Okun Law puzzle in 2007-09 crisis

I had posted a while ago on Okun’s law. It is a relationship between output gap and unemployment. If output gap is this much how much will unemployment decline by? Historically, in US it was seen that unemployment declines by half as much as the difference between actual and potential GDP.

Now in this crisis there has been a puzzle. The unemployment has risen far more than the output gap. Janet Yellen in a very good speech explains:

 I should warn that there is a great deal of uncertainty surrounding this forecast. In the past, a given level of economic growth produced a more-or-less predictable change in the unemployment rate. Historically, a pattern emerged in which unemployment declined by half as much as the difference in the growth rates of actual and potential GDP. This is commonly referred to as “Okun’s law” after the economist Arthur Okun, who first described this relationship back in the 1960s.

Let me sketch out how this should work. In my forecast, GDP growth exceeds the growth rate of potential GDP by 1 percentage point this year and 2 percentage points next year. According to Okun’s law, the unemployment rate should fall by about one-half percentage point by the end of this year and a full percentage point during 2011. These figures are in line with my unemployment forecast.

However, Okun’s law let us down big-time in 2009. Given that GDP was stagnant last year, the unemployment rate should have gone up by about 1¼ percentage points, according to Okun’s law. In fact, it shot up 3 percentage points. Understanding what happened last year has important implications for what unemployment does in the future.

Few reasons for the puzzle are:

The first explanation for the failure of Okun’s law is that special factors not directly related to output growth may be pushing up the unemployment rate. One possibility is that the severe recession is fundamentally altering the labor market, shifting jobs away from such sectors as manufacturing, real estate, and finance to other sectors. This reallocation takes time. Until it is complete, we will see higher levels of unemployment.

A second possibility is that extended unemployment benefits are artificially boosting reported unemployment rates because workers who collect unemployment checks may be saying they are looking for work even if they have given up. In the past, such people might not have said they were searching for jobs and would no longer have been considered part of the labor force and counted in the official unemployment statistics.

Though there are loopholes in both ideas:

Still, there is little evidence that structural shifts in the labor market or extended unemployment benefits have had large effects on the unemployment rate. Take the unemployment benefits explanation. If true, we would expect to see a large increase in the labor force participation rate, that is, the percentage of people who are working or saying they are looking for work. In fact, currently, the labor force participation rate does not appear to be unusually high.

A second possible explanation is that last year’s enormous decline in employment was somehow an aberration. GDP was basically unchanged over the four quarters of 2009. But payroll employment fell by 4 percent over the same period. In other words, the economy produced roughly the same quantity of goods and services with 4 percent fewer workers, which translates into a 4 percent increase in output per worker. That’s a huge rate of productivity growth, well above estimates of the long-term trend in productivity gains that stem from such factors as improved technology. So, if we ask where Okun’s law went astray, we can see the fingerprints of this unusual pattern of employment and productivity last year. But that’s not the end of the mystery. What would cause employment to dive and productivity to soar during such a severe recession? And is it a temporary or permanent phenomenon?

The productivity angle could be argued both ways. It could be temporary as economies improve, more people will be hired and productivity will decline. It could be permanent as business still see risks and don’t recruit much. Yellen like most central bankers believes in the second outcome.

Hmmm..so okun puzzle answered via productivity.

Yellen’s speeches always have something interesting to offer. The title of speeches are boring – Outlook on US economy etc. But she always adds something more than plain outlook.

6 Responses to “Okun Law puzzle in 2007-09 crisis”

  1. Sudoku Tips For Beginners Says:

    […] Okun Law puzzle in 2007-09 crisis « Mostly Economics […]

  2. Romer speaks on Obama’s proposals for emplyment creation « Mostly Economics Says:

    […] is all so complicated. As Yellen pointed recently, the unemployment has been much higher than what Okun Law would have predicted. She added […]

  3. Adrien Says:

    Good morning, Happy April Fool’s Day!!

    Moishe had been single for a long time. One day, he excitedly tells his mother that he’s fallen in love at last and he is going to get married. She is obviously overjoyed.
    Moishe then tells his mother, “Just for fun, Mum, I’m going to bring over 3 women and you try and guess which one I’m going to marry.”
    His mother agrees.
    The next day, Moishe brings 3 beautiful women into the house and sits them down on the couch and they all chat for a while. Then Moishe turns to his mother and says, “Okay, Mum. Guess which one I’m going to marry?”
    She immediately replies, “The redhead in the middle.”
    “That’s amazing, Mum. You’re right. How did you know?”
    “I don’t like her.”

    Happy April Fool’s Day!

  4. NBER Economic Fluctuations and Growth Program – a report « Mostly Economics Says:

    […] is a big puzzle. Why unemployment decline has been so severe? Yellen pointed to some interesting ideas on this. According to her, increase in productivity is the main reason. […]

  5. Modern recessions vs Older recessions « Mostly Economics Says:

    […] this recession, unemployment has been much higher than Okun law would propose. The main reason for fall in employment has been a surge in productivity. Hall says same […]

  6. jack Says:

    hmm… maybe “real” GDP had fallen in 2009, but it was compensated by QE and other governmental expeditures?

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