Thoughts on the effects of Brexit on UK unemployment and the labour market

Earlier today I participated in a plenary panel session of the Learning & Work Institute’s IntoWork Convention 2016 on the broad subject of what Brexit might mean for the UK labour market and employment policy. Here is a write-up of the issues considered during my brief opening comments:

I broke my ankle a month or so before the EU Referendum vote.

The experience provides a suitable metaphor for Brexit – initial pain and trauma followed by a prolonged period of hobbling along at slower than usual pace plus considerable uncertainty about whether in due course things will ever again be as good as if the break hadn’t happened.

Translated into economic jargon, Brexit is a supply side shock to the economy with probable negative short-term to medium term demand side effects on output and at present indeterminate but probably negative effects on the potential long-term growth rate.  

The short-term – recession and higher unemployment

Looking first at the initial trauma, there is a fair amount of consensus about the nature if not the exact magnitude of the short-run economic impact. The initial source of pain is due to a combination of uncertainty about the future and the associated adverse effect this has on both business and consumer confidence. Lack of confidence in turn affects willingness to hold sterling and is also likely to cause borrowing costs to rise if lenders impose higher risk premiums on loans.

The value of the £ has already suffered a sharp drop, providing a stimulus to exports but at the same time set to raise import prices which will eventually hit real household incomes with knock-on effects to consumer spending.

Alongside this there will at best be a temporary pause in business investment while businesses assess the progress and type of post-Brexit institutional arrangements and trade deals negotiated with the EU and other countries.

It is probable that the combined negative effects on domestic demand will to some extent be offset by various forms of stimulatory policy action by the Bank of England. But monetary policy is a blunt instrument at times when economic confidence is low and might therefore need to be supported by active fiscal policy intervention of a kind eschewed during the era of austerity and ‘small government’ ideology that has prevailed since 2010.

The Government has already wisely abandoned the idea of introducing a contractionary emergency budget of spending cuts and tax hikes and accepted that it will now take longer than previously intended to eliminate the fiscal deficit. Whoever is Chancellor of the Exchequer in the incoming May administration should be wiser still and open to introducing an expansionary budget of tax cuts and higher targeted public investment once the Office for Budget Responsibility has had an opportunity to assess the economic and fiscal outlook in the immediate aftermath of Brexit.    

Nonetheless, even with suitable policy interventions, a sharp slowdown in short-term economic growth is widely thought to be inevitable, with many economists, myself included, expecting this to include a period of outright recession – i.e. at least two successive quarters of falling output – at some point in the next 12 to 18 months.

However, although Brexit amounts to a significant shock to the UK economy (with compounding knock-on effects to the EU and wider global economy) the consensus view expects the effect of this ‘home grown’ Brexit economic downturn to only be around a third as severe as that caused by the global financial crisis in 2008/9.

As for the short-run impact on the labour market, a crucial factor will be the effect of Brexit on employer psychology, which might exaggerate negative short-run decision making on hiring and firing.

Official data already show some sign of a slowdown in hiring activity in the run-up to the referendum debate, with further independent evidence suggesting a substantial drop in hiring activity immediately following the vote to leave.

But despite limited initial reports of employers shifting either work or staff from the UK to other EU locations, there is nothing as yet to suggest employers are cutting jobs albeit it is far too early to be sanguine about this.    

Some may recall the aftermath of the £’s ejection from the European Exchange Rate Mechanism in autumn 1992. Although this in fact provided a welcome stimulus to the economy, it initially triggered the biggest ever single quarterly shake-out of jobs since World War II, greater than anything that occurred in the recessions of the early 1980s, at the start of 1990, or the end of the 2000s. Such a response is not beyond the realm of possibility in the next six months.

In this respect, of course, optimists will take comfort from what happened following the financial crisis of 2008 which saw the fall in demand for labour diffused between a rise in unemployment, falling or stable nominal wages compounding the effect of higher price inflation on real wages, plus increased underemployment and a shift towards insecure work for employees and self-employed.

As a result, while the degree of economic pain inflicted on the UK workforce proved as great as economist’s expected, unemployment peaked at a lower than expected rate, limiting the amount of psychological pain experienced.

Yet it is perhaps naïve to expect such a relatively benign outcome for jobs in any post-Brexit recession since some of the parameters of employer decision making have changed in more recent years.

For example, the Coalition Government substantially relaxed the law on unfair dismissal, this decision by former Business Secretary Sir Vince Cable now making it easier and cheaper for employers to fire staff during economic downturns.

Similarly, the weakness of productivity growth in the past decade shows that the economy is to some extent ‘overstaffed’ and potentially vulnerable to a swift bout of restructuring and downsizing.

Moreover, the climate of wage setting may prove different in a post-Brexit recession, with significantly more workers protected by the National Living Wage – which puts a limit on downward wage flexibility – and others perhaps less than willing to undergo a further prolonged period of voluntary wage restraint.

Overall, therefore my expectation is that the post-Brexit recession, while less severe than the 2008/9 recession, will be proportionately less job friendly, pushing the aggregate level of unemployment back above 2 million within the next 2-3 years.         

The long-term – slower real wage growth

It should be stressed that a rise in unemployment of around 0.5 million would be far from catastrophic when viewed in UK historical perspective, thus making it more than manageable in policy terms, albeit it will be important for those with influence over such matters to press the case for immediate additional investment in both Jobcentre Plus services and welfare to work programmes.

Assuming programme expenditure is sufficient to prevent a rise in long-duration unemployment, the labour market will over time adjust to reduce unemployment to the pre-Brexit rate. In other words, Brexit will not lead to a permanently higher rate of structural unemployment.

However, it is virtually impossible to assess how long the adjustment will take, or at present to judge what the job structure and sustainable level of real wages might look like once the post-Brexit economy has returned to full employment.

The crucial and as yet unknown factors in this respect are what post-Brexit trade arrangements will mean for investment, immigration and employment regulation.

The consensus view of economists at present points either toward an unfavourable form of Brexit arrangement in terms of access to the EU single market which lowers the overall volume of trade and investment - dampening long-term growth in productivity and real wages – or a favourable form of Brexit arrangement but one that has little impact on immigration, which while beneficial on average to productivity might also have a dampening effect on growth in real wages for less skilled workers.

The type of Brexit arrangement secured will also determine the extent to which the UK is free to set its own regime of employment regulation. 

Given that the UK labour market is already lightly regulated by the standard of developed economies it seems unlikely that even an extreme right wing government with free rein would gain popular support for a widespread bonfire of employment rights, although some watering down of regulations on matters such as working time and the rights of temporary agency workers might be feasible. Action on the latter could serve to lower the UK’s rate of structural unemployment post-Brexit but at the risk of further entrenching forms of employment practice that already foster a large segment of low-productivity, low wage and insecure jobs.   

Making the best of a bad break

Views clearly differ on the efficacy of Brexit. It is possible that the overwhelming majority of economists who worry about the short and long-term consequences are wrong and that the future for the UK outside the EU will be one of even greater prosperity.

For the time being, however, I remain firmly on the side of the pessimists and expect Brexit to heighten the pain of unemployment in the next few years and from then on limit the improvement in living standards that would otherwise have been achieved.

A sensible policy response will help ease the pain of adjustment and help us to cope as best as possible with future challenges, but this will nonetheless amount to making the best of a bad (and sadly self-inflicted) break.