Brexit - Should the UK Government abandon austerity?

Following the Brexit vote, normal service seems to have been resumed. A key question in economic policy since the General Election of 2010 has moved centre stage again. Should the government abandon austerity?

At one level, the question has an easy answer. Interest rates are now so low that the UK government can borrow for 30 years at a rate of not much more than 1 per cent. So some relaxation in terms of infrastructure spending does seem sensible. It is essential that the projects are not motivated by purely short term political expediency, but in principle they are a good idea.

For Jeremy Corbyn, the answer is even easier. He would carry out no less than £500 billion of extra public spending. How would this be paid for? Even easier, just grow the economy, stupid! Extra taxes generated by growth will pay for it. This is not a spoof, it is what Corbyn and his Shadow Chancellor, John McDonnell, actually believe. Now, taxes are just over 40 per cent of the economy, so to pay for £500 billion of extra spending, the economy needs to grow by something like £1,250 billion. Its total size at the moment is just under £2,000 billion. This stupendous growth will take place like something out of Harry Potter, once Jeremy waves his wand.

The real task of political economy facing the Chancellor is a much more difficult one.

At one level, there is no need to relax the policy of austerity. The simple reason is that the UK is at full employment. The unemployment rate from April to June, the latest data available, was just 4.9 per cent. This is well below the average of 7.3 per cent during the period since the major oil price shock in 1973. Record numbers of people are in work, no less than 31.75 million of them, up by 600,000 on the same period a year ago. The labour market is essentially in equilibrium, almost anyone who wants a job can get one.

But a key reason for full employment is that labour has priced itself back into work.

Following the recession in 2008, earnings after allowing for inflation fell every single year until 2014. Only last year was this trend halted and a modest increase registered. Workers have become cheaper to employ.

The downside is that many people in work have experienced falling living standards. If real earnings rose by 5 to 10 per cent to make up lost ground, on the one hand there would be less incentive for an individual employer to hire someone. But on the other hand, the ‘price’ of labour is the wage, and higher wages mean more money to spend, and higher demand for goods and services. So more workers would be needed. In principle, full employment can exist with higher earnings.

The risk is that we become trapped in a relatively low wage full employment situation.

This is a very difficult balancing act to pull off. But the political rewards would be huge