Abiding by the (Okun) Law

July 26th, 2011 at 11:33 am

Back when I was in the White House we got hit with some pretty bad Okun residuals.

Which is to say this: There’s an age old relationship between GDP growth and unemployment that says when GDP grows 1% above its trend, the unemployment rate will fall by half-a-percentage point.

But as you can see, if you plot this relationship in a scatter graph, the 2009 observation is way off the line in a most unfavorable way—we got a much higher increase in unemployment than the rule of thumb would predict.

That’s not so unusual—clearly the sharp demand contraction was historically unique, and you expect to get an outlier at such times.

We never got a bounce back the other way, and where we are now is that yucky clump in the lower right. 

It’s a picture of an economy stuck in neutral, where GDP is bumping along at trend or a little worse, so, by “Okun’s law” the unemployment rate stays stuck where it is.

Basically, the law was violated in the “wrong” direction back in ’09.  Now we’re law abiding once again, and we’re stuck at 9%.

Graphic: Hannah Shaw, Inc.

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4 comments in reply to "Abiding by the (Okun) Law"

  1. marc sobel says:

    Could you please explain your 09 comment. What caused it?

    • Tom says:

      Only a guess, but I suspect the 09 outlier is because the unemployment rise lagged the GDP drop by a quarter, so when you measure Q4 to Q4 the gdp drop hits more Q4, unemployment more Q1 09. If you measured Q2-Q2 or Q3-Q3 you might not notice so much.

  2. Jan Martin says:

    Jared, you need to tell whoever made the graph to put signs on the bottom axis values. You can’t tell which side is the growing economy and which is the shrinking.

  3. Michael says:

    Financial recessions are different.