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. 

Would Remain win a second referendum?

I think it unlikely that we will have a second referendum before we leave in 2019. [1] Brexiteers fear losing it and Labour fears fighting it. So why ask the question? It will become clear.

I think if a second referendum was just a rerun of the first, then Remain would win comfortably. It is now pretty clear there will be no £350 million a week for the NHS, and instead as the OBR suggests there will be less money if we leave the EU. The economic concerns that the Leave campaign so effectively neutralised with ‘Project Fear’ are now becoming real: we had a depreciation (as predicted), real wages are falling, and GDP per head in the first half of the year is almost stagnant. I could go on, but this is enough for many Leavers to change their minds.

Partly because of this, a second referendum would not be a rerun of the first. Leave would have a new theme, which they would plug away at relentlessly. They would argue that the very existence of a second referendum was an attack on democracy. The people had already decided, and a second referendum was an attempt by MPs to take power away from the people. The people needed to take back control from MPs as well as the EU. They would argue that you should vote to Leave again to preserve democracy.

The simple point that people should be allowed to change their mind would be met by lots of rhetoric that sounds convincing. If a second, why not a third? Referendums are meant to last a generation, and not to be held every few years. (Quotes from David Cameron saying similar things from the last campaign would be trotted out.) We know from the polls that this argument has power, as many people who voted Remain think that nevertheless we should respect ‘the will of the people’. Many think that on a constitutional issue like this, a referendum should override the views of MPs, and will feel that by voting Leave they will be upholding this principle. In this sense it would be like the Labour leadership election in 2016, which Corbyn won in part because members felt MPs were trying to take members power away.

If your reaction to this is to say ‘what nonsense’ or ‘who would be so idiotic to fall for this tactic’ then you are who I’m writing this post for. The view that Remain lost and that result should be respected is a perfectly valid point of view. Furthermore, as Owen Jones has pointed out, the polls suggest there are many besides himself who take that view. It does the Remain cause no good whatsoever to suggest that people who hold this view are in any sense stupid. (The opposite is also true - the Re-Leavers view is also not obviously right, and needs to be argued. Is parliament overriding the referendum result really a 'coup against the popular will' when people realise they were duped and so no longer support Leaving?)

In addition, Remain campaigners just saying a majority of the electorate didn’t vote for Leave because some people did not vote will not convince anyone. Simply asserting that the original Leave campaign was based on lies is also not sufficient, because all election campaigns involve politicians telling lies of some kind. We need much better arguments than this if we are going to convince Remainers who think the original referendum result should stand.

A good place to start is a post by Richard Ekins, a Professor of Law at Oxford University, who argues “Political fairness and democratic principle require one to respect the outcome of the referendum even if one is persuaded that Brexit would be a very bad idea”. His arguments are strong and they need to be addressed (as I tried to do in March). We need to argue that the chosen electorate for the first referendum was not fair, and to allow just a simple majority to decide such an important and potentially irreversible event is not democratic, even after the event. We need to argue, as I tried to do, that the lies told by the Leave campaign went well beyond what normally happens in an election. In these circumstances a referendum result is not something to respect, but something you resist with all your power.

Remain campaigners also need to be politically realistic. To say, as some do, that Labour’s commitment yesterday (to staying in the Single Market and Customs Union during the transition period) means nothing and is “not good enough” because it still involves leaving the EU in 2019 completely misunderstands political realities. Brexit is not going to fall apart of its own accord. As George Eaton argues (see also Stephen Bush), the best bet for reversing Brexit is through a Labour government. Given this, to suggest that Labour would campaign against Brexit if it wasn’t for Jeremy Corbyn is both misdirected (it ignores many MPs in Leave voting constituencies who think Labour have to support Brexit) and counterproductive (if Brexit is reversed, it will likely be by a Labour government under Jeremy Corbyn).

When Owen Jones described ‘Hard Remainers’ online as increasingly resembling a cult, I was both shocked and surprised. I am, after all, someone who argues online that the referendum vote should not ‘be respected’. By cult he meant those he encountered who were

“Intolerant, hectoring, obsessively repeating a mantra that doesn’t convince outside of their bubble, subjecting any who dissent from their hardline stance to repeated social media pile-ons, engaging in outright abuse and harassment, saying that people who voted Remain aren’t really Remain supporters and are heretics.”

Now I like to think I do none of those things, and I know some of those campaigning to Remain who do not do these things either, but I can also see that others might take a much more aggressive and purist approach. This is a strange but I think real phenomenon: the less likely something is to happen, the more some demand that only it will do. The reality is that staying in the Single Market and Customs Union outside the EU permanently is a lot more likely than simply staying in the EU, and less costly that leaving either. Because it is obviously inferior to staying in the EU it may be how rejoining the EU eventually happens. Those campaigning to Remain are in no position to be aggressive or absolutist.

[1] A referendum where Remain is an option, and assuming we leave in 2019 and the Conservatives remain in power until then.  

Medicine and the microfoundations hegemony in macroeconomics

Mainly for economists

I’m beginning to think I should have made much more of analogies between economics and medicine in discussing what I call the microfoundations hegemony: the idea that the only ‘proper’ macroeconomic models are those that have all their equations consistently derived from microeconomic theory. The analogy I have in mind is that biology represents microfoundations, and statistical analysis linking, say, smoking to lung cancer are the non-microfounded models. (I've used the analogy in other contexts.)

I was thinking about this in the context of a paper I have just finished which uses a diagram that Adrian Pagan used to describe different types of macromodels. The diagram, which you can find in an earlier post, has ‘degree of empirical coherence’ and ‘degree of theoretical coherence’ on the two axes. Particular macromodels can be placed within this space. At one extreme involving the highest theoretical coherence but weaker empirical coherence are microfounded DSGE models. At the other are VARs: statistical correlations between a group of macro variables with no theory-based theoretical restrictions imposed. In the middle are what I call Structural Econometric Models and Blanchard calls Policy Models, which use an eclectic mix of theory and econometric evidence.

If you have a simple view of the hard sciences, this diagram looks very odd. Theories either fit the facts or they do not. But I think a medic could make sense of this diagram by thinking about medical practice based on biology (for example how cells work and interact with various chemicals) and practice based on epidemiological studies. Ideally the two should work together, but at any particular moment in time some medical ideas may borrow more from one side or the other. In particular, statistical studies could throw up links which do not have a clear and well established biological explanation.

Now imagine the microfoundations hegemony in macroeconomics applied to medicine. Statistical longitudinal studies in the 1950s showed a link between smoking and lung cancer, but the biological mechanisms were unclear. The microfoundations hegemony applied to this example would mean that medics would argue that until those biological mechanisms are clearly established they should ignore these statistical results. The investigation of such mechanisms should remain a top research priority, but for the moment advice to patients should be to carry on smoking.

OK, that is perhaps a little harsh, but only a little. That some macroeconomists (I call them microfoundations purists) can argue that you should model and give policy advice based not on what you see but on what you can microfound represents something that I cannot imagine any philosopher of science taking seriously (after they had stopped laughing).        

The BBC and Patrick Minford

Over the last few days the BBC has given considerable publicity to Patrick Minford’s new report published by the ‘Economists for Free Trade’. I have looked at both the BBC News website entry and listened to the Radio 4 Today programme’s discussion. They are both classic ‘2 sided controversy’ formats, with Monique Ebell from the National Institute of Social and Economic Research (NIESR) providing the main opposition.

So why was this coverage something the BBC should be deeply ashamed about? There are two main reasons, but first let me make a more general point which applies to journalism more generally. There is no quality control in most of the media when it comes to giving publicity to a report like this. There is a very simple reason for this, and that is the primacy given to immediacy. In a better world, when a report like this came out, journalists would spend a few days ringing around to see what the reaction of other experts were, or nowadays just look at reactions on twitter.

In this particular case such a strategy would have thrown up some apparently large errors, and this should have led journalists to question whether they should give the report any publicity. They might at the very least have waited until the full report was published next month.

Let me give an analogy. Suppose a report of a medical trial had suggested a miracle cure for some serious disease. The report had not been peer reviewed, and its author had connections to a drug company that stood to benefit from the alleged cure, but the BBC had decided to give it considerable publicity nevertheless. Within days it became clear that there were serious problems with the report, and that there were other existing papers that came to a completely different conclusion. The BBC would then look very foolish, and many sufferers from this disease would have been given false hope. I suspect for that reason the BBC would be much more cautious. Yet if the report is about a subject matter with any political implications this caution appears to go out of the window.

Now let me get to the two reasons why the BBC should be ashamed in this case. First, Patrick Minford is no expert in international trade. He is a macroeconomist, who in his younger, less obviously political, days served as something of a role model for me. He published a very similar argument about the benefits of unilateral trade liberalisation during the referendum campaign. It was heavily criticised by individuals or groups that are experts in international trade. So we have already had the quality control, yet the BBC decided to ignore that. Returning to my analogy, it is as if there had been earlier claims of miracle cure that had been thoroughly debunked by medical experts and the BBC had ignored these.

Second, at no point in either of the two items I looked at is there any mention that the overwhelming consensus among academic economists is that Brexit would be harmful to the economy. We just have reports that give two opinions, with no context whatsoever about which opinion is the consensus view and which is the maverick. It is exactly equivalent to giving considerable publicity to a report from some climate change denial outfit, and including a response from one or two climate scientists with no mention of what the consensus among climate scientists is. Again to draw on my analogy, it is like reporting a miracle cure and failing to say that nearly all doctors thought this was rubbish.

This last point about ignoring the clear consensus touches a particular nerve for me, because it is exactly what the BBC appeared to many of us to do during the referendum campaign. Yet when the Royal Economic Society complained about this, they were told that the economic consensus had been mentioned in this and that bulletin. Whether this was cherry picking by the BBC is not easy to establish after the event. [1] Well here is an example where it was not mentioned, and I would like to hear from the BBC why this information was not thought to be useful to convey to its audience. [2] 

On both counts, this is very bad journalism, even if you do not think economics has the same standing as medicine. The BBC may have thought they had brushed off complaints from economists, but here is a specific example where they really do have a serious case to answer. As Ben Chu rightly says: “The legitimate news story around Minford’s work is how bad science can survive and thrive when it supports the desires and prejudices of powerful people in our society … the BBC ... has become part of the problem.” Brexit is the Emperor's New Clothes, and no one - including the BBC - dares say that the Emperor has no clothes.

[1] Not easy but not impossible: it would cost a few thousand pounds in research time for someone to go through the main news reports during the Brexit campaign and establish how many times the economic consensus was mentioned.

[2] Channel 4 News did put the point to Minford that many economists thought his work was flawed, to which he responded by saying “all these trumped up economists and the consensus they are all hired hands”‘. A very political answer from a very political economist, and therefore very revealing, but not a question the BBC apparently thought worth asking.  

Brexit remains an exercise in deception

I talked last week about how the Leave campaign involved lies at its centre. Not the occasional exaggerations of the Remain campaign, but claiming things that were the opposite of the truth. Like there will be more money for the NHS, when in fact there will be less. That particular lie probably swung the result, according to the man who organised the Leave campaign.

Labour people tell me that public opinion on Brexit will turn once these lies become apparent, and at that point Labour can safely take up the Remain cause. What this overlooks is that the managing of information characterised by the Brexit campaign continues. The Tory tabloids continue to distort the truth, and the Telegraph acts in a very similar fashion. The UK government appears more interested in saying stuff to please its UK audience than actually negotiating with the EU, and its studies of the impact of Brexit remain secret [1].

Meanwhile the opposition give no hint of the costs that Brexit will involve, and by design or conflicted confusion are just a tiny bit less pro-Brexit than the government. The broadcast media, and particularly the BBC, appear hopeless at questioning the facade that both main parties and supporting think tanks have erected. I have never heard a politician pulled up for saying we must retain access to the Single Market: all countries have access to that market! (This is the kind of journalism we should be seeing.) Individual MPs are intimidated into silence by the power of the Tory tabloids.

When I talk to Leave voters, all they tell me is how the economic ‘catastrophe’ predicted by Remain did not come to pass, or other Leave nonsense talking points like the exchange rate was overvalued anyway. They are often unaware that falling real wages are the direct result of the Brexit depreciation, and as a result the economy hardly grew in the first half of this year. They, and many people who voted Remain, do not realise that the government’s position papers are largely fantasy and that the EU is in a position to dictate terms. This is not because these voters minds are closed. They just get their information from sources that go along with the government’s Brexit fantasy, unless they are fortunate enough to read the Financial Times. No wonder there has been no major change in public opinion since the referendum.

Those in the Labour party should realise more than most how the media can present a one-sided reality which many non-political voters accept, until they see for themselves the other side during a general election campaign. The problem with a ‘wait and see’ attitude to Brexit is that its major economic cost will not become apparent until years after we actually leave the Single Market. Few realise that the original Treasury study, with the central estimate of an average annual cost of £4,300 per household (6.2% of GDP) was not some piece of Remain spin but a perfectly reputable study, which economists at the LSE said was “overly cautious”. Instead we get nonsense like this reported by the BBC. [2]

Some time ago I calculated a conservative estimate for the cost of austerity, and it was £4,000 per household. Ironically it was based on OBR estimates that the MSM largely ignored, just as they ignore the OBR’s estimates for the short term cost of Brexit. But my austerity cost estimate was a total cost, over all the years of austerity. The Treasury estimate is a cost each year. There is therefore a strong liklihood that Brexit will be far far worse than austerity in terms of lost resources, and unlike austerity there is no way of avoiding these costs once we are outside the Single Market.

For Labour party members and MPs I would put it this way. Imagine winning the next election but having to accept continuing austerity. Winning an election after leaving the Single Market will probably be much worse, and of course the media and voters will blame it all not on Brexit but on Labour’s ‘far left’ policies. Winning an election after Brexit is a poisoned chalice.

[1] Here is Mike Galsworthy on this and the earlier 'Balance of Competences' reviews that the government kept very quiet about before and during the referendum.

[2] I’ve talked to people at the BBC, including their economics editor, about why they cannot apply the BBC Trust’s recommendations on science coverage to economics. (The Trust’s conclusion, in summary, is that in controversial areas the BBC should go with the overwhelming scientific consensus. In other words recognise scientific knowledge, and not treat it as just an opinion.) I think a summary of their response to my question is that economics should not be regarded as a science: there is no economic knowledge, just opinions. What that attitude means in practice is that the public do not hear from the many experts in international trade we have in the UK (and there are many), but instead they hear from Patrick Minford.

Japan and the burden of government debt

I don’t write enough about Japan, and now that some of my posts are very kindly being translated into Japanese I should try to remedy that. In fact there is currently a very good reason to write about the Japanese economy, and that is a very strong 2017 Q2 performance. Annualised growth was 4%, compared to 1.2% in the UK. What is particularly heartening about recent Japanese growth is that it is led by domestic demand rather than trade. In the past Japan seemed to have the opposite of the UK’s problem: growth was often led by trade, while domestic demand was weak.

This recent growth is not just making up for poor past performance compared to other countries. Comparisons of GDP growth are misleading for Japan because (unlike the UK and US) it has relatively little inward migration, so it is better to use GDP per head for such comparisons. (As Noah Smith points out, even this my bias comparisons against Japan because its population is aging.) Between 2006 and 2016, Japan increased GDP per head by a total of about 5.5%, compared to around 5% in the US and about 3% for the UK. Good compared to other countries, but all these countries should have had stronger recoveries from the recession.

Strong growth is good news because inflation is so low (around 0.5%): way below the 2% inflation target. The government is trying to stimulate growth using a modest fiscal stimulus and large scale quantitative easing (short and long interest rates are exactly zero) as well as implementing various structural reforms. But the striking thing about all this is that their net government debt to GDP ratio is 125% and rising (OECD Economic Outlook measure). This is higher than any other OECD country except Greece and Italy.

Does the conjunction of relatively strong growth and high government debt confound economic theory, as Bill Mitchell suggests? Like high powered money and inflation, any relationship between government debt and growth just does not work when interest rates are stuck at zero. High government debt could crowd out private investment (although some dispute this), but not when real long term rates are zero and inflation is near zero. Servicing high debt could discourage labour supply, but again not when interest rates are zero. Nor is debt a burden on future generations when the real rate of interest is well below the growth rate.

Of course most people think such high debt levels are a real concern because of ‘the markets’. But the markets will only stop buying this debt if they expect default or rampant inflation, and there is no way a government with its own currency can be forced to default. There is also no way it will choose to default with interest rates so low. This is the basic truth that our leaders in the UK choose not to tell us (and pretend otherwise).

But what happens when growth finally raises inflation, and interest rates rise. Will debt not be a problem then? Maybe, but only in the long term, so the government will have plenty of time to fix that roof when the sun shines. [1] Right now Japan does worry about its high levels of government debt, but it rightly worries about the combination of low growth and low inflation much more. In that sense it sets a good example to other countries.

[1] Fixing the roof while the sun shines is one of the Cameron/Osborne little homilies I approve of. The problem when they used it was the UK economy was actually in pretty poor shape, as we could tell because interest rates were so low.    

What does respecting the referendum result mean?

Take the people who voted Leave because they believed there would be more money for the NHS if the UK didn’t have to contribute to the EU. People, and there were plenty of them, who believed the £350 million a week figure. Should we respect their vote by leaving the EU, which would mean considerably less money available for the NHS?

And how about those who voted Leave because they believed less immigration from the EU would mean they had better access to public services. They can hardly be blamed for voting that way, because plenty of politicians from the Prime Minister downwards have told them that immigration is to blame for pressure on public services. In reality reducing immigration would almost surely reduce the money available for public services. So how are we respecting their wishes by leaving the EU?

And those who voted Leave because they were worried about being ‘swamped’. Not because it was happening to them right now, but because they have read that it is going to happen. When Turkey joins the EU. Or with all those refugees. Because they read countless articles that scare them. The only difference between this example and others is that this is explicit in talking about ‘the Muslim problem’. Do we honestly think that leaving the EU but continuing with free movement is going to assuage their fears?

It is an awkward truth that what many people wanted when the voted Leave is either simply impossible, or cannot happen without making everyone significantly poorer year after year. It is this reality that keeps the government in a fantasy world. Almost no one who voted to Leave is going to be happy with the result of government decisions. Those who wanted better access to public services will not get it. Those who wanted more sovereignty will find their sovereignty sold off cheap in a desperate attempt to get new trade deals. Those who wanted less immigration will also find their wishes largely frustrated because the UK cannot afford to reduce immigration. 

The parallels with the US are clear. The Republicans, after spending years denouncing Obamacare, found they could not produce anything better. Those promoting Leave also did so without any thought to how it might actually happen, and therefore they have nowhere to go when confronted with reality. As a result, the government invents a magical customs union so that Liam Fox can have something to do. I have never known a UK government look so pathetic. 

This is why the lies told by the Leave side are so critical. People tell me this is not important because most elections involve politicians lying. I'm afraid this is exactly equivalent to saying that Trump is just another politician who lies. It should be obvious that Trump and today's Republican party are something new and dangerous: people who tell blatant lies all the time about crucial issues and construct an alternative reality with the help of media outlets like Fox News. In exactly the same way, those in charge of Brexit live in their own imaginary world supported by the pro-Leave press. It is this imaginary world that they got 52% of the electorate to vote for.

That alone is enough to completely discredit the referendum as an exercise in democracy. But there is more. The debate we should have had during the referendum was about the costs and benefits of immigration, This never happened because the person leading the Remain campaign had spent so much of his political life stoking up fears about immigration. It is hardly surprising that so many people voted to end free movement when both campaigns were united about immigration being a problem and way too high. The referendum campaign was like a boxing match where one side tied one of his hands behind his back and the other side brought knives.

Respecting the referendum result means passing all this off as just normal. It is not normal. It is no more normal than Republican's taking health insurance away from millions. It is like an election held by an authoritarian state that runs a xenophobic campaign and controls much of the means of information. In that case we would say that this authoritarian state respected democracy in only the most superficial sense, and the same was true for the EU referendum. 

We cannot say that we should respect the right of people to make mistakes when the information they were given was so untruthful. The people voted for Trump and it is right to struggle to limit the damage and overturn that result after 4 years. Those who struggle against Trump are not disrespecting democracy but fighting to preserve it. In the same way it is right to limit the damage the referendum vote does and reverse it whenever that opportunity arises.

I understand those who say that in today's political environment anything other than another referendum is politically impossible. I understand why it benefits the opposition to sit on the fence and triangulate. [1] But please do not tell me that by being politically expedient in this way you are keeping the moral high ground. [2] There is nothing noble in defending an exercise in democracy that was as deeply flawed as EU referendum. It is no accident that the only major overseas leader that supports Brexit is Donald Trump, and that those pushing Brexit hailed his victory. Brexit is our Trump, and the sooner both disappear the better the world will be.  

  

[1] Although what is the point of Labour hedging bets on keeping in the customs union? It makes their Brexit strategy look much more like confused and conflicted than strategic triangulation.

[2] It is very easy to tell the difference between political expediency and political conviction. Imagine the very unlikely event that parliament votes to end Brexit. Would you join demonstrations outside parliament calling this an affront to democracy, or would you breath a huge sigh of relief?

Postscript 17/08/17   If you think that these lies were not important in influencing the result, then you should read what Dominic Cummings who ran the Leave campaign thinks: in particular the paragraph that starts "Pundits and MPs kept saying"