John Hussman: Based on Okun's Law Obama's Stimulus Plan May Fall Short

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.

Comments

[Hefaistos:]

Regarding the last paragraph, that consumers change their preferences for more savings in times of crises is a well known pattern. The most famous example is Sweden, which at the end of 1980's had a slightly negative savings rate. Then a banking crisis erupted, and over the course of only two years, the savings rate rose to a whopping 8%. That of course put an enormous drag on the real economy, since what is saved, isn't consumed. We now see a similar development in the US.

Jan 26 01:37 PM

[gorgo54:]

John, Several things that are missing from your piece; the effect of declining household wealth, stock portfolios, etc.in other words, asset devaluation, the overall decoupling of productivity and wage growth over the past few decades which resulted in significantly slower growth in real wages which was "made up for" by the past increases in asset value, overall reduction in wages that are now happening as businss slows, reduction or elimination of bonuses and raises, and finally the income recution resulting from those with higher paying jobs forced lower paying work elsewhere for various reasons.

As a personal example, my business - I am self-employed - has fallen 15% for 2008, including the 50% drop in the last quarter. Ouch. Normally I could have taken care of the shortfall with the help of the large amount of equity I USED to have in my home. This is no longer the case as home values have dropped precipitously. So instead of using my idle time and equity to significantly remodel my house and/or purchase new equipment and software for my business in anticipation of the up turn, I am left with the possibility of having to sell my house, using as little of my resources as possible to do mostly cosmetic work to make it ready for sale, I'll be left with little surplus to make any significant business investment as any remainder will be saved as a hedge for the slow times, which may be significantly long-term given the depth of the problems.

Next time the GOP brings out the twin Santa Clauses of massive deficit spending and tax cuts (along with deregulation), I say shoot 'em.

Jan 26 02:28 PM

[Al-USA:]

Good article.

So the solution is to protect labor, or people who work for a living. That is, instead of doing everything possible to undermine the working stiff, as has been the case for at least the last 30 years, when the dismantling of labor unions started and the export of high paying jobs where shipped overseas...

Increased job security will make people want to strive more, make more and consume more. However, we should put a stop to the derivatives model builders or CDO salesmen who, along with their financial aristocratic masters, drove the world off a cliff...

Jan 26 03:38 PM

[jgonion:]

With regard to Okun's rule of thumb, the key words are "is accompanied by", not "causes". This article appears to make the assumption that unemployment somehow *causes" a reduction in DGP: ("underestimates the economic impact of job losses").

On the contrary, unemployment is a lagging indicator of economic activity. Unemployment typically begins to rise *after* the economy slows, and usually continues to increase after the economy has turned around (Usually peaking 18 months *after* the bottom of economic activity.)

So rather than worrying about the "economic impact of unemployment", we should be worrying about the job losses that will be caused (18 months from now) by the downturn in economic activity.

Jan 26 10:27 PM

[Danny Newton:]

I think there is a signifigant demographic distortion due to the aging baby boom population that is going to make rules of thumb more dangerous to apply. What is natural with respect to the unemployment rate is not a constant or fixed percentage.

Jan 27 03:34 PM

[Cardio:]

In practice savings are invested. Very few people "save" by stuffing hard currency in pillow cases. So, saving only becomes a "drag" on economic activity if the savings cannot find a productive investment outlet within the economy from which the savings is drawn, true?

If so, then if savings actually causes drag it is because those savings are being invested in foreign markets, as an example, where it is deemed to be more productive.

I'm not an expert, but it seems logical that saving does not evaporate money from circulation, it simply redirects it from consumer spending to business investment. True? Or am I full of nonsense?


On Jan 26 01:37 PM hefaistos wrote:

> Regarding the last paragraph, that consumers change their preferences
> for more savings in times of crises is a well known pattern. The
> most famous example is Sweden, which at the end of 1980's had a slightly
> negative savings rate. Then a banking crisis erupted, and over the
> course of only two years, the savings rate rose to a whopping 8%.
> That of course put an enormous drag on the real economy, since what
> is saved, isn't consumed. We now see a similar development in the
> US.

Jan 28 02:22 PM