George Osborne's "commitment" to full employment poses the question: what's stopping us reaching it?
The standard answer is the Nairu; if unemployment falls below a particular rate, inflation will rise.
This answer, though, runs into a problem. Since the start of 1997 the correlation between the unemployment rate and CPI inflation in the following 12 months has been strongly positive - 0.46 in quarterly data. It is high unemployment that has led to higher inflation, not low. Falling unemployment in the early 00s led to low inflation, and the rise in inflation in 2007-08 followed a rise in unemployment. And the recent drop in inflation has followed a fall in unemployment.
This might tell us that inflation and unemployment have both been driven by supply shocks - a low China price in the early 00s and rising commodity prices in 07-08. Or it might just show that the idea of the Nairu doesn't make sense in an open economy. The standard undergrad macro textbook says:
In the closed economy there is a unique unemployment rate consistent with constant inflation. By contrast, in an open economy, there is a range of unemployment rates consistent with the absence of inflationary pressure. (Carlin and Soskice, p343)
However, it doesn't follow that we can achieve full employment simply through expansionary demand policies. There might be another constraint on this - the current account deficit.
Now, you'd expect there to be an inverse relationship between the current account balance and unemployment; when unemployment is high, domestic demand is weak and so imports should be low which should mean a current account surplus, and conversely the high demand that reduces unemployment should also suck in imports, causing a deficit.
However, last week's figures suggest that this trade-off has worsened. We had a near-record deficit of 5.4% of GDP in Q4, despite a jobless rate of 7.2%. In early 2009 the same jobless rate was associated with a deficit of just 1.4% of GDP, and in 1997 it was associated with a surplus.
This suggests that any attempt to significantly cut unemployment by higher demand would suck in even more imports causing an even bigger deficit. This might be sustainable for a while - we're starting with low net overseas liabilities - but it can't last forever.
Worse still, the two obvious solutions here are questionable.
One is for sterling to fall. However, the pound fell by 20% in late 2008 without a major stimulatory effect. And engineering a fall in sterling at a time when other nations are running loose monetary policies might be difficult.
The other is to simply let overseas demand rise. But this might not be sufficient. OECD data show that the volume of world trade in goods and services has grown by 29.5 per cent since it troughed in the second quarter of 2009. However, during this period the volume of UK exports of goods and services has grown by only 15.1 per cent. This warns us that stronger overseas demand might not be sufficient - because some mix of gravity or some supply-side failure is holding back exports.
Perhaps, then, there is a constraint upon how far we can reduce unemployment through demand policies. There are two implications of this.
The one that's friendly to Osborne is that he's right to see that full employment needs some kind of supply-side policies - though whether tax and benefit reform is sufficient is doubtful.
The less friendly implication is that Osborne (and I suspect Labour too) are giving us another example of cargo cult management. Announcing a target without any idea of how to achieve it is just, well...