Okun, Unemployment, and Wages

January 8th, 2013 at 8:37 pm

I just finished reading a great little paper on Okun’s rule about the relationship between output gaps and the unemployment rate (I’d say it’s uniquely readable for this sort of thing, btw).

Fifty years ago, when economists were a lot more likely to be driven by what the data actually did as opposed to what they wanted it to do, Arthur Okun “reported an empirical regularity: a negative short-run relationship between unemployment and output.”  The rule of thumb came to be that when real GDP is one point above or below its potential, unemployment would go down or up by about half-a-percentage-point.  So, if the underlying trend in GDP was 2.3% per year and growth some year was 1.3%, we’d expect unemployment to rise by roughly half a point.

I know.  The idea that economists choose to spend our time convincing ourselves that output slumps lead to higher unemployment may well lead you to conclude that we have too much time on our hands.  And if it were only a few Chicago professors who disbelieved that output gaps increase unemployment, I wouldn’t much bother you with it.  But ponder this:

The current policy agenda being applied in virtually every advanced economy with a current output gap is in direct opposition to the reality that there is a negative relationship between such gaps and the unemployment rate.

Okun’s rule may be alive and well in the statistics, but it’s in serious trouble in practice.  The pivot to fiscal austerity well before real GDP was back to its potential level is the rule in today’s advanced economies, not the exception.

Almost daily these days someone asks me, in so many words, “Why is that?”  This post gets at part of the answer though I’m sure there’s more to it.

But for now, let me focus of one of the underappreciated costs of this policy mistake: the impact of output gaps and the ensuing high unemployment on real wage trends.  That is, Okun’s relations go from an aggregate demand shock to jobs to unemployment.  But others have carried this through to the next step: the impact on earnings.

I looked at this today in the context of low earnings (10th percentile) for men and women, by constructing a simple statistical model that maps changes in the unemployment rate onto real wage changes.  The results, based on a long-term unemployment rate forecast, are in the figure below (thanks to EPI for the wage data).  Data from 2012 forward are forecasted.

I’ve got the unemployment rate falling pretty slowly from 8.1% in 2012 to 5.4% in 2018—this is the Okun-rule part: as we slowly close the remaining output gap, the unemployment rate comes down.  However, while the earnings of low-wage workers are a lot more closely tied to the unemployment rate than high-wage workers—they’ve generally been doing well regardless—their real wages continue to decline up until the point when the job market is a lot less slack than it is today.

And that’s assuming we make it to 2018 without bumping into the next recession first.

Obviously, these are simplistic calculations of complex variables.  But I suspect they’re ballpark, if not optimistic.  Extensive research has clearly revealed that absent very tight labor markets, middle and low-wage workers lack the bargaining power to capture the growth to which they’re contributing.

So let’s just be clear about the cost—in real dollars and cents—of our policy mistakes.


Source: EPI, my calculations; forecasted data begin in 2012.



Print Friendly, PDF & Email

4 comments in reply to "Okun, Unemployment, and Wages"

  1. Harry Minot says:

    Ahhhh! Those funny economists and their math! While I have none of that expertise myself I do admire those who do, and those who think in ways which are both inventive and corrective. That would be YOU, Jared, and I bow deeply toward you. Nassim Nicholas Taleb is another. And so is Rick Bookstaber. Here’s a fascinating Bookstaber entry which illustrates his intellectual prowess: http://rick.bookstaber.com/2012/10/a-crack-in-foundation-of-economics-more.html

  2. jo6pac says:

    Just wonder if it has been factored in that the boomers that can’t get a job choose to retire so U looks lower but it’s not in reality?

    • Kevin Rica says:

      Lots of people retire prematurely because they can’t find work. Others take disability.

      Unemployment is much worse than any of the standard statistical measures capture.

  3. Kevin Rica says:

    How could we possibly have unemployment?

    Unemployment (more people than jobs) is the mutually exclusive and diametric opposite of a labor shortage (more jobs than workers: what chapter 4 or 5 of almost every freshman economics textbook tells you raises wages).

    So we can have one or the other — but not both.

    Yet we have a “labor shortage.” The Chamber of Commerce tells us so:


    So now “progressives” (the body snatchers that took over the Democratic party from us Truman Dems) will now have a panic attack and start hyperventilating, breathing into bags, wetting the floor, and begin screaming: “Oh my God! Oh my God! It’s an emergency. There is a labor shortage! Save the economy! Help the employers! We need more immigrants! Employers are paying the minimum wage and no one will take the work! Americans are lazy! They won’t do hard work for the minimum wage and no health benefits! Who will save the employers? We must evacuate Central America!”

    And then they will be shocked because wages don’t rise. Except for Ted Kennedy who always said wages shouldn’t and wouldn’t rise):


    Read Paul Krugman’s excellent blog on “The Curious Politics of Immigration.”