Tuesday, March 27, 2012

How can an economy that is growing so slowly produce such big declines in unemployment?

See Piecing Together the Job-Picture Puzzle by Jon Hilsenrath of The Wall Street Journal. Excerpts:

"Back in 1962, Yale University economist Arthur Okun described a long-running relationship between economic growth and jobs. When the economy grew faster than its long-run trend, the unemployment rate tended to fall by about half as much as the additional growth in percentage terms. So growth of 3.5% in a year—one percentage point above a long-run trend of 2.5%—would bring down the unemployment rate by a half percentage point in that year. And it worked the same way in reverse. Growth one percentage point below trend would push the unemployment rate up half a percentage point.

Economists called the relationship "Okun's Law." Forecasters still depend on this principle to make predictions about the future. But the law has been unreliable lately. Under the old rule of thumb, it would take growth between 4% and 5% to explain the improvements in unemployment in the past year—much more than the recovery has actually delivered."

"...Okun's Law also broke down in the other direction a few years ago..."

"Some of the miss was because the downturn turned out worse than expected and much of it was because unemployment rose more than Okun's Law predicted."

Why might Okun's Law not be working?

"...company managers were so shocked by the financial crisis in 2008 and 2009 that they fired workers more aggressively than they would in a conventional downturn."

"Over the past six months ... as fear and uncertainty have dissipated, firms appear to have reversed course and gone back toward more normal staffing levels."

One economist said

"these overshoots might soon run their course and that Okun's Law will reassert itself. When it does ... the unemployment rate could stall out at high levels because the economy isn't growing fast enough to justify more hiring.

"The only way unemployment will keep coming down is if GDP growth picks up substantially,"

But there are other potential sides to the story:

"Other story lines could be at play. The government's growth data are always a work in progress. Government statisticians regularly revise it as more information—such as more complete tax returns from businesses and households—becomes available. Revisions to the data could someday show the economy is actually growing more robustly than the data currently show. It is also possible that companies are on to something and they are hiring aggressively because they anticipate more growth than the data currently show.

A less sanguine explanation could be a dangerous productivity slowdown. It might be the case that the workers being hired aren't improving their productivity as much as workers had before. If they aren't as productive, companies need more of them."

Click here to read an earlier post about Okun's Law

Click here to read "Is Okun’s Law Really Broken?" by Justin Wolfers. It from 2010. A little on the technical side but very interesting.


Anonymous said...

I do find this to be interesting as well. The declines in unemployment do appear to be significant, but I would actually expect it to be different due to discouraged workers. It seems that higher levels of unemployment would sustain on the account of the discouraged returning to the workforce

Cyril Morong said...

Glad you liked it. Yes, as the economy improves, the discouraged workers come back and so that means that although jobs are created, more people are looking and the UE rate won't all that much

Sebastian Albrecht said...

Paul Krugman criticizes measuring growth of GDP, because he says that although there was a growth in last decades, gradually was the surplus less and less fairly divided - so from 1% of growth in 2000 went higher proportion to the "rich" than in 1980. If it was true, higher decline of unemployment could be caused by the fact that companies are simply willing to accept lower returns then before crisis.

Cyril Morong said...

Many principles books mention that a weakness in GDP is that it does not take the distribution of income into account, so it just isn't Krugman saying that.

I am not clear on why your last sentence is true and how it is related to the first one. Are you saying that if companies are accepting lower returns (does that mean lower profits?), they hire more more workers?