Okun’s Law Rules the FOMC

Zzzzz…oh…what’s that? The FOMC say’s what?

Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment.

(Full statement available here.)

Stop the presses! New headline: Central bank warns recovery too slow to curb unemployment (Financial Times, Dec. 14, 2010).

Oh no! Well, we’d better get that growth going then. What’s everyone waiting for? Increase G! Increase M! Increase…increase…..Zzzzzz.

Sorry, but I stayed out way past my regular bedtime last night. And for some strange reason, I find myself mulling over this curious phrase: “…though at a rate that has been insufficient to bring down unemployment.” Why did the FOMC include it in their statement? What does it mean? And where does it come from?

Let me start with the last question first. It comes from the late Arthur Okun, who discovered something called Okun’s law back in the 1960s. Evidently, Okun’s law was widely taught back in the day. These would have been the days when most of the now senior members of the FOMC were impressionable youngsters; see ——–>

Alright, so now we know where it comes from. But what does it mean? Obviously, it refers to some sort of ironclad law of economic nature, right?

Uh, well…no, not exactly. When the law breaks down, proponents like to refer to it as a “rule of thumb,” instead. To be honest, it’s really just a statistical correlation. When economic growth goes up, the unemployment rate goes down. At least, on average this is what happens at business cycle frequencies.

Of course, it’s also true that when the unemployment rate goes up, economic growth slows down. To put things another way, output tends to go up when more people are working. I know it’s quite the shocker, but many economists believe this to be true. This is why they pay us the big bucks.

But why am I confusing you in this manner? Let’s see what that great purveyor of purloined propositions (PPP) has to say about the subject: Growth and Unemployment.

What you see is that unemployment tends to fall when growth is high, rise when it’s low or negative. You also see that growth has to be fairly fast — more than 2 percent — just to keep the unemployment rate from rising. Why? Well, productivity is rising, so that you can produce any given level of output with fewer workers; so output has to rise to keep employment from falling.

(That darned productivity growth–scourge of the labor market.)

Alright, so what is PPP trying to say here, especially in that last sentence? As far as arithmetic goes, it’s obviously correct (the language is sloppy, but let’s cut him some slack). But arithmetic is not theory. He is trying to explain the empirical correlation of Okun’s law. And explanation requires theory. Where is the theory?

To see what I mean here, let me alter the last sentence in the quote like this:

Well, productivity is rising, so that you can produce any given level of output with fewer workers; so employment has to rise if output is to rise at a more rapid pace.

As far as arithmetic goes, this statement is also correct. But the sentence appears to convey a different message, doesn’t it?

Evidently, there’s more to Okun’s law–the way it is commonly expressed–than a simple correlation. It seems to be sort of a “theory” too (I use the term loosely here). The theory is to be found in the assumption that the direction of causality runs one way only, and that it runs from output to employment, rather than the other way around. Output growth causes–nay, output growth is needed–to bring unemployment down. I guess the idea that more employment might cause more output–reversing the causality–seems less obvious.

The way Okun’s law is commonly expressed naturally leads to more sympathy for “demand side” policies, like increasing G or M, to stimulate employment. I am not saying that this shouldn’t be done. What I’m saying is that the arithmetic supplied by PPP is not what supports such a policy. My use of the arithmetic, for example, might instead be used to support “supply side” policies, like a cut in the payroll tax. It would be equally wrong to abuse arithmetic in this manner.

Anyway, I think it is time to bring my morning rant to a close. But I still haven’t answered the question of why that silly phrase was included in the FOMC statement. Would anything of any substance have been lost if the statement had not included it? It’s not as if QE2 can only be justified if one believes in Okun’s law (PPP version). I guess it’s difficult to rid oneself of some youthful impressions.

About David Andolfatto 91 Articles

Affiliation: Simon Fraser University and St. Louis Fed

David Andolfatto is a Vice President in the Research Division of the Federal Reserve Bank of St. Louis. He is also a professor of economics at Simon Fraser University.

Professor Andolfatto earned his Ph.D. in economics from the University of Western Ontario in 1994, M.A. and B.B.A. from Simon Fraser University. He was associate professor at the University of Waterloo before moving to Simon Fraser University in 2000.

His current research is focused on reconciling theories of money and banking. His past research has examined questions relating to the business cycle, contract design, bank-runs, unemployment insurance, monetary policy regimes, endogenous debt constraints, and technology diffusion.

Visit: MacroMania, David Andolfatto's Page

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