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‘Okun’s Law’ weakens as growth-jobs link turns tenuous (KEVIN VAN PAASSEN/THE GLOBE AND MAIL)
‘Okun’s Law’ weakens as growth-jobs link turns tenuous (KEVIN VAN PAASSEN/THE GLOBE AND MAIL)

‘Okun’s Law’ weakens as growth-jobs link turns tenuous Add to ...

The U.S. recovery has been unkind to Arthur Okun, a former economic adviser to John F. Kennedy, who died in 1980.

Mr. Okun established in the 1960s that there was a link between economic growth and the unemployment rate: When one goes up, the other goes down. “Okun’s Law” became central to policy making, as it justified efforts to stoke economic growth by whatever means.

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Economists over the years have established that the relationship held, although it is different depending on the country. In the United States, current thinking is that a 1 per cent deviation from potential growth causes an opposite change in the unemployment rate of half a percentage point.

The nature of the U.S. economy has caused many economists to ask whether Mr. Okun’s biggest contribution to economics may be another casualty of the financial crisis. The unemployment rate has fallen considerably since it peaked at 10 per cent in October, 2009. Yet economic growth has been far from spectacular. So great was the outcry against Okun’s Law that some economists at the International Monetary Fund were moved to investigate. (They determined that the relationship between growth and unemployment still held, and that it’s the work of its critics that is “flawed.”)

Still, the doubts linger. One needs to look no further than the Federal Reserve’s latest economic projections, which were released Wednesday.

The Fed cut its forecast to economic growth in 2013 to a range of 2.3 per cent to 2.8 per cent from an estimate of 2.3 per cent to 3 per cent in December.

Yet policy makers at the same time said they expect the unemployment rate will end the year lower than they had imagined previously. The Fed now predicts the unemployment rate in 2013 will fall to a rate between 7.3 per cent and 7.5 per cent, compared with its earlier estimate of 7.4 per cent to 7.7 per cent.

“There has been some disconnect, at least in the short run, between unemployment rate changes and growth in this recovery,” Fed chairman Ben Bernanke said at a news conference Wednesday. “There have been periods, at least, where unemployment has fallen relatively quickly even though growth has been more limited. We’re just going to have to monitor developments in the economy and see what happens.”

Mr. Bernanke didn’t offer any more by way of explanation. In the past, he has suggested that the apparent break between economic growth and the unemployment rate could have something to do with the panic employers felt at the outbreak of the Great Recession. Companies fired workers faster, and in greater numbers, than might have been expected. Now, those companies could be rehiring at a faster rate than economic growth would suggest is necessary because they acted too rashly earlier.

That’s one possibility. It’s also possible structural changes are affecting the predictive powers of Okun’s Law. The sharp decline in the unemployment rate has been aided by a shrinking work force. There’s debate whether the decline in the number of people looking for work reflects a lack of confidence in the economy or is the result of demographic changes such as a growing number of retirees.

While Mr. Bernanke stopped short of abandoning Mr. Okun, he also made clear that he’s not relying on gross domestic product to guide Fed policy. For that, the central bank is focused on labour market indicators, and has pledged only to change course once it’s satisfied there is a lasting improvement in hiring conditions.

“We do need to see a sustained improvement; one month, two months doesn’t cut it,” Mr. Bernanke said, referring to the unemployment rate. “Normally, you would expect you would need to see a reasonable pace of GDP growth in order to achieve that. We’re just going to have to keep providing support for the economy and see how things evolve.”

Follow on Twitter: @CarmichaelKevin

 

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