What is the answer to Britain’s labour shortage?

youUnemployment is falling. The number of people in work is increasing. Wages are rising faster than inflation. What’s wrong with that?

Well, the truth is that the latest readings on the state of the UK labour market are certainly not bad news, as such, but they also do not indicate that the country is ready for a swift round of interest rate cuts, let alone that much-needed boost to economic growth that everyone would love to see.

The overall picture remains one of wage inflation too high to satisfy and an acute shortage of labour generally, as well as workers with specific skills. The chancellor, Rachel Reeves, is certainly in no mood to celebrate: “There is more to do to support people into employment… This will form part of my budget later this year, where I will take tough decisions on spending, welfare and tax to set the foundations for our economy so that we can rebuild Britain and make every part of our country better.”

Is this then evidence of the “worst set of economic circumstances since World War II”?

Reeves has often complained about the mess he has to sort out, but it is obviously not as dire a situation as that faced by, say, the Labour government in 1974, or the Conservatives (more arguably) in 2010, because the economy is, despite everything, more competitive and robust. He has a stronger case about the sorry state of public finances and national debt, which also affect the “real economy”.

Overall, given poor long-term trends in investment and productivity, Reeves is right to worry that Britain is trapped in a semi-permanent “vicious circle” of low growth, high taxes and spiralling debt.

What is the inflation outlook?

The good news is that most of the energy price shock caused by the war in Ukraine is now behind us, and that has largely helped to more than halve inflation since the end of 2023 (as promised by Rishi Sunak). In fact, it is now at its official target of 2%, although this is expected to rise a little in the coming months as energy prices have fluctuated.

But there is bad news too. While overall wage growth is moderating to an annual rate of 5.4% (the lowest in two years) and is allowing people to buy more, that also means rising wage costs, which are still being passed on to consumers. This is especially true in the private sector, as well as in the service sector, where wages account for more than 70% of costs.

The glaring statistic to emerge from the Office for National Statistics (ONS) statement is that wage inflation in the “services sector” stands at 8.4 per cent. This suggests that the medium-term outlook for inflation is less optimistic than the current reading of 2 per cent. There are simply too few workers, which means wages are being pushed up and costs are rising. Much of that will end up being paid for by higher prices – the dreaded wage-price spiral is underway, although there are also signs that it is easing.

Will interest rates go down?

Yes, but with wage inflation still persistent and uncertainties about where it will settle, we may not see any big, radical rate cuts for many months. The Bank’s rate cut from 5.25 to 5 per cent may be repeated in November (the next likely date for a change), but the Bank of England needs more and better data on the labour market. So mortgages will remain elevated well into next year.

Why is there a labor shortage?

It’s not because Britons have suddenly become lazy bums living off generous new welfare payments. The short answer is “Brexit and long Covid”. Brexit, despite high levels of immigration under the visa system, has restricted the supply of workers, especially in agriculture, social care and hospitality. Long Covid has also meant more people are suffering from long-term illnesses for indeterminate periods.

Among the more established trends that are reducing the labor supply are the rise in early retirements, and those who are lucky enough to have a pension plan with their last salary and/or have made a lot of money by collecting the value of their house have no desire to go to work in a hospital or a warehouse.

The Resolution Foundation also suggests that the rise in “economic inactivity” – that is, people who do not need, want or can work – is also being driven by young people with long-term health problems, particularly mental health issues: “People in their twenties and forties are now more likely to be out of work due to illness than people in their forties, which is really worrying.”

What can the government do?

Reeves, working with the Work and Pensions Secretary, Liz Kendall, promises that some steps will be taken to get people back into the workforce. This will likely be a combination of reforms to skills assessments and social security eligibility; more training; new apprenticeships; changes to the way jobcentres work; and improvements to mental health care. Labour’s manifesto warned ominously: “Our system will be built on rights and responsibilities – people who can work, should work – and there will be consequences for those who fail to meet their obligations.”

It must be said that all of this is basically a continuation of the policies pursued by Reeves and Kendall’s predecessors, Jeremy Hunt and Mel Stride: same problems, similar policies.

Will it work?

Common sense suggests that welfare and training reforms will not transform the labour market situation, and that if the government is serious about reducing net migration, then it is difficult to see where all those new workers will come from.

Britain’s economic problem is that it has too few workers. Some of that can be solved by more automation and artificial intelligence (such as self-checkouts in supermarkets or chatbots on websites), but not all of it – and in any case, this requires substantial investment from the private sector. In conclusion, labour shortages are very bad news for growth, living standards and the prospects for success of the Starmer administration.