The GDP report and Okun’s Law

August 2, 2010

One of the mysteries of the Great Recession is why unemployment rose so far so fast. The usual rule of thumb, Okun’s Law, called for a much lower rate of joblessness.  The White House has been hoping that as the economy turned around, the labor market would outperform just as it underperformed during the downturn.  As it turns out, the downturn was deeper than first thought, so the “snapback” scenario is less likely. This from JPMorgan:

The revisions incorporated in last Friday’s GDP report go part way toward resolving two puzzles concerning the recent recession and recovery.

First, the unemployment rate had arguably looked too high relative to the decline in output experienced over the course of the recession. The first chart below estimates an Okun’s Law (the relation between GDP and unemployment) through 2006, and then since 2007 sees what that would predict about unemployment given the revised and pre-revised data.

The pre-revised GDP data implied that the Q1 unemployment rate should have been about 8.7%, the revised data imply it should be 9.1%. Both estimates fall short of the 9.7% unemployment rate actually experienced that quarter, though the newer data close about half the gap.

The forward-looking implication of partly resolving this first puzzle might be seen as negative, as some had argued that the excessive increase in the unemployment rate meant companies over-fired and that a snap-back is coming. The over-firing argument now looks less compelling. (To be sure, we’ve never found any tendency for Okun’s Laws errors to subsequently reverse themselves).

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