Okun’s Law

A regular correspondent of mine – Stephan – suggests that I add an addendum to my comment yesterday about the current hyperbole in the media. To refresh your memory, one of my points was that even rapid GDP growth in 2011 is not likely to reduce unemployment significantly, and that to restore the economy to more normal levels of unemployment, or to reach the level economists call full employment, could take years. Lots of years. The point being that we should not get carried away by all the current breathless talk of “surges” or “booms”. That seems just to be Wall Street speak. Stocks may do well. Regular folks less so.

At any rate the basis for my assertion is something called Okun’s law, and it is to this that Stephan thinks I should make specific reference. So here goes.

Like many so-called laws in economics Okun’s law is really more a rule of thumb based upon a detailed review of history. The essential conclusion is that there is not a one-for-one relationship between shifts in GDP and changes in unemployment. For unemployment to move by 1% the typical shift in GDP has to be about 2%. Interestingly one of the authors who has articulated this relationship in detail is none other than Ben Bernanke. So we should assume he is well aware of the hill we still need to climb to get back to health.

Putting this in our current context we can see that growth has to do two things. First it has to cover, or absorb, growth in the workforce due to population changes. A good rule of thumb in the US is that GDP needs to rise by about 2.5% for unemployment just to stay even with such changes. Only after that does Okun’s law kick in. This suggests we need to see GDP growth of 2.5% + 2.0%, i.e. 4.5%, per annum just to bring the unemployment rate down by paltry 1%. And we need to keep repeating this for years on end to undo the terrible damage wrought during the crisis.

So movements in unemployment are “sticky” with respect to overall economic growth. The two do not move in tight lock step.

Growth at those heady 4.5%+ annual rates is well above the long term average for the US.The last time we saw such a string of years was at the end of the 1990’s. For the four years 1997 through 2000 GDP grew at an average of 4.45% per year. We remember those years as exceptional rather than the norm. Given the hobbled nature of our economy and its financial imbalances, not to mention the possibility of anti-growth government spending cuts at the federal and state levels in the near term, I just don’t see the economy making the headway we need.

Most forecasts are for the economy to grow around 3.5% to 4.0% this year, and then to taper off beyond that as various stimulus efforts fade, the atmosphere of crisis gives way to the need to rein in debt, and the emphasis turns to spending cuts or tax increases. It is very difficult to construct a credible forecast for growth sufficient to bring unemployment down to acceptable or more normal levels during this entire decade. Our economy is mature and still very vulnerable to the whims of an unrestrained banking sector. Also, the likelihood, in my opinion, is that somewhere in the next ten years we will see another recession caused by financial instability, an event that would undo all the good work up to that point.

So, putting this all together: Okun’s law provides us with an empirical basis for making the assertion that we will not return to normal unemployment rates during this decade. Further, current and likely policy will make matters worse. This is the reason some observers, like Paul Krugman, talk of a Japanese style “lost decade”. History supports that pessimistic view. The counter view, the more optimistic spin churned out on Wall Street and similar upbeat places, is not based upon a review of facts, but is simply opinion. There is no hard evidence to support the optimists, and no amount of wishful thinking can substitute for empirical study.

In the absence of such hard evidence to the contrary I will go with Okun and his law.

We are in for a long slog. Get ready.