Excerpt from the Hussman Funds' Weekly Market Comment (1/26/09):
Several decades ago, economist Arthur Okun proposed a relationship between GDP growth and unemployment that came to be known as Okun's Law (or at least Okun's rule-of-thumb). Okun proposed that every 1% deviation in unemployment from its “natural” rate is accompanied by a 2-3% reduction in GDP. Current Fed Chairman Ben Bernanke and economist Andrew Abel re-estimated that relationship in 2003, and suggested that U.S. GDP declines by about 2% for every 1% increase in the unemployment rate. Since the “natural” rate of unemployment can't be observed, Okun's Law is typically expressed as a deviation from the long-term trend of real GDP, which has been about 3% annually. So a 1% increase in unemployment over the course of a year would be associated with GDP growth of about 1% (3% trend – 2 x change in unemployment), while a 1% increase in unemployment over the course of a single quarter would be associated with quarterly GDP growth of about -1.25% (0.75% quarterly trend growth – 2 x change in unemployment) or roughly -5% at an annual rate.
The U.S. unemployment rate surged by a full percent during the fourth quarter of 2008, from 6.2% in September to 7.2% by year-end. Yet even this slightly underestimates the economic impact of job losses because the civilian labor force participation rate also dropped by about 0.3%, making the overall contraction in employment activity the worst since the second quarter of 1980, when GDP declined by 2% (an 8% annual rate). It will be important to remember this week that relatively small differences in quarterly economic performance will be magnified in the headline numbers, which invariably quote growth figures at an annual rate.
In the coming days, Congress will contemplate an economic stimulus plan that is expected to approach $825 billion in size. Economist Paul Krugman recently used Okun's Law to estimate the impact of the proposed plan, concluding “This really does look like a plan that falls well short of what advocates of strong stimulus were hoping for.”
For my part, I tend to lean away from the Keynesian view that sees recessions as times of inadequate “aggregate demand.” Rather, recessions are essentially times when there is a mismatch between the mix of goods and services demanded by individuals in the economy, and the mix of goods and services that was previously supplied. The clear area of mismatch here is in housing, as well as various sectors of the economy that have made a business of irresponsibly increasing the debt burden of the nation (including mortgage companies, investment banks, and other purveyors of leverage). Those mismatched sectors are experiencing enormous losses, as they should. The job of economic policy is to ease that transition in a way that reduces the spillover onto the broader economy.
However the fourth-quarter data comes in, it is clear that about 99% of the workers who had jobs at the beginning of the quarter still had jobs at the end of the quarter. About 98% of the economic activity that was proceeding at the beginning of the quarter continued to proceed at the end of the quarter. From that perspective, the problem isn't that the economy as a whole has lost an enormous amount of purchasing power.
The retrenchment of economic activity and consumption that we're observing isn't explained by lost income among the majority of consumers, but rather because of increased risk-aversion and defensive saving. Generally speaking, American consumers aren't slowing consumption because of falling labor income. Rather, they are slowing consumption because they are protecting themselves from uncertainty and attempting to offset the impact of investment losses. Adding to this is the difficulty of obtaining credit, because of risk aversion among lenders. To try to 'stimulate' people to spend and consume more is to miss the point. What the economy needs most is to mitigate the impact of foreclosures and the credit stress in the financial system that triggered this risk aversion in the first place.