Nearly 52% of British citizens (17.4 million) voted in the ‘referendum’ on Thursday to exit the European Union. The outcome is startling because, from all accounts, the economic cost to Britain in the short- and long-term is expected to be staggeringly high. In less than 3 days, the global financial markets lost more than $3 trillion. During this period, the FTSE lost more than 100 billion pounds. The British pound, which was trading at an exchange rate of around $1.7 about a year ago is trading today at around $1.35.
The worst may not be over. Many sophisticated analysts believe that the pound could fall to as low as $1.10 within a year and it is projected that the U.K economy might hit a recession with a precipitous decline in property prices.
Why did the majority of the voting electorate elect to exit the EU and embrace large economic costs? One common explanation is linked to the sustained inflow of migrants from other EU countries.
Statistics disproves this theory. In 2015, the inflow of foreign nationals into Great Britain was 630,000. The increase in foreign population in 2015 as a percentage of Britain’s population, which is around 65 million, is less than 0.01%. Most economists would consider such an increase as a rounding error.
Between 1990 and 2015, Britain’s population grew from 57 million to 65 million, which translates into a modest increase of less than 1% per annum. Again, this small magnitude of the inflow of foreign nationals into Britain is unlikely to drum up mass hysteria among British citizens. Granted, the politicians have exploited the foreign migration issue to harness their individual political careers. However, the migration numbers from the census bureau do not support the casual observation that migration is a key factor driving the British anger.
If the scale of ‘legal’ migration fails to provide a compelling narrative why the majority of British nationals, principally the English, chose to exit the EU, there must be other persuasive economic explanations why 17 million rational British individuals didn’t hesitate to marry into an economic uncertainty.
Factor Price Equalization Theory
The Nobel Laureate in economics, Paul Samuelson, wrote his theory of “factory price equalization” in 1948. His theory might provide deeper insights into Britain’s current dilemma.
The Theory: According to factor price equalization theory, the prices of identical factors of production (typically labor and capital) will be equalized across countries as a result of international trade in commodities. Thus, when two countries have a free trade agreement, even without free mobility of labor, any differential in wage rate (price of labor) and rent of capital (interest rate) between two trading countries is expected to slowly dissipate. With the advent of free mobility of labor, as in the case of EU-Shengen countries, the factor price equalization process converges rapidly.
Anecdotal evidence suggests that much of the migration of EU nationals into the U.K. has been mostly from Eastern Europe, which is typically identified as having depressed wages. For instance, according to World Bank statistics, the average monthly wage rate of Poland is €430, for the Baltic States (Lithuania, Latvia and Estonia) it is €380, for Hungary it is €358, for Romania it is €279, and for Bulgaria it is €215. For some Western European countries like Spain and Portugal the wage rates are also quite low (around €600).
In sharp contrast, the average monthly wage rate of Great Britain is around €1,550. Thus, the average wage rate of U.K is about 3 to 5 times larger than the wages of the migrant countries.
- Negative outcomes
- Wages in the host country are expected to decline as new migrants from lower wage-rate countries provide their services at a lower price in the U.K. The influx of competition injects considerable downward pressure on the wage rate of the host country. Unfortunately, U.K. workers must bear the brunt of this cost. In the absence of any barriers to entry in the labor market, i.e., specialized degrees or technical skills, wages of the host country will decline. Typically, “blue collar” workers who do not have a comparative advantage are most affected by migration. In contrast, “white collar” workers remain unaffected because migration does not affect competition in this sector.
- Depending on sector specific labor migration, the abundance of labor force will also lead to some loss of jobs. Again, the job loss is expected to be confined to the blue collar working class because of fierce competition and limited growth opportunities in this sector.
The combination of job losses and a decline in wages gives rise to public discontent, anger, and resentment. This resentment is likely to be confined to working class. This is a strategic reason why the voting pattern in the referendum can be explained by the level, or lack, of education. The more affluent people or the more educated people would vote against an exit while those with lower levels of education or having less financial security would vote in favor or an exit.
- Positive outcomes
Economists often underscore the gigantic economic benefits of migration. Yes, wages/rates decline with migration but it spurs investment, which in turn leads to more jobs. Consumers always benefit from migration and trade because of lower prices.
The Politics of Winner and Losers
A fundamental human natural law is that there are winners and losers in any society. An optimal and emancipated society aspires to minimize the number of losers while maximizing the number of winners. Judging from the referendum, a disproportionally small segment of the U.K population appropriated much of the gains from being part of the European Union, while a large segment of the population lost because of the union.
The U.K experience is a reminder that gains from trade, or common markets, must accrue to all strata of society. Otherwise, there will be social unrest or perverse outcomes that are to the detriment of the country’s long term economic welfare.
Migration issue is a sensitive topic in the U.S. as well where the discussion centers around illegal immigration. Whether the benefits of migration accrue to the majority of the citizens of the host country will decide whether ultimately host countries become more welcoming towards migration (illegal or legal).
At the end of the day, we are all migrants. Some migrated recently, while others migrated a while back.
Helsinki, July 1, 2016; 9.59Pby