Economics: An uphill struggle for the Chancellor

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THE BRITISH economy has had an unusually good run for the past five years. It has been a long recovery and, at least last year, a vigorous one. But no Chancellor can escape the business cycle, and the downturn is coming. As far as anybody can tell from here, it is not going to be as severe as the last one, but it will still pose a challenge to the Government's broader ambitions for the economy. And these are broad indeed. Gordon Brown wants to raise the UK's level of productivity towards those achieved by its competitors, and he wants to tackle the severe problems of withdrawal from work, income inequality and poverty the Government inherited.

Just in case anybody was in danger of underestimating the size of the task, the OECD's annual report on the UK, published earlier this week, sets out these problems in all their glory, with chapters on both welfare- to-work and competitiveness. Although it concludes that the Government is adopting pretty much the right strategy, it is hard to emerge from reading the document feeling optimistic. Just to run through the extent of the structural problems in the jobs market is sobering.

For instance, Britain has enjoyed one of the best recent performances in reducing unemployment, which has fallen to 6.4 per cent on the internationally comparable measure. Yet another 6.5 per cent of the working age population, 2.3 million people, would like jobs but are not classified as unemployed. Nor has there been any growth to speak of in the employment rate since the business cycle upturn started in 1992. The number of "economically inactive" but not "unemployed" people who want a job has been rising by 5 per cent a year throughout the recovery.

So the structural unemployment rate might have fallen, but it has had no effect on the employment rate. The proportion of the workforce that is actually working is higher in the UK than most of the Continent, but well below its peak in the late 1980s, and below the rates in the US, Japan and most of Scandinavia.

A closer look at the people who are out of work reveals that younger women have been entering the workforce in greater numbers, while older men have been dropping out. The fastest-growing group amongst the 2.3 million "inactives" who want jobs are the long-term sick and disabled, mostly older, unskilled men. Lone parents form the next category - the UK has more than a million, and fewer of them work than in most other OECD countries. Finally, there are the spouses of the unemployed, trapped by the benefit system.

Side by side with this chronic lack of work problem goes the UK's above- average income inequality, dramatically increased since the late 1970s. The highest-earning tenth of the population now makes eight times the lowest earners, up from a ratio of about 4.5 times in 1979. Twenty years ago the typical person on low-income was a pensioner. Now poverty is more likely to affect the unemployed, the sick and disabled and lone parents, and a third of British children live in poverty.

Changes in the world of work seem to account for much of the increase in poverty and inequality, especially the changing industrial structure, which has seen traditional manufacturing decline and advanced services grow. This has made for increased returns to educational attainments and skills. People with a degree on average earn more than double those who leave school before A-levels.

The link means tackling the jobs market will help tackle poverty and inequality, and perhaps more effectively than direct welfare reform. The key is therefore, as the OECD puts it, "harnessing the potential of those who are non-active but willing to work" - or raising the employment rate as opposed to reducing the unemployment rate. But getting more people into work means qualifying more of them for available jobs.

The report is therefore sceptical about the New Deal, with its direct jobs subsidies. It places more emphasis on "active" policies that help match workers to jobs by providing information and in-depth advice from the Employment Service. Schemes that help with travel to job interviews and support with applications, photocopying and letter writing can also be surprisingly effective. More of this sort of help is needed in the most deprived areas.

Of course, these are no miracle cures. The other element in improving employability is raising the skill level of the inactive workforce. Unemployment amongst those with university or further education qualifications stands at less than 4 per cent, compared with 12 per cent amongst those who leave school at 16. It was the focus of a seminar this week held by the Smith Institute, the new think tank founded in memory of the late Labour leader John Smith. Participants emphasised the links between education, equality and economic success, especially in the most deprived areas.

However, with many young people leaving school without basic literacy and numeracy skills, tackling the broader economic and social problems through the education system is an uphill task - and one that will not help the older people trapped outside the jobs market. The OECD's authors conclude: "It will take many years before the average qualification achievement in the UK reaches a level similar to that in most OECD countries" - especially when all parts of the UK education system are crying for more cash.

Nevertheless, the new report places more hopes on a combination of skill improvements and "active" labour market policies than on tax and benefit reforms such as the new working families tax credit. The latter approach is only likely to make any inroads into poverty if the Government is prepared to spend a lot more money, because of the inescapable trade-offs in the tax and benefit system. Incentives to work for those on low incomes can only be improved by pushing the disincentives further up the income scale.

Even so, the Government is without doubt adopting the right sorts of policies. They will make a start on raising potential output, get more people who want to work into jobs, increase the incomes of the poorest and reduce inequality. But the unwelcome moral is that it would be a mistake to expect too much too soon, especially with the economy heading straight for the chilly waters of a downturn.