Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 4 August 2017

How Brexit will constrain a future Labour government

Those who suggest that Brexit is of second order importance to getting a Labour government need to think about what that government will be able to do and how long it will survive if we leave the Single Market and customs union. The OBR did a rough and ready estimate of the near term impact of Brexit [1], and concluded that productivity growth would fall (which means lower GDP and real wage growth) and the government deficit would deteriorate by around £15 billion by 2020. That sum is about a third of the current defence budget, or a tenth of the entire health care budget.

It is simply wrong to imply that this can be ignored, because Labour is anti-austerity. That large deterioration in the deficit due to Brexit is mainly the result of low productivity and less immigration, not the consequence of an economic downturn. It cannot be undone by the government spending more on infrastructure: public investment is not some magic instrument that can get you any GDP you want.

No economic theory that I know of suggests you can safely ignore the public finances outside of a recession. In a world where monetary policy regulates demand (absent the lower bound) then a build up in government debt risks crowding out private capital, discouraging labour supply (because higher debt has to be serviced through higher taxes) and redistributing income between generations. This is why Labour’s fiscal credibility rule aims to balance current public spending outside of a recession. Every £billion lost to Brexit is a £billion that cannot be spent on public services, or has to be raised in taxes.

The same logic meant that Labour’s election manifesto in 2017 had a large increase in current public spending entirely financed by higher taxes. Their programme is anti-austerity because their fiscal credibility rule would do the opposite of what Osborne did in 2010 if interest rates were at their lower bound. It also sensibly allows public investment to rise when borrowing costs are so low.  But once interest rates begin to rise, the Labour government would have a current deficit it needed to finance, and its difficulty in doing this would be made much worse by Brexit. [2]

In all this it is vital to not be distracted by some of those who see Brexit as an opportunity for Corbyn-bashing. Those that do so seem to forget two key points. First, the attitude of a large number of Labour MPs in Leave voting areas is just as much of a problem as the views of the leadership. Second, there is a purely political argument for Labour being just a bit less supportive of Brexit than the government right now. My own view is similar to this discussion by Mike Galsworthy.

However I feel I have to end by responding to a second post from Owen Jones. Let me do so by imagining the following scenario. Suppose the Conservative leadership changed, and the new leader said this on being elected: “we tried as hard as we could to respect the result of the referendum, but we found there was no way of doing so without causing the economy great harm. As a result, I have regrettably decided to revoke Article 50, and remain in the EU.” What should Labour’s response to that be? The logic of Owen’s position is that Labour should oppose this, and side with the Hard Brexit faction of the Tories and defeat the new Tory leader.

A highly unlikely scenario I agree, but it helps establish this point. Owen, unlike many Corbyn supporters, is not arguing that Labour should remain pro-Brexit while in opposition as simply a strategic move to gain votes. He is saying that Labour has to support leaving the EU because of the referendum demands it. Indeed he says anyone arguing otherwise because the referendum was advisory is “beyond delusional”: It seems I have become a beyond delusional ‘Hard Remainer’.

Does democracy mean being bound by a referendum that was called only to appease the hard right, decided by lies using a rigged electorate, and apparently made mandatory as a result of the words of a now departed Prime Minister? Is it a democracy when we are unable to change course because new facts clearly deviate from promises made, resulting in a decision that imposes costs on the young largely as the result of votes by the old? These are difficult questions, but not delusional questions.

I doubt it will happen, but would ignoring the referendum destabilise democracy? Let me turn the question around. If the final Brexit deal involves staying in the Single Market and therefore accepting free movement, will that destabilise democracy? The number of people who voted Brexit but wanted to stay in the Single Market may be more than 2% of the population, but it is bound to be small. There will therefore be plenty of people who will say that accepting free movement ignores the referendum, and plenty of aggrieved voters to back them up. Is that going to produce a reaction which is very different from the reaction to actually ignoring the referendum?

The hard truth is that any deal which avoids serious economic costs for the UK is going to make most of the 52% pissed off. And they will remain pissed off until either we reduce immigration, with the economic costs that will bring (less schools, less hospitals, higher taxes), or senior politicians start being honest about the benefits of immigration.


[1] Stupidly, the OBR were not asked to estimate the impact of Brexit before the referendum, and their mandate prevented them from doing so themselves.

[2] And please no MMT inspired comments about how taxes are not needed to finance spending. The MMT world is very different from our current world: fiscal policy rather than monetary policy regulates demand. In that case you never worry about the deficit, but spending is constrained by inflation.  

36 comments:

  1. You say that if Brexit causes a drop in real GDP then we will inevitably have "less schools, less hospitals". Let us imagine that Brexit causes a shift in exchange rates and that accounts for the drop in real GDP (isn't that the mechanism you're suggesting?); wouldn't the MPC see that as a step change rather than as "true inflation"? So the MPC would presumably keep interest rates at essentially zero. Even if stronger unions meant wage inflation and so the MPC chose higher interest rates, then I don't see the limitation on how many doctors, nurses and teachers we train up and employ. Perhaps we won't be able to entice already trained staff as easily from abroad if the exchange rate is worse but I don't see UK students deciding that they don't want to enter medicine because the exchange rates mean that in US dollar terms their prospective pay won't be so good. Furthermore, many doctors, scientists etc work here motivated by the wish to exchange expertise. It is the quality of the medical system they are working in that encourages that sort of exchange of expertise rather than the currency exchange rate. I'm also not at all convinced that the "sound money" principle of hiking interest rates at the first whiff of wage inflation is justified. I wonder whether 1940s style financial repression and inflating the debt away isn't a much better choice.

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    1. Less immigration, less GDP, mean less resources for hospitals etc. Nothing to do with exchange rates.

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    2. I'm still really struggling with this. If less GDP means less employment of people designing luxury watches or exotic financial instruments, then that means more people available to train as teachers and doctors. Japan has very very low immigration and yet has no shortage of doctors and teachers.

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  2. Just to clarify, when you say "a build up in government debt risks crowding out private capital" -are you suggesting some channel by which that could manifest over and above causing the MPC to choose to raise interest rates? I can't see any other channel and would welcome an explanation if there is one. Thanks.

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    1. Its an overlapping generations model. Suppose all savings are for retirement. If government debt increasing does not increase savings by same amount, saving for private capital gets squeezed out.

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    2. But the crucial point seems to me that government debt increasing creates savings of the same amount as an integral part of the process of creating government debt. They are indivisible sides of the same coin. Am I really wrong about that?

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    3. ILF garbage.

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  3. The 2008 crisis caused a massive hit to real GDP in Iceland, but they continued to provide an excellent health care and education system. If they could do that there, letting exchange rates shift wildly, can't we cope fine with Brexit?

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    1. Well, ask an Icelander whether they think the health system is better now than before the crisis, and they’ll tell you that there is less care available, because many doctors emigrated and there were sharp cuts in expenditure, and you have to pay much more for health than before.
      More generally, Iceland defaulted on a large part of its foreign debt - the consequences of that on their reputation and future economic performance may not have fully played out. Yes, there has been strong economic growth recently, but it is not sustainable - much of it is due to tourism which has expanded 6-fold, with dire consequences for the environment and the housing market. Many people in Iceland can no longer afford to rent flats - the costs have been driven up so much.
      And for those Brexiteers who rail against free movement, Iceland is in Schengen…and they have to accept all internal market legislation without having a say.

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  4. I think GE2017 has opened up all sorts of possibilities.

    Now the British Election Study is out, we can see how reliant the Labour vote was on Remain voters coming from the Tories, Liberals, and the Greens.

    At the BBC Prof Ed Fieldhouse & Dr Chris Prosser said 1 August 2017:

    "The Conservatives' position on Brexit, coupled with the absence of Nigel Farage, saw the UKIP vote collapse and the majority of its support go to the Tories. More than half of UKIP's 2015 voters who voted again in 2017 switched to the Conservatives, compared with only 18% to Labour and a further 18% who stayed loyal. Labour picked up a few Leave voters, but lost roughly equal numbers to the Conservatives - undoubtedly the party of Leave...Despite uncertainty over its position on the single market, Labour was seen as the best bet by those wanting to keep closer ties with Europe. Not only did it win over a large number of Remainers from the Conservatives, but also from the pro-EU Greens and Lib Dems. Overall, nearly two-thirds of 2015 Greens went to Labour, as well as about a quarter of Liberal Democrats...The results reveal a striking correlation between wanting to control immigration and voting Tory on one hand, and wanting access to the single market and voting Labour or Lib Dem on the other. For example, the Conservatives lead Labour by more than 40 percentage points among those most in favour of full control of immigration, with Labour having a similar lead among those wanting complete access to the single market."

    It must be remembered that May at 42% got the same percentage of the vote as Thatcher 1983, Thatcher 1987, and Major 1992.

    Labour must tack carefully, but it is clear where the majority of its voters want the party to go.

    And if they enfranchise 16 and 17 year olds for general elections, they should do likewise for a second EU referendum if and when they get into government.

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    1. Immigrants per 1000 inhabitants in EU28: the UK stands 12th in the league, which is topped by Luxembourg.
      If countries like Germany, Denmark and Ireland cope with higher levels of immigration than the UK, why has it caused such problems in this country that we need to leave the EU to solve them?

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    2. Germany as the champion exporter has an electorate which feels the EU makes it prosper, and when they want to blame foreigners they do it by a different route than anti-immigration: instead they accuse the Greeks and other southern Europeans of stealing.

      Denmark is Mr Social Democracy so presumably working ppl there are less discontented and eager for a win by kicking out the immigrants to try and get a pay rise.

      Immigration isn't popular with working class ppl in southern Ireland but since the Single Market in 1992 is credited with letting Ireland catch up economically, and it knows it's a small country, the public fears leaving the EU or even the euro, even though the euro gave them 15% unemployment.

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  5. Every front bench Labour statement on Brexit I have seen leads me to believe Labour Policy is on track to stay in the single market and customs union as near as dammit. "Put the economy first" Corbyn and McDonnell and Starmer keep saying. I don't think they could be any clearer about this under the circumstances. Understandably, because the politics of this have been a nightmare for politicians and electorate alike, confusion abounds from panic driven commentary. If Labour's soft Brexit includes 'free movement' so be it. Will this anger the 52%? Not necessarily. Why? First of all, because there is and always has been scope for some immigration control within the EU or within the single market if that is what we are left with) and this can be demonstrated to the comfort of those who fear invasion by mongol hordes. Secondly, the driver for Brexit has always been a proxy for dissatisfaction with neo-liberal austerity policies which have starved public services in the name of profitability (creating wealth which has been captured disproportionately by an elite few). A different approach, which Corbyn certainly promises, will change this perception and this includes especially the perception of those I have spoken to on the doorstep who blame immigrants for the lack of school places and housing shortages and the deterioration of the NHS.

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  6. Genuine question: how was the electorate rigged for the referendum? May have missed a previous post.

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    1. https://fullfact.org/europe/who-can-vote-eu-referendum/ Excluding EU citizens who had been here for 15 years and 16+17 year olds obviously favoured Leave.

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    2. What I find galling is the inconsistency, the asymmetry of it. EU citizens like yours truly who have lived here for a long time didn't get to vote. Fair enough: we declined to seal our commitment to this country in naturalisation. But Brits who have lived in the EU for more than 15 years also didn't get to vote, even though they are both British citizens and profoundly affected by this decision. So what determines whether you can vote: citizenship, or length of settlement? The answer is a bit of both, rigged so that all those most likely to vote Remain were excluded from the vote.

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  7. dear Prof. Wren Lewis:

    What you write here is entirely counter to the insights of MMT regarding 'crowding out' and the so-called deficit dangers not to mention the whole concept of Monetary Policy 'regulating demand.'

    Bill Mitchell points out in his blogs that the 'crowding out' hypothesis is based on what he considers the 'flawed' IS/LM model.

    On crowding out, Bill Mitchell States:

    1. Increased fiscal deficits do not force a competition for funds between the government and the private sector. There is no finite pool of savings that the government drains at the expense of private borrowing – this is the old, pre-Keynes ‘Loanable Funds’ doctrine that was categorically refuted by Keynes in the 1930s, but still rears its ugly head.

    2. Interest rates are not driven up by on-going fiscal deficits.

    3. On-going fiscal deficits at full employment do not “crowd out” private investment.

    The loanable funds doctrine, which Krugman adheres to, is an aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking.

    It is pre-Keynesian thinking and was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving.

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    1. These are interesting issues - discussed in the mainstream literature as well - which I hope to discuss at some point. But the problem of servicing much higher debt through taxes remains.

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  8. Remoaner Corbinistas live in fairyland. The Venezuelan socialist dystopia that Corbin wants is not possible inside the single market. In fact, this is the biggest argument for soft Brexit. Also maybe rename the blog "mainlybrexit"? I miss the great macro posts...

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    1. This comment has been removed by the author.

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    2. Venezuela is suffering balance of payments problems due to a collapse in the oil price when it depends utterly on oil exports and doesn't have other industry. Since the USP didn't diversify, they have decided to blame their opponents and grab more power to try and survive. None of this resembles the Corbynistas, the UK isn't an oil-based economy and Corbyn isn't going to turn himself into a dictator.

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  9. This comment has been removed by the author.

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  10. More immigration equals more schools and hospitals? Uterly absurd idea, a single british woman could have 10 babies (incentivsed or forced). A large number of british babies should have at least the same positive effect as mass immigration could ever have.

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    1. I was going to comment on various points in the article, but now I see that a fascist who fantasises about forced pregnancies to increase the British birth rate is welcome to comment here. So I'll just go away now and try to forget I was ever here.

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    2. Reduced immigration won't lead to more British women having babies! That is certainly an absurd idea. Moreover, immigrants tend to be available for work on entry. Babies take 18 years to grow first.

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    3. I think the author is referring to evidence which shows that immigrants add more in revenue than they take in public services. Lower immigration therefore means less funds for public services. In the OBR recent report on fiscal risks, the low immigration scenario led to around £30bn more public debt by 2021.

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    4. Anon at 6:37. I must admit I missed the 'forced' bit when I read it, and my presumption is to avoid censoring comments - I think I've only done it once or twice. Luckily comments of this kind are very unusual on this blog.

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  11. Assuming that brexit does result in a deterioration of productivity, wage growth, GDP,and the public finances, would't that actually underscore the macro-economic need for a fiscal expansion that could not just be confined to public investment, given time profile? Why would interest rates then rise allowing escape from the ZLB, given they are set by the BoE, rather than the level of the public deficit?


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  12. As ever you simply assume that the dynamic effects of Brexit over a long period will be negative and this will therefore have knock on effects for the rest of economic policy, especially for a party that wants to spend more from the public purse.

    The fact is that no-one knows what the dynamic effects will be over time. Frankly I'm inclined to agree with you that this will be a difficult process which will have a negative economic impact for some considerable time, but whether it will do so permanently is a matter of complete conjecture. If the long term impact of a hard Brexit was more or less neutral then your point would not be valid and you cannot say with any degree of certainty that it will not be neutral. You seem to assume what you are required to demonstrate. Your analysis cannot capture the full range of dynamic effects that will occur during this process of change and there is no reason to suppose that they will be all one way.

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    1. Climate change is complete conjecture. But some conjectures are based on pretty solid evidence, and the prediction that Brexit will reduce UK GDP by a large amount is one of those.

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  13. I voted Leave wanting to remain in the Single Market. Quite a lot of Leave campaigners left it as an option to be decided by the government - you just have to look for mentions of 'Switzerland' by Andrea Leadsom, Nigel Farage ( yes really ), Brexit - The Movie, Dan Hannan, The Adam Smith Institute, Boris Johnson, and many others in their efforts to persuade us that voting their way was a good thing to do.
    And yet there are still an illiberal group of people who insist that everyone knew that a Leave vote was a vote to also Leave the Single Market, who think they are being entirely consistent.
    Ending free movement is not mandated by the result of the referendum. It is an option that government can take, leave or defer.

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  14. It does seem as though Norway got to their present arrangement because in the referendum the population chose not to join the EU and so the political leadership effectively ignored the content of this, while respecting it as a technicality, and paid up for the access that they understood would be beneficial to their constituents (even the one who voted not to join).

    I believe they are still a democracy, so far at least.

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  15. "Does democracy mean being bound by a referendum that was called only to appease the hard right, decided by lies using a rigged electorate, and apparently made mandatory as a result of the words of a now departed Prime Minister?"

    Yup Prof, that is exactly what it means.
    Only solution is to abolish all voting and accept rule by unelected master of the universe. That would be you - obviously.

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  16. "undone by the government spending more on infrastructure: public investment is not some magic instrument that can get you any GDP you want.

    o economic theory that I know of suggests you can safely ignore the public finances outside of a recession.N In a world where monetary policy regulates demand (absent the lower bound) then a build up in government debt risks crowding out private capital, discouraging labour supply (because higher debt has to be serviced through higher taxes) and redistributing income between generations. This is why Labour’s fiscal credibility rule aims to balance current public spending outside of a recession. Every £billion lost to Brexit is a £billion that cannot be spent on public services, or has to be raised in taxes"


    Isn't this the kind of Neo-liberal claptrap that we all have since the crash, come to ignore?

    We have a fiat money system.

    You talk of crowding out the private sector, do you mean borrowing from the private sector?

    You say that: "no economic theory that I know of suggests you can safely ignore the public finances outside of a recession".

    If we start by saying a government working with trade deficits of between £3-£4 billion a month, month in month out, is hardly a balanced economy.

    A government though with a fiat money system has no constraints where it has to rely on its own private sector to service government debt or expenditure.

    Alan Greenspan puts it this way:

    "That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency. A fiat money system, like the ones we have today, can produce such claims without limit".

    So essentially a government like our's can spend directly into the economy, whether to buy goods and services, invest in its infrastructure, create real jobs, pay for public services, or simply pay down its debts. The sole constraints are human and raw material resources not money as Neo-Liberals would have us believe.






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    1. I assume you're an MMTer. Inflation and the balance of payments are also constraints on growth, so it's not just a question of the economy's capacity and your willingness to stimulate it by printing money or whatever.

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    2. Inflation is regulated by taxation and interest rate policy, it goes without saying that if we expand the economy beyond our ability to produce goods and services....... due to shortages in labour or raw materials then hyperinflation will occur. Money though is not a problem and the Neo-Liberal theology that our country is like a house hold and must earn it before it spends is a totally false premise. Neither do we have to raise taxes in order to spend in the economy.

      Balance of payments are indeed a constraint on the economy but, there are ways in which we can reduce the need of imports by creating industries that serve the needs of people rather than relying on cheap imports of other countries finished goods. Most trained in engineering production understand that today's technology is used worldwide and there is no reason why we can't produce goods to the same standards as any other country in the world.

      The profit motive is now coming under the microscope as a problem, in that how much profit does private enterprise need, the answer of course is never enough, which of itself is destroying the very market place seeks to take advantage from.

      If we accept that people make up the economy as producers of goods and services, then we can say they are the creators of wealth. So without money to spend we can't sustain the economy. We have the money all we need now are politicians who work on behalf of people rather than the corporate sector.


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