FRBSF: Okun’s Law and the Unemployment Surprise of 2009

The Federal Reserve Bank Economic Letter of March 8, already starts like this:

Economists have long known that the overall performance of the economy as measured by GDP has a direct bearing on unemployment. But the relationship between changes in output and changes in the unemployment rate deviated from expectations in 2009. Over the course of the year, unemployment rose rapidly, while GDP remained relatively flat, or near zero growth. This pattern was surprising because it departed substantially from a long-standing forecasters’ rule of thumb known as Okun’s law.

Named for Yale University economist Arthur Okun (1962), the law describes the empirical relationship between changes in output and changes in the unemployment rate. Okun’s law tells us that, for every 2% that real GDP falls below its trend, we will see a 1% increase in the unemployment rate. Since real GDP was almost flat in 2009 while its trend level increased by 3%, the unemployment rate under Okun’s law should have increased by 1½ percentage points. Instead it rose by 3 percentage points, more than twice the predicted increase.

Oh, really. Economists have long known? I’d think not. They have long assumed. That is an important difference. The letter’s content is interesting nevertheless.
It continues farther down:

The simple rule-of-thumb relationship between output and unemployment hides more complex relationships that influence Okun’s two-to-one rule. One way to see this is to recall that total output, or GDP, reflects a combination of several variables, including number of workers, the hours they work, and the efficiency with which they produce output. Thus, a natural starting point for thinking about why Okun’s law failed to hold in the recent past is to ask which, if any, of the underlying variables deviated from normal cyclical patterns.

Well, let’s assume that there was no change in methodology in arriving at or calculating the GDP in recent years. Then we can indeed assume that one or more underlying factor(s) actually changed and old relations no longer hold – or at least didn’t hold in 2009. Which one was it?

They letter’s authors conclude:

The data presented here consistently point to unusually strong productivity growth as the main driver of the departure from Okun’s law in 2009. A key question that remains unanswered by this analysis is whether this pattern will continue in 2010. Most forecasters assume that the economy will return to its historical path this year, following Okun’s two-to-one ratio of changes in GDP and changes in unemployment.

Refer to Fig. 3 in the letter to see what that means. It means less people do work more. That’s all. But is it really all? The GDP is a measure for the health of the economy. Generally, it is assumed that rising GDP=good, falling GDP=bad.

So let’s look at a post on George Washington’s blog:

Tim Geithner claims:

We saved the economy but kind of lost the public doing it.

So Mr Geithner thinks that they saved the economy. Whether this claim is true or not depends on how you define ‘economy’.
Obviously, you can define economy in a way that is not connected to the (economic) well-being of the people who make up and contribute to that economy. If defined in such a way, than the economy can be doing well even if everyone is out of work.

What is than the worth of this GDP measure? I would say zero to me and you. If you are not aware what GDP actually measures than you will be fooled into believing that a rising GDP=good (for you). That is flat-out wrong.
Rising GDP does not indicate overall improvement in living conditions for the population. It only signals rising profits for some people.

So Geithner may be right. By saving the plutonomy, which makes up a large part of the economy, they may have saved the economy. That the ‘economy’ is not connected to my or your well-being is just tough luck for me and you. They obviously couldn’t care less nor would they take the time to explain this.

But did they really save the ‘economy’. I’d wager they didn’t but I am ok with them believing that they did.

FRBSF Economic letter March 8, 2010: