Hamish McRae: How long can private sector jobs fill gap left by public spending squeeze?

The great British job machine runs on. There is an astounding contrast between the deterioration of conditions in the financial markets, and most latterly the housing market, and the performance of the real economy. Is this just a lagged effect, or do the strong employment numbers suggest that the economy will pull through the forthcoming downturn in rather better shape than expected?

You might reasonably have expected to see signs of a softening economy by now and the latest retail sales numbers do show some declines. Business confidence, at least as reported in the surveys, is OK, maybe off a little but not dramatically so. There are signs that the financial services industry will shed labour in the coming year. But if you look at what UK business as a whole is doing, rather than saying, it continues to hire staff that must surely be the biggest sign of confidence of all.

Yesterday, we had a further fall in UK unemployment, with the claimant count measure now down to 2.5 per cent, the lowest since 1975. The unemployment figures can be manipulated, for example by reclassifying people as disabled, but the employment numbers are hard to quarrel with. The Labour Force Survey showed employment had risen by 114,000 in the three months to October, suggesting than the ability of the economy to create a net half-million jobs a year was being sustained. These jobs are entirely in the private sector and entirely in services. The public sector has now become a net shedder of labour and manufacturing has continued to slim down.

There are three patterns of employment: the continued overall job creation, the switch that has happened in the public sector, and the surge in employment in the private sector. The data raises a number of questions, questions that are central to the performance of the economy in the next couple of years.

The first and most obvious is whether the problems of the financial sector will be big enough to stop the job-creation machine. Will other forms of private sector services be able to offset financial sector losses? At an individual level the answer must be no, but at a macro-economic level the outlook may be more hopeful. The point here is that the skills of people displaced from the City are quite specific to financial services so these people will not automatically slide into other jobs. But that is always the case. At least there is no geographic issue: the jobs that will be lost (Northern Rock aside) will principally be in London and the South East, which also happens to be the power-base of other and growing service industries.

But remember these employment numbers are characteristic of an economy growing at an estimated 3.1 per cent during the current year. The long-term underlying rate of growth is around 2.5 per cent, 2.75 per cent at a push; grow faster than that and you create a lot of jobs. Independent forecasts for growth in 2008 are mostly around 1.8 per cent, i.e. below the long-term rate, so you would expect job creation to slow and maybe even go into reverse.

The next question is: who is taking these jobs? This is impossible to answer precisely but obviously immigration has helped the supply of labour a great deal. Some calculations suggest that three-quarters of all net new jobs have gone to immigrants, which is possible but that does feel too high. There is also evidence of older people, including the retired, coming back into the job market, the natural size of the population of working age is also rising a bit and of course unemployment is coming down.

My guess would be that up to half the increase in jobs has come from migration, with the rest split between the natural increase in the labour force, returning retirees and people coming off the unemployment register. There was a nice little footnote to these figures yesterday in the form of a survey by the Office of National Statistics that suggested that three-quarters of the people who were currently "inactive" expected to return to jobs in the future. About half these inactive people are students so you would expect something like this but it is encouraging none-the-less.

That leads to another question. Suppose job demand does ease back, what then? In the past you would have expected this to feed through swiftly into the unemployment numbers and to some extent this will doubtless happen. But it is also plausible that some migrants will return home, particularly those from Eastern Europe where growth is very rapid much faster in fact than it is here, albeit from a lower base. Further, some retirees who have gone back to work may decide that retirement was not so bad after all. Finally, self-employed people can simply trim back their business without actually giving it up.

So it is plausible that employment could come back quite a bit without unemployment actually rising much. The thing to watch, though, must surely be the employment numbers rather than the unemployment ones.

The big point here is that there are huge benefits to having a flexible labour market on the upswing as we have already seem but there may also be benefits on the downswing, too. The UK has benefited from its ability to suck in labour as activity has risen. Had it not been for that, we would have already started to see a much tighter job market and corresponding upward pressure on wages. There is really no sign of the latter, something that will give the Bank of England comfort when it considers its next reduction in interest rates either next month or February. It seems reasonable, too, that we will benefit as demand slackens when people ease out of jobs, or for the self-employed cut back their activities, rather than pile onto the unemployment register.

Unfortunately, a flexible labour market, while helpful, does not insulate the economy from a fall-off in overall demand and that challenge will remain. The public sector will not be able to offset any slowdown in the private sector by continuing to expand as you can see, the flip from being a net job-creator to a net job-shedder is well-established.

That is not going to change because there is no money to change it. The puzzle must surely be how the Government's finances are in such trouble despite the fact that it has been steadily shedding staff. But that is a story for another day. Meanwhile, keep your fingers crossed that the private sector service industries can continue to take up the slack for a while longer yet.