Are We Really Breaking the Law?

March 12th, 2012 at 7:59 pm

Okun’s Law, that is.

There’s lots of agita* out this AM regarding faster employment growth and a bigger decline in unemployment than would be justified by the rule of thumb known as Okun’s Law.  The idea here is that if the economy is growing at trend, which is thought to correspond to real GDP growth of about 2.5%, then unemployment should hold steady and job growth should come in lower than it has in recent months.

Based on the view that GDP has been growing below trend—year-over-year growth, 2011q4 over 2010q4, was 1.6%–and is expected to slow further, analysts are reasonably worried that a) we’re getting more job growth than you’d expect, and b) job growth will slow.

I think that’s probably right, and my forecast is for unemployment to stay around where it is for awhile.

But I don’t think we’re breaking Okun’s Law, at least not in the short run, because I think the recent trend growth rate for GDP is probably well below 2.5%.  If that’s so, then we’d expect to see better labor market outcomes, even with slower growth.

My view is based on the following two graphs.  Before I go into them though, remember: trend GDP growth is the sum of trend labor force growth plus trend productivity growth.

The first figure shows the annual growth (or not) in the labor force (aficionados: this uses the BLS series which smooths out population control changes, i.e., when they change their weighting scheme; see here).  As you see, trend growth in the labor force–averaging over the last few years–has come down a lot and is only now regaining some oomph.

Source: BLS, see text.

The second figure is a repeat from here wherein I argued job growth is currently getting a boost from low productivity growth.

Source: BLS

Put these numbers together and in the near term, trend growth has probably been closer to 1-2% than 2.5%.  Labor force growth has been slightly north of flat and productivity growth averaged around 1% over the past year.  So, I’m not sure we’re breaking the law–at least the near-term law–as much as we’re taking advantage of a temporarily reduced economic speed limit.

If the labor force continues to pick up—you can clearly see a new trend developing at the end of the first figure—and productivity climbs off the floor—I don’t believe we’re a lot less productive than was recently the case–I expect less progress against unemployment.  Like I said, my forecast is that by the end of the year, we’re around where we are now.

In fact, while you were chopping bananas for your Cheerios this AM, I was saying no less at about 6:30 (!!) on CNBC…I’ll post the clip later.

*Btw, the song Agita is from one of the great all-time movies: Broadway Danny Rose, by Woody Allen.  If you don’t know this film, see it immediately—it’s pure Americana at its best, with a large side of schmaltz.  Or, if you prefer, I could probably act out the whole film for you, including the songs.   “And I mean neither to be facetious nor didactic.”

Update: Thought I should add an Okun graph so you could see for yourself what all the shootin’s fer.  The figure plots the change in unemployment against the change in real GDP.  It highlights two large “Okun residuals” meaning dots far away from the regression line.  The one in the upper left quadrant is a tough residual–big increase in unemployment for a small decline in GDP–especially if you happen to be an economist working for the White House at the time.  The one in the lower right is a sweeter residual: a bigger decline in unemployment than you “deserve” based on GDP growth.

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2 comments in reply to "Are We Really Breaking the Law?"

  1. Michael says:

    Are we still talking about unemployment instead of labor force participation rates? Why? Do we not like knowing what’s going on or something?

  2. kio says:

    It is better to use real GDP per capita in Okun’s law and convert the original differential form in an integral one:

    Then it gives us an almost ideal relationship with a standard error of 0.5% between 1957 and 2011; Rsq=0.9. This eror corresponds to 1% accuracy of GDP measurement, which some BEA employees consider as a natural uncertainty of masurements (see BEA working papers).
    Moreover, it works for all developed contries.