That is the conclusion of a fascinating new paper from the National Bureau of Economic Research titled ‘Okun’s Law at fifty’. The authors, Laurence M. Ball, Daniel Leigh and Prakash Loungani, look at a long series of historical data to assess the claim that Okun’s Law has broken down in recent times. Whilst there has been many claims that this fundamental economic ‘law’ is no longer applicable, Ball et al show that this interpretation is incorrect: the relationship between economic growth and unemployment has held up remarkably well.
What is Okun’s Law?
In the early 1960’s, Arthur Okun noted that output and unemployment had a negative short run relationship. In other words, an increase in output of one percent above potential will reduce unemployment by a certain percentage (the coefficient of Okun’s Law). Ball et al note that this is as close to an economic ‘law’ as possible in the field, so it is with great importance that we are sure if it has been violated or not.
Okun’s Law is captured by the following relationship:
In this equation, U refers to unemployment, Y refers to output and * variables refer to the long run levels of unemployment and output. β here is the coefficient in Okun’s Law.
How did Ball et al test this apparent breakdown?
Ball et al examined Okun’s Law on both quarterly and annual data for the US, in both the ‘levels’ version of the law as shown above and the ‘changes’ version of the law. In the levels equation, they use d the Hodrick Prescott (HP) filter to estimate the long run levels of output and unemployment. The authors take care to account for the different interpretations of recent movements of output and unemployment (whether it is structural or cyclical as discussed in last week’s post ). Regardless of the interpretation of recent events, Ball et al find that Okun’s Law fits the data well, with a coefficient of around -0.4. When this coefficient is inverted, it provides a rule of thumb that a one percent reduction in unemployment will occur when output grows by 2.5 percent above potential.
The use of quarterly data highlighted some important points about the dynamics of adjustment in unemployment. With lags included in the equation, the coefficient on the current output gap is smaller, needing the addition of the coefficients from previous periods to give a total coefficient similar to the annual only specification. This implies a modest delay in the adjustment of unemployment to output movements. Ball et al note that this may reveal a slight mis-specification on behalf of Okun, who thought the effects were entirely contemporaneous – that is, in the same period.
Why is this study so important?
This study is very important because it has become almost common language that the US is experiencing a ‘jobless recovery’. To a non-economist this sounds as if output is back to normal but the labour market has failed to recover. Yet, Ball et al believe this to be an incorrect conclusion. In fact, what the US is experiencing is a ‘weak recovery’.
Ball et al stress this point with the figures shown below. They show (the log of) output and unemployment from 2007 to 2011. They note that some commentators have claimed that GDP growth has returned to normal – as seen by the similar slope of the two output lines from 2009. Okun’s Law, however, is a statement about deviations from long run levels. As output is clearly below it’s long run (pre-recession) trend, then Okun’s Law would expect unemployment to be higher than it’s trend as well.
Ball et al also look across countries to examine claims that Okun’s Law has broken down in these countries as well. The missing factor here, from the analysis of other commentators, is the length of recession. Ball et al note that when comparing across countries, Okun’s Law will hold if the length of recession in different countries is controlled for. Furthermore, when Ball et al adjust for country specific factors, the fit across countries is even more impressive.
Placing these results in a macro-economic context
It is a powerful result to state that Okun Law’s still holds and that what the US is experiencing is a weak recovery rather than a jobless recovery. So, if Okun’s Law is still intact and the real issue is weak output growth, a similar conclusion can be drawn to that of last week’s post. It seems, again, that it is not a dysfunctional labour market that is the cause of high unemployment, rather, it is weak output growth from inadequate demand.
Crucially, then, the focus shifts from looking for labour market failures to the causes of weak output growth. It seems that a coherent macro story involves the notion of financial recessions (see here ) and something like the leverage-deleverage cycle (see here ). A deleveraging economy that occurs during a financial recession such as this one will indeed exhibit weak output growth below trend, thus resulting in high unemployment. This, however, does not imply that weak output growth is inevitable in these types of recessions. The IMF (see here ) has already performed some excellent analysis about the need to address private sector debt and how some policies are much more successful than others in accelerating the deleveraging process.
This story contains a nice blend of new and old in macro-economics. One of its oldest laws still holds and is highly relevant. But a new understanding is emerging about the aftermath of financial crises and the need for additional theories is clear (see here for my attempts). Importantly, given the existence of new and old macro-economic behaviour, policy still matters and the appropriate recognition of the macro story will encourage the appropriate policies to be engaged.