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. 

Opportunity costs

I wrote this about a month ago, but decided not to post it because it sounded a bit like a personal rant. Following the Brexit result, and more introspection among economists about what more they could have done, I think this basic point is worth making

When I complain about the media ignoring economic ideas or economics generally, I’m told that economists - and academics more generally - must learn about PR. Indeed it may be my moral responsibility to do so. When I wrote about how other social scientists made useful criticisms of economics, but were often ignored because it was couched in language economists did not understand, I was told that economists should learn that language. And when I said in my post on Mirowski that he knew more about the history of economics and neoliberalism than I did, Lars Syll says I should educate myself. Note that in none of these cases am I saying there should be no engagement from economists: all three examples come from cases where I did attempt to engage.

In economics we do not just learn about opportunity cost, we also know about comparative advantage and the division of labour. It makes sense to set up systems (in production, trade, research or other things) where people do what they are good at, rather than just do a bit of everything. In academia people specialise for good reasons. To understand the macroeconomy better it really is sensible that I spend most of my time reading macroeconomic research rather than doing PR, reading sociology or the history of economic thought. Note I said most, not all.

That does not mean that we all become isolated in our own little worlds of knowledge. Indeed I think both good research and good application often benefits from some breadth of knowledge. But I think it beholds those of us with some knowledge to try and communicate it in terms that are easy for outsiders to understand, and avoid them having to read our literature. That is why I try to avoid jargon in my blogs unless I only want to communicate with other economists. If policymakers want macroeconomic advice I do not tell them to go read some article or change their policies before I’ll talk to them - I just give them advice.

To some it seems terribly arrogant if you say I do not have time to read a new literature, or cultivate relationships with journalists, particularly if you work in that literature or you are a journalist. To see why it is not arrogant just turn it around: how would that person feel if I said you had to start reading a lot of macroeconomics literature. I never say that, but write blogs instead, and put a considerable effort into doing so. To be told that in addition I have to learn the arts of PR as well as reading other literatures is not only annoying, it makes no economic sense.