Okun’s law

The relationship between unemployment and growth

What is the relationship between economic growth and unemployment? Okun's law provides an answer to this fundamental question.

Arthur Malvin Okun, an American economist, economic adviser to President Kennedy and professor at Yale University is one of my favourite modern economists, because Okun’s law is both simple (which is rare in Economics) and solid.

What is Okun’s law?

Contents

Okun's Law establishes a relationship between the rate of growth (GDP) and the variation in the rate of unemployment. It determines that a GDP growth higher than 3% on average is needed to lower unemployment. This rate varies depending on the country, because it depends on two factors: growth of the labour force and labour productivity.

In fact, the labour force is not stable (as population demographics has a direct impact on employment), if it increases by 1% per year, product growth must also increase by 1% for unemployment to stabilise, and new entrants to the labour market to be "absorbed".

Identically, labour productivity normally increases each year (technical progress, training of personnel, more and more "effective” management, etc.). If productivity increases by 0.5%, growth needs to increase by the same value to stabilise unemployment.

Okun's Law and the French example

In France, GDP growth currently needs to be higher than 1.9% for unemployment to decrease.

According to the National Institute of Statistics and Economic Studies, between 1990 and 2007, annual hourly productivity increased by 1.7% on average. This was an average annual increase of 0.9% of the labour force and an annual decline of 0.7% in working hours (Reduced working time indirectly creates jobs) which limits the damage (1.7+09-0.7=1.9).

To sustainably reverse the unemployment curve, the French economy must therefore grow at a rate above 1.90%. There is a long way to go... unemployment is endemic, the fantasy of full employment is a distant memory.

What are the consequences of Okun’s law?

It is understandable that for unemployment to fall there must be strong economic growth, because growth needs to exceed the increase in the labour force and labour productivity.

We can look at a few quick ideas:

1) Low or moderate economic growth will not reduce unemployment, but there can be a "paradox" where the economy is in good health, with 1.5% growth and a relentless increase in unemployment.

=> With all due respect to Chancellor Schmidt whose moto was "today's profits are tomorrow's investments and the jobs of the day after tomorrow", which was the basis of the German economic miracle of the 1960s and 70s, this unfortunately is no longer valid.

2) Increase in productivity is bad news for employment (we need fewer people to produce the same). Increase in productivity is touted by our politicians for "competitiveness", thereby destroying jobs, but this is obvious.

3) Reduction in working hours (in fact, increased flexibility) has perhaps helped to limit the damage in terms of employment (-0.9% in the French example), reductions in working hours automatically create jobs but it also promotes increased productivity (reorganisation, increases in part-time employment, etc.). This change generally remains more favourable for the company than for the employee even if it is difficult to determine.

4) Unemployment is falling in Germany because of its reduced labour force, France needs to create more than 100,000 new jobs every year just to keep up with increases in its labour force. It is paying the price for high demographics, numerous children will automatically become the numerous unemployed (or more specifically the numerous job applicants). On the other hand, when Germany creates 100,000 jobs that largely means 70,000 fewer unemployed people.

In parodying Schmidt, “today’s children are the social costs (education, nurseries, etc… which are not "profitable") of tomorrow and the unemployed of the day after tomorrow". Low demographics is one of the most efficient and simple solutions in the medium term for reducing unemployment and stabilising debt, because a child is expensive to the state (a pupil in secondary school= €12,000 / year) and most graduates (those who have cost the most, with studies at University) will often seek work abroad. In a closed economy, education is a good investment, but if our researchers, engineers, etc. go to look for work abroad, we pay fully for their training and recover nothing. The USA and Canada are well known for welcoming young graduates with open arms (zero investment, maximum profitability).

5) The general public still knows little about Okun’s law, because it is not in politicians’ interest that their citizens become aware of it, because the ultimate conclusion is that full employment becomes a myth in an open, modern economy unless a Malthusian demographic policy is accepted. In short, a world without a great deal on the horizon for 90% of the population in OECD countries.

What are the limitations of Okun’s law?

Jim Lee’s work shows the effectiveness of Okun's Law for OECD countries, numerous additional studies in countries such as Mexico, Malaysia, etc. say the same thing.

Okun’s coefficient

Using Okun’s law, we can calculate Okun’s coefficient. This enables us to calculate broadly how many jobs are created when the critical threshold (+1.9% for France) is crossed. What is interesting is that Okun’s coefficient for France was 0.19 between 1970 and 1989 compared to 0.57 currently. This means that for each 1 point in growth above the critical threshold, France will create 3 times more jobs than in the years 1970 to 1989. A very good sign if we draw hasty conclusions.

In fact, this indicates French society’s movement towards greater flexibility in the labour market: if there is an economic upturn it potentially creates 3 times more jobs than before, but this is because employees were laid off more quickly.

This coefficient may be understood as follows: Businesses hire more when there is increased production, but they lay off more quickly when there is any difficulty: the same rate of growth therefore currently has a more significant impact on the unemployment rate than 20 years ago, both upward and downward, a sign of the acceleration of our globalised world.

Sources:

Arthur Okun, Potential GNP: Its measurement and significance, American Statistical Association, Proceedings of the Business and Economics Section, 1962