Economist Arthur Okun in 1962 introduced us to what became known as Okun's Law. It describes the relationship between economic output, unemployment, hours worked, and productivity.
The "law" is more accurately viewed as a general "rule of thumb" which can serve as a useful way to predict future rates of unemployment.
Accordingly, Okun's rule of thumb is a helpful and simple guide to the threefold relationship between productivity, the size of the labor force and unemployment. Let's see what Okun's rule of thumb says about today's environment.
We are obviously in a slow growth economy, and unemployment stands at a high ~9%. How we get it down from this height is the question before us.
Productivity and growth in the labor force play key roles in the unemployment calculation. The historical record teaches that annual productivity gains will approximate 2%, and that the workforce will likely grow at a 1% pace. 2+1=3.
Accordingly, unemployment levels should remain stable at a ~3% rate of GDP growth.
In other words, Okun's rule suggests that the current unemployment rate of 9% will remain pretty much unchanged if accompanied by a 3% rate of GDP growth.
And we're not achieving 3% economic growth today. That's why bringing down unemployment from current levels requires substantial and sustained private sector economic growth. Nevertheless, due to the negative effects on consumer spending resulting from the ongoing deleveraging in American households, we're not likely to achieve a greater than 3% growth rate anytime soon.
Now let's return to how we can best predict changes in unemployment rates. Unemployment is 9% today, and the broader U-6 rate stands at 16.2%.
To reduce the unemployment rate by a full percentage point would require a meaningful change in one or more of the important variables associated with Okun's rule of thumb.
For example, reducing the unemployment rate would result if economic growth proceeded at a faster pace than 3%.
While not desirable, a lower than annual 2% productivity improvement or a less than 1% growth in new labor force entrants would accomplish the same result.
However, we want high productivity from current workers as well as new jobs for the many now unemployed as well as those yet to enter the labor force.
Thus, we don't want to reduce unemployment rates either resulting from poor productivity or due to discouraged workers dropping out of the labor force.
Annual private sector economic growth in excess of 3% is the only legitimate way to reduce current unemployment levels. That would also do much to help us out of our current financial mess and reduce government fiscal deficits, too.
To repeat, a meaningful reduction in the rate of unemployment will be preceded by annual GDP growth in excess of 3%. For each 1% increase in real economic growth beyond 3%, Okun's rule of thumb predicts that the rate of unemployment will fall by ~0.5 percentage point.
Meanwhile, an increase in labor productivity or an increase in the size of the work force will mean that real output can grow quickly without unemployment rates declining much, if at all. This condition is referred to as "jobless growth."
In today's world, this all suggests that the U.S. unemployment rate will remain very high for many years to come. For instance, annual economic growth of 4% would take another four years to reduce the unemployment rate from its ~9% level to ~7%. And, of course, a 4% growth rate is nowhere in sight.
The important thing to note is that the unemployment rate will tend to rise or decline as real economic growth is greater or less than 3% annually. Each one percentage point variance from the 3% stability level should increase or decrease the rate of unemployment by ~0.5 %. The message?
It's going to take a very long time to bring unemployment levels down to acceptable levels, barring an unforeseen spurt in real economic growth.
That's why the focus on private sector economic growth is so crucial to our nation's well being.
Thanks. Bob.
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