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How to bring down unemployment: Follow Okun's Law

The unemployment rate remains stubbornly high, both nationally and locally. Last Friday's national employment report confirmed that the unemployment rate has hovered around 9 percent throughout 2011. This is better than the 10.1 percent peak unemployment hit in October 2009, but a far cry from the 5 percent rate at the beginning of the recession in December 2007.

The Minnesota data tell a similar story. Starting at 4.7 percent in December 2007, unemployment rose to 8.5 percent in June 2009, and then fell over the next year to roughly 7 percent, where it has remained ever since.

What's going on? Part of the answer lies with a simple statistical relationship developed by an economist who died too young.

Getting the country moving again
In 1960, John F. Kennedy campaigned on the slogan "Get the country moving again." This applied especially to economic matters since the United States suffered recessions in both 1953-54 and 1957-58.


"John F. Kennedy came to the White House without a settled economic agenda or ideology," according to Robert Solow and James Tobin, who both served as economic advisors in the Kennedy administration. Instead, JFK turned to a group of economists led by Walter Heller of the University of Minnesota. These men, in turn, educated the president in the basics of macroeconomics as it was then practiced and studied.

Heller and his team had a ready prescription for increasing economic growth: stimulate the demand for new equipment through an investment tax credit. This policy would pay off in both the short run by raising short-term growth rates and in long run by increasing the stock of productive capital.

The big question they faced was: How much faster did the economy need to grow in order to reduce the unemployment rate?

Professor Okun goes to Washington
Thirty-two-year-old Arthur M. Okun joined the President's Council of Economic Advisors staff in 1961. He had been a professor at Yale University since 1952, and when his colleague James Tobin became a member of the council he asked Okun to come with him.

Arthur M. Okun
econ.yale.edu
Arthur M. Okun

The job of figuring out how much faster the economy needed to grow fell to Okun. He knew that earlier studies found a link between economic growth and the unemployment rate, and so he focused on quantifying this connection more precisely.

Here is what he discovered: In general, the economy must grow faster than 3 percent per year to reduce the unemployment rate. In particular, the unemployment rate falls by one-half percent for every percentage point of output growth above 3 percent.

What is amazing is that 50 years later this pattern continues to hold true. It also shows up when we study other countries, and it appears when we look for it at the state level. The resiliency of this finding has earned it a name: Okun's Law.

Okun joined the council as a member in 1964 and assumed the chairmanship in 1968. He then moved to the Brookings Institution, where he helped found the Brookings Papers on Economic Activity, one of most important forums for macroeconomic research in the United States. In the 1970s, Okun turned his attention to the connections between growth and income inequality and published his classic book "Equality and Efficiency: The Big Tradeoff" in 1975. He died of a heart attack on March 23, 1980, at age 51.

Lessons of Okun's Law for today
The U.S. economy is currently growing at less than 3 percent and the unemployment rate is 9 percent. Okun's Law tells us that we need to grow faster in order to reduce the unemployment rate. For instance, an increase in the annual growth rate from 3 percent to 5 percent will decrease the unemployment rate by one percentage point per year.

This is why the unemployment rate remains high both in the United States and Minnesota. And no one is currently predicting any improvement. Neither the Federal Reserve's latest forecasts nor those used by Minnesota Management and Budget show growth reaching, let alone exceeding, 3 percent in the next two years.

Arthur Okun told us what to do. Let's get to it.

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Comments (17)

Ah, if only Okun had an equation for increasing growth.

In effect, this article tells us the way to reduce unemployment is to create more jobs than we are at present. I think most of us already knew that.

The chart at:

http://usbudget.blogspot.com/2009/02/real-gdp-growth.html

clearly shows that 5 and 10 year average real GDP growth have been firmly anchored at 3% or less since the mid-70's. The annual GDP growth has not been at or above 5% since the mid 80's.

Was Jimmy Carter wrong about the malaise, or just early?

There is no doubt that faster economic growth would bring mare jobs. The real question is where will the growth come from?

It was going to be computers. It then was going to be dotcoms. It was then going to be real estate. It was then going to be finance. Each of these as proven to be ephemeral and hazardous to the financial situation and jobs of many Americans.

In a way Okun was wrong--the unemployment will fall without any new jobs--eventually the unemployed are classified as "not in the labor farce", and no longer add to the unemployment figures. Eventually, we'll be back to "full employment", it'll just be a reduced "full".

The chart at:

http://usbudget.blogspot.com/2009/02/real-gdp-growth.html

clearly shows that 5 and 10 year average real GDP growth have been firmly anchored at 3% or less since the mid-70's. The annual GDP growth has not been at or above 5% since the mid 80's.

Was Jimmy Carter wrong about the malaise, or just early?

There is no doubt that faster economic growth would bring mare jobs. The real question is where will the growth come from?

It was going to be computers. It then was going to be dotcoms. It was then going to be real estate. It was then going to be finance. Each of these as proven to be ephemeral and hazardous to the financial situation and jobs of many Americans.

In a way Okun was wrong--the unemployment will fall without any new jobs--eventually the unemployed are classified as "not in the labor farce", and no longer add to the unemployment figures. Eventually, we'll be back to "full employment", it'll just be a reduced "full".

"Arthur Okun told us what to do. Let's get to it."

Kennedy's strategy for spurring economic growth resulted in the economy growing at a rate of 5.3% by 1966. He did it by lowering the cost of production with his 1962 investment tax credits for new equipment, but he also cut the top personal tax rates from 90% to 70% (effective in 1964) explaining how "a rising tide lifts all boats."

Dear Mr. Louis Johnston,

If one of your students turned in this article of yours as a paper to be graded....you would give it a D-, or you should turn in your teaching credentials.

Growth is what everyone is looking for (because, as you so obviously pointed out...it creates jobs!). The age-old arguement is how to get there. From what I have read, JFK was a "supply-sider".

That works for me, Mr. Tester. Let’s make sure there are functioning investment tax credits for new equipment, and let’s set the top personal tax rate at 70%, then sit back and await that rising tide…

But Ray, if you jump ahead 15 years, when the economy slumped in the late 70s, Reagan halved them again to 38% ... spurring the longest peace-time economic expansion in history.

The investment tax credit idea wouldn't work so well today since we don't have the heavy industrial base we did then.

Dennis, Reagan roughly tripled the public debt from $712 billion in 1980 to $2,052 billion in 1988. So, I assume you are in favor of massive amounts of debt-based stimulus spending.

Dennis, Dennis, Dennis...

...spurring the longest peace-time economic expansion in history....

What can I say?

Just because this is a treasured belief of Republicans doesn't mean that it is true.

Take a look at the graph:

http://usbudget.blogspot.com/2009/02/real-gdp-growth.html

The Reagan tax cuts did not spur any extraordinary long term growth in GDP. There are a quarter or so of spikes in growth but nothing was sustained.

On the whole, the GDP growth remained at about 3% from the 70's, to the 80's, to the 90's and through the 00's, until the Bush debacle when the wheels finally fell off of the creaky old wagon.

Frank, Reagan's tax cuts resulted in tax revenues doubling from about $500 billion to about $1 trillion. The problem is the democrat congress spent it and more.

(#11)...The problem is the democrat congress spent it and more....

And St. Reagan didn't know how to use a veto pen?

Dennis @11, The first sentence is Laffer curve nonsense. Do you have a legitimate citation to back up such a ridiculous claim. ... I thought not.
Re second sentence:
"By the time Reagan stepped down from the helm, he had expanded the U.S. military budget to a staggering 43% increase over the total expenditure during the height of the Vietnam war." http://www.u-s-history.com/pages/h1957.html I suppose you are blaming the Democrats for the Reagan military buildup, which was largely justified by CIA exaggerations of Soviet military and economic strength and support of revolutionary violence. (See Wikipedia entry for CIA director William Casey for a start.)

Mr. Tester:

Democrat Congress? Does that mean we now have a Republic House of Representatives?
Is Rick Perry running for the Republic nomination for President?

Just curious.

Frank, the Soviet Union doesn't exist today due to Reagan's defense buildup. I'd consider that a worthwhile investment, wouldn't you? Maybe not.

The major driver of Reagan tax revenues was not productivity--it was *inflation*. Remember? Most conservatives knowingly *choose* to ignore that fact because it undercuts their basic claims.

Ocun's law is interesting and might provide some predictive ability once GDP starts growing, but it doesn't tell us how to create jobs. Again, Johnson's title doesn't match his content.

I think one thing that history definitely shows us is that in periods like this massive government spending creates growth. After WWII we built infrastructure, paid Social Security, sent million of GI's to college, etc.

What we're doing now is finding out what the great depression looks like without FDR. Were it not for the safety nets we created back the late 40's and 50's we be looking at Great Depression II. Democrats don't have the guts or the sense to push for massive spending and the tax hikes to finance it, and Republicans don't seem to mind recessions and are happy to let them go on forever, so they fight spending and taxing in any way except military way.

The Democrats had a chance the first two years of Obama's administration, but too many of them have drank the Chicago School coolaid so they blew it. Don't expect unemployment to fall much until the Democrats get back into power, and then do what they need to do.