The Absolute Truth Isn’t Nearly So Absolute Or True Anymore

by Dave Schuler on March 26, 2012

When I first took economics the Phillips Curve, the empirical (at least at the time) inverse relationship between inflation and unemployment, was taught as Holy Writ. The stagflation of the 1970s changed that a bit. Two things happened in tandem: the postulate was restated in more refined form and it was given a theoretical basis, something it lacked when it was taught to me. Back then it was just a rule of thumb.

Another rule of thumb is coming under increasing scrutiny. Okun’s Law, which relates unemployment to a decrease in GDP, has become a bit tarnished lately. Zerohedge quotes liberally from an analysis from JPM:

One of the bedrock relations of macroeconomics, even more fundamental than Okun’s Law, is that aggregate GDP (which we label Y) can be represented as function of the amount of capital (K) and labor (L) used to produce output, along with the overall level of technical progress (A) made in using capital and labor. More specifically, the relation Y=A*K1/3*L2/3 seems to describe US production fairly well. This means that a 1% increase in labor input will raise GDP by 2/3%-pt. If the size of the labor force is constant then a 1%-pt drop in the unemployment rate should increase labor input used in aggregate production by 1/(1-u)%, where u is the unemployment rate. This implies that holding all else equal, a 1%-pt drop in the unemployment rate should increase GDP by about 1/(1-.083)*(2/3)=0.7%, a number well below the 2% boost implied by Okun’s Law. The apparent disparity is resolved by the fact that all else is usually not equal: declines in the unemployment rate tend to be correlated with (1) increases in the average workweek, (2) increases in labor force participation rates, and (3) increases in average labor productivity.

[…]

The breakdown of correlation (2) has received the most attention recently: instead of increasing, the labor force participation rate has declined even as the unemployment rate has declined. However, Okun himself realized that the correlation of labor usage and productivity was historically the most important reason that the Okun coefficient was so large. The fact that this correlation has gone the “wrong” way over the past few years can explain both why unemployment increased more than Okun’s Law would have predicted in 2008-2009 and why unemployment has come down so much recently. In fact, if the correlation between productivity growth and changes in the unemployment rate that prevailed between 1947 and 1984 held last year, then the decline in unemployment we have witnessed would have been accompanied by GDP growth of around 4.1%, and there would be little left to explain.

Output—GDP—equals productivity, or output per hour, times hours worked. As we noted above, growth in productivity, or correlation (3) listed above, has been weaker than what would have been expected given the decline in unemployment. However, the growth in hours worked has been only a little weaker than what would be expected. Although the labor force participation rate, correlation (2), is weaker than what one would have expected given the decline in unemployment, the average workweek, correlation (1), is stronger than what would have been expected. On net, hours worked have not behaved too abnormally given the decline in unemployment—productivity has.

The conclusion that the author draws from this is that productivity growth is now countercyclical with respect to employment and, simply stated, just about everything that has been thought about macroeconomics will no longer hold true. Zerohedge blames this on “central planners”, generally, and the Obama Administration in particular.

I think I see things a bit differently. Although I have little more regard for central planning than Zerohedge does, I think that we are now seeing the realization of a process that has been going on for some time—the last thirty years, at least. The effects of productivity growth in the United States may not be limited to the United States and may well produce employment effects outside the United States, just as the employment effects of productivity growth in California may be seen in Texas, Florida, and Illinois. It’s all one big economy now and there is no central central planning. Rather, there are lots of central plans, all operating at cross-purposes.

There is no ready solution to this problem at hand. China won’t abandon its political system any more than we’ll abandon ours. We might be able to limit the effects that the other guys’ central plans have on us by building a figurative wall. That would result in slower economic growth here as well, IMO, as dramatically slower growth elsewhere. The international tools that we have aren’t robust enough to deal with the circumstances we have. There are no mutually shared values on which to build better international tools and the power and scope of effective tools would be truly frightening. For reasons that are well known an international planning regime is likely to be even worse than 200 national planning regimes.

We’re engaged in a planetwide Prisoner’s Dilemma and no player trusts any other.

{ 1 comment… read it below or add one }

Ben Wolf March 26, 2012 at 2:31 pm

“. . . instead of increasing, the labor force participation rate has declined even as the unemployment rate has declined.”

This would be because people who cease participating are no longer counted as unemployed. That’s a failure of metrics and politics, not central planning as Hyperinflation-Hyperventilator Durden would have us believe.

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