care workers or nurses and so on.

But what if people still feel that immigration must reduce wages in some way. Perhaps just the possibility of potential immigration restrains workers for asking for pay increases. The final mistake that people make so often is to assume that lower nominal wages means lower real wages. For that to happen prices have to be unresponsive to lower wages. And that in turn would mean the share of profits in national income would have steadily risen since we had large migrant inflows, which it has not. The main determinate of real wage growth in the UK has and always will be productivity growth.

Falling nominal wage growth would still have an important effect, however. It would keep inflation low, which would allow policymakers to let unemployment fall relative to previous trends while keeping inflation on target (it would allow the NAIRU to fall). And that has to be a good thing.

Implications

Although the evidence overwhelmingly suggests that immigration does not reduce real wages, it is fairly easy to see why people would think otherwise. That contrast is ripe for exploitation. How it was exploited, and how it is turned a previously outward looking, tolerant nation into one that tries to deport someone who have legally lived here for over 50 years, will be the subject of a second post.

Was an anti-austerity policy politically possible in 2010?

Could left and centre politicians in the US or Europe have got away with saying forget about the deficit?

It is clear to some of us at least what the appropriate macroeconomic policy should have been in 2010. No switch to austerity. In my VoxEU piece I imagine that in the US, UK and Eurozone government spending on consumption and investment had grown at an average rate from 2010 onwards, rather than being cut back sharply. Back of the envelope calculations suggest that by 2013 GDP would have been about 4% higher in all three countries or country blocs. In that eventuality by 2013 short term interest rates would probably be on the rise, and then governments could begin to reduce deficits. There would of course have been no government funding crisis in the UK or US. In the Eurozone, with appropriate ECB policy, the debt crisis would have been confined to Greece. We would have all been much better off.

So would such a policy have been politically possible? I think if there had been a reasonable political consensus behind it, almost certainly yes. After all, G.W. Bush was quite happy to use Keynesian economics to support tax cuts in 2001. One of the points I have made about mediamacro is that it finds it difficult to argue a case when there is a political consensus going the other way. The media would, of course, have raised concerns about rising budget deficits, but if the political consensus had been that macroeconomics tells you not to worry about the deficit during a recession, I think it could have survived. (An exception might be Germany, where the thought experiment is perhaps too difficult to imagine.)

The moment that the major right wing political parties decided to abandon consensus macroeconomics and use the deficit as a political weapon, then it became much more difficult to say that the deficit was not an immediate concern. This was for two reasons.

First, the default position of many political commentators is that a government is like a household, so it should respond to a deficit by tightening its belt. To counter this requires referencing macroeconomic expertise (although of a very simple kind). However opinion among academic economists about ignoring the deficit is divided, and even if the clear majority supported the anti-austerity line the media’s default mode is to frame this as a two-sided debate. If academic economists are perceived to disagree, political commentators will fall back on household analogies.

Second, and perhaps more seriously, a large section of economists - mainly economists working in the City - would have been warning of an impending financial crisis if the deficit remained high. These are the bond vigilantes that are always just over the horizon. As one former economics editor said to me, bond economists never saw a fiscal tightening they didn't like.

In this situation, it could be politically fatal to try and argue that the deficit should only be dealt with when the recovery was assured. (Here an assured recovery is code for when interest rates start rising.) It is not only counterintuitive, but you would have lots of City economists saying that you are courting disaster. Every time that long term interest rates rose, they would pop up on the TV saying it was because of fears about the deficit. We do not have to imagine this, because it is what happened.

Finally, in Europe at least, there is a killer argument. The line that we should ignore the deficit would have been dealt a fatal blow by the Eurozone crisis. Those that had been warning of a financial crisis caused by the deficit pointed to Greece and said I told you so. The subsequent contagion was a result of decisions by the ECB, but again the media framed it as a result of excessive deficits in these countries. Even outside of the Eurozone, any politician that tried to say that a similar crisis could not happen here would have been treated by the media as completely out of touch.

In this situation it is not at all surprising that the left would adopt a degree of appeasement. Voters will be less worried if you say ‘I understand the concern about the deficit, and we are doing something about that’ than if you say ‘the concern about the deficit you are always hearing about is misplaced’. It is easy for someone who understands the macroeconomics to imagine the second line would have been tenable, but we are not in the business of getting votes.

To some extent you can see the proof in all this in the change in Labour’s rhetoric in the UK. They did go for stimulus rather than austerity when in government in 2009, even though the Conservatives opposed this. Before and after the election they labelled Osborne’s plans ‘too far, too fast’. Yet that line also failed to survive, so now Labour have committed to (try and?) reduce the deficit each year.

Some, like Robert Skidelsky for example, describe these movements, and a failure to extol the virtues of fiscal policy under Labour, as a mistake. However, I suspect that if Labour’s shadow Chancellor Ed Balls could ever speak the truth, he would say that he did not want to gradually acquiesce to the austerity line, but the evidence from focus groups was overwhelming. Defending Labour before the financial crisis was pointless because it just reminded people that the Great Recession happened under their watch, and that Labour (like everyone else) gave finance too free a hand. The ‘too far, too fast’ line just sounded feeble when the news was all about the Eurozone crisis. In the end, Labour just had to be ‘tough on the deficit’.

Of course this is speculation. We might also wonder if things would have been different if the press had not been relentless in emphasising the deficit. What if the Eurozone crisis had not happened? Questions like this are not just idle speculation. They help to answer whether countercyclical fiscal policy will ever be possible again. If, every time there is a large negative shock, the political right play the deficit card, then we are doomed to pro-cyclical policy and being stuck in a liquidity trap with ineffective monetary policy much too often. That suggests to me that we need to change the way monetary policy is done.