Growth will be lower if the Conservatives win

The Conservatives want Brexit to be the central issue in this election. Partly as a result, the relative macroeconomic outlook under the different parties has not been discussed as much as it should, or as much as it was in 2015. The other reason it has not been discussed very much is that the economic record of the last seven years has been dire, but prospects under either Labour or the LibDems would be distinctly better. [1]

The last seven years have seen an extraordinary decline in real wages. To quote Rui Costa and Stephen Machin:

“Since the global financial crisis of 2007/08, workers’ real wages and family living standards in the UK have suffered to an extent unprecedented in modern history. Real wages of the typical (median) worker have fallen by almost 5% since 2008, while real family incomes for families of working age have just about recovered to pre-crisis levels.”

This stagnation in real wages is greater than any other advanced economy bar Greece. [2] In addition, as Laura Gardiner from the Resolution Foundation points out, current government policies imply the “biggest increase in inequality since Thatcher”. The less you earn, the more this government plans to take income away from you.

The Conservative response is to point to record levels of employment, and to keep saying ‘strong economy’. But these two apparently diverse developments, high employment and falling real wages, may be related in a very simple way: workers may have been forced to price themselves into jobs by keeping real wages low, or workers who might otherwise have retired are continuing to work to earn enough for their old age. When high employment is a symptom of no growth in living standards, it is nothing to cheer about. They both reflect a weak rather than a strong economy.

The different party manifestos have been discussed at length, but one aspect that has been almost totally ignored by the media has been their different macroeconomic implications. A lot of the responsibility for this lies with the IFS. As I wrote in a recent tweet, the “problem with IFS analysis of manifestos is not just the absence of macro dimension, but their failure to acknowledge it even exists.” **

Both the Labour and LibDem manifestos amount to an increase in public investment, and an increase in public spending financed by higher taxes, compared to current government plans. Standard macroeconomics implies that both higher investment and spending will lead to an increase in GDP, unless the Bank of England raises interest rates to exactly offset this effect. With interest rates currently stuck at their lower bound, and with public investment helping aggregate supply, that last possibility is extremely unlikely. The conclusion therefore has to be that GDP over the next few years would be higher under a Labour or LibDem government than under the Conservatives.

This is why, according to Larry Elliott, Oxford Economics estimate that “the economy would be 1.9% bigger under the Lib Dem plans and 1% bigger under Labour’s plans than under Conservative plans.” The argument that this cannot be done because it would involve some more borrowing is rightly dismissed as pre-Keynesian nonsense. It is for this reason that the IFS approach of ignoring macro is so helpful for the Conservatives. I understand that the IFS does not do macro, but its failure to even mention this gap in their analysis not only encourages mediamacro, but in the current situation represents a clear bias towards the Conservatives.

This is not the only reason why living standards would be significantly higher under a Labour/Lib Dem government. Just as the IFS ignores macro, I fear Theresa May ignores economics. In this post I noted her obstinate refusal to take foreign students out of their net migration target (causing considerable damage to one of our leading export industries), but more generally her obsession with reducing immigration is likely to do further damage not just to the public finances, but output and living standards too. It is increasingly clear that while the the coalition government (and in particular George Osborne) had no intention of meeting their immigration target, May regards it as an unfulfilled commitment despite the economic damage this would do. This marks a big difference between the Conservatives and Labour.

Finally, in comparing the economic outlook under a Conservative or alternative government, we should not ignore Brexit. After my previous post outlining why May is in many ways unsuited to the forthcoming EU negotiations, some comments were along the lines that surely Corbyn would be worse. I think not, for two reasons. You have to put out of your mind the government’s and media’s framing of these negotiations as some kind of poker game or battle of wills. They are much more like a cooperative exercise involving give and take. I see clear reasons for thinking that May/Davis will be worse at this than Corbyn/Starmer. Last but not least, I think there is no chance of a No Deal outcome under Labour, but a significant chance that the Conservatives would walk away. As Ben Chu points out, what is best for the UK economy might well be rather different from what Theresa May sees as best for Theresa May.

If the last 10 days of the campaign seem to ignore the outlook for the economy, there will be a very simple reason why. As a result of the manifestos, attitudes to immigration and Brexit, the UK economy will be better off and subject to less risk if Theresa May is no longer the Prime Minister after 8th June.

[1] Implicit in these two sentences is that the Conservatives tend to dictate the issues discussed by the media during an election, as was clearly the case in 2015.

[2] See also this New York Times piece from Simon Tilford, which presents a rounded picture of our performance relative to other European countries, rather than the carefully chosen snippets beloved by the government's spin machine.

** In the original version of this post I said that the IFS analysis assumes GDP would be fixed. This is incorrect: what I had missed is that they do allow a short term impact from additional public investment on GDP (see slide headed 'Impact on the Economy' here). However this slide illustrates exactly the concern I have.
(1) It makes no sense to allow a short term impact from public investment, but no short term impact from a balanced budget increase in public spending.
(2) The slide says that the long term positive impact of this public investment on GDP will be exactly offset by the macro impact of a higher minimum wage and additional public holidays. Is this a result of detailed macro analysis, or just a convenient assumption?
(3) The slide also says that the Conservative commitment to reduce immigration would weaken growth and public finances, but despite this they assume no impact of lower immigration on growth. This makes no sense whatsoever, unless we are working backwards from the fixed long run GDP assumption. 

Did the Bank of England cause Brexit?

Suppose that by the mid-2000s, immigration from the EU (and the potential for additional immigration) had led to an important shift in the UK labour market. The possibility of bringing labour from overseas meant that old relationships between the tightness of labour market and wage increases no longer held.

You might think that was bad for workers, but that is not so. It would mean what economists call the natural rate of unemployment (or NAIRU) has fallen. Unemployment can be lower without leading to wage increases that threaten the inflation target, because workers fear that the employer can resort to finding much cheaper overseas labour. It reduces the power of workers in the labour market, but also leads to overall benefits. (This is just an example of the standard result that reducing monopoly power is socially beneficial.)

But it is only good news if the Bank of England recognises the change. If they do not, we get stagnant wage growth and unemployment higher than it need be. The obvious response is that the Bank will know there has been a change because wages will start falling faster than they would expect based on previous relationships. However that effect may be masked by the well documented employee and employer reluctance to actually cut nominal wages. Add in the shock of the financial crisis, and this change in the way the labour market works might well be missed.

Here is the big leap. Suppose the above had happened, and the Bank of England did not miss the change. Monetary policy would have been much more expansionary, bringing unemployment well below the 5% mark. Nominal wage growth would have been stronger, and a buoyant labour market would have generated a feel good factor among workers. With more vacancies and less unemployment, concerns about immigration would have begun to fade. The Brexit vote would still have been close, but would have gone the other way.

You may say how could monetary policy be more expansionary given how close we are to the Zero Lower Bound? If that was the case the Bank should have said they were out of ammunition, and placed responsibility with the government and austerity. But for the last two years at least, the Bank could have cut interest rates and has not. You could blame the relentless expectation in the media and financial sector that rates would increase, but the Bank should be able to rise above that.

Of course the Brexit blame game is easy to play when the vote was so tight. The most speculative aspect of this chain of thought is the initial premise about a shift in the NAIRU created by immigration potential. While the possibility makes sense, whether the data backs it up is much less clear. Yet there is some evidence of a structural shift in the UK labour market in the mid-2000s, as Paul Gregg and Steve Machin report.