Tuesday, August 4, 2009

Unemployment and economic growth

In two excellent posts, Paul Krugman explains the current unemployment rate in the US and how it will continue to grow even with a recovery on.

Okun's law (or rule of thumb) claims that a country's GDP will experience a two percentage point drop from its potential GDP output for every one percentage point increase in the unemployment rate.

With real GDP drop of 3.7% for six quarters from 2007IV to 2009II, annual potential output growth of 2.5% (or 4% for the six quarters), Krugman calculates the net decline in GDP to be around 7.7% (=4%+3.7%)from trend. Now using Okun's law, he calculates that the 7.7% net decline in GDP should have pushed up the unemployment rate by about 3.9%. The actual unemployment rate rose from 4.8% in 2007IV to 9.3% in 2009II - a 4.5% rise, close to the Okun's law estimation.

In another post, he compares the real GDP growth rate with the change in unemployment rate for the period from 1995-2009, and finds that real GDP growth has to be fairly fast, more than two percentage point, just to keep unemployment rate from rising. The increasing productivity means that it becomes possible to produce the same output with fewer workers, thereby necessitating real GDP to grow much faster than productivity so as to ensure unemployment does not rise. So, any small recovery now, by way of smaller rate of contraction compared to the sharp declines in the previous quarters, cannot prevent unemployment from rising. As Krugman writes, "That’s how you can have a technical recovery that feels like a recession: real GDP may be rising, but if it doesn’t rise at a sufficiently high rate, unemployment keeps going up."

There are other reasons too for the rising unemployment despite the "green shoots" of recovery sprouting. The initial sprouts of economic recovery will have to absorb a lot of slack due to the cuts made in work hours and working days, temporary shutdowns, forced furloughs, wage cuts etc, before businesses can start hiring new workers. Further, those forced off and who dropped off will first get back, before the newer additions to the workforce start finding their places. And through all this, the productivity improvements will keep happening and new workers will keep joining the labor force. And on top of all this, it would be natural to expect businesses to be conservative in their investment and hiring decisions in the initail phases of the recovery.

The substantial capacity under-utilization and resultant weak labor market, despite the recovery, means that wages will remain stagnant. At best, certain small slivers of the economy will experience some wage increases. Mark Thoma writes, "It is not until the existing workforce returns to normal and the unemployed find new jobs that wages come under pressure". And Tim Duy writes, "Until economic growth is sufficient to propel wages upward, any residual price pressures are likely to be snuffed out by deteriorating real wage growth."

Update 1
Mark Thoma discusses how unemployment and excess capacity track each otehr during recessions. Based on past experiences, the peak in the unemployment rate will come between 16 and 19 months after the peak in excess capacity.

Paul Krugman examines the reasons for this lag, and attributes it to the low-inflation environments of recent recessions and the depressed housing market.

Update 2 (23/02/10)
Janet Yellen of the San Francisco Fed believes that the Okun’s Law "let us down big time in 2009", since given the lag between potential and actual output, unemployment should be lower than it is (10% plus as at the end of 2009). She attributes this deviation to the increase in business efficiency and labor productivity - "strapped by tight credit and plummeting sales, businesses have overhauled the way they manage supply chains, inventory, production practices and staffing. Stores don’t order merchandise unless they think they can sell it right away. Manufacturers and builders don’t produce unless they have buyers lined up... this (is) a paradigm shift and... it’s permanent."

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