One of the great mysteries surrounding the US economy is the seemingly inexplicable discrepancy between the plunging unemployment rate on one hand, which at 5.1% in August was the lowest since April of 2008 – a data point which on the surface would suggest virtually no slack in the labor force – and the crawling pace of growth of the broader economy, on the other hand, namely the deterioration in US output and labor productivity, and the constant failure of wages to actually grow despite constant predictions by economists and pundits over the past 5 years that “wage growth is just around the corner.”
This relationship has had a name since 1962 when Arthur Melvin Okun first observed the empirical relationship between unemployment and losses in a country’s production. It is called Okun’s law.
In theory, the original statement of Okun’s law said that a 2% increase in output corresponds to a 1% decline in the rate of cyclical unemployment; a .5% increase in labor force participation; a .5% increase in hours worked per employee; and a 1% increase in output per hours worked (labor productivity). Okun’s law states that a one point increase in the cyclical unemployment rate is associated with two percentage points of negative growth in real GDP. The relationship varies depending on the country and time period under consideration.
As the chart below shows, the “Okun Law” relationship has been one of the empirically observed mainstays of the US economy, with the real GDP growth rate constantly superimposed on top of the inverted unemployment rate… until 2010 when something snapped.
To be sure, both we and others have commented on the unprecedented discrepancy between the “strong” economy dictated by the unemployment rate, and the “weaker” economy signaled by virtually every other indicator, certainly the annual growth rate of US GDP, which in Q3 rose 2.7% from a year ago.
Back in 2012 we first asked “Is Okun’s Law The Latest Casualty Of Central Planning” (incidentally, the answer is yes). Then several months later it was the turn of WSJ’s Jon Hilsenrath to follow up on our observations with his own question: “How can an economy that is growing so slowly produce such big declines in unemployment?”
Something about the U.S. economy isn’t adding up. At 8.3%, the unemployment rate has fallen 0.7 percentage point from a year earlier and is down 1.7 percentage points from a peak of 10% in October 2009. Many other measures of the job market are improving. Companies have expanded payrolls by more than 200,000 a month for the past three months, according to Labor Department data. And the number of people filing claims for government unemployment benefits has fallen. Yet the economy is barely growing. Many economists in the past few weeks have again reduced their estimates of growth. The economy by many estimates is on track to grow at an annual rate of less than 2% in the first three months of 2012. The economy expanded just 1.7% last year. And since the final months of 2009, when unemployment peaked, the economy has expanded at a pretty paltry 2.5% annual rate.”
Fast forward to September 2015 when the same questions keep popping back: in fact, since 2013 the economic slowdown has only grown more acute manifesting itself in last week’s failure by the Fed to hike rates: a direct confirmation that nothing with the US economy is as strong as the 5.1% unemployment rate suggests.
In the meantime, our conclusion from our June 2013 take on “Broken Okun” is still applicable:
Something is way off: either the unemployment data is very much wrong and the real unemployment rate is far higher especially when normalized for the collapsing labor participation rate and the surge in part-time and temp workers, or the GDP calculation is incorrect and the economy is growing at a 4%+ rate. (It isn’t). The scarier implication is that in addition to all other seasonally adjusted economic data points which have become painfully unreliable, daily Treasury tax receipts must also now be added to the docket of meaningless and corrupt data points. The question of just how the Treasury could explain a massive (and deficit boosting) cash discrepancy could only be answered if somehow the Fed is found to be parking cash directly into the Treasury’s secret basement.
But that would be very illegal…
Obviously, the US economy is not growing at a 4% pace, although following next month’s wholesale revision of the GDP calculation which will include the benefit of intangibles, we wouldn’t be surprised if the BEA and BLS push the country’s entire economic reporting apparatus fully and entirely into wonderland, and absolutely every economic number is no longer accurate, relevant or unmanipulated.
Two years later, the BEA did indeed push the country’s economic reporting aparatus into wonderland when it decided to “adjust away” winter weakness by double seasonally adjusting the GDP, thus making it the latest utterly meaningless data indicator.
Still, the BEA will have to do much better to “unbreak” Okun again.
In the meantime, we decided to conduct an exercise in which we assumed that Okun is in-fact not broken, and that as a result of political pressure US employment data has been massaged. We then superimposed the annual growth rate of US unemployment (indicative of 4%+ growth in the past 5 years) to be in line with the actual change in real GDP growth, roughly half that number.
This is how such a collapse in the divergence between the unemployment growth rate and GDP would look like.
What does the above “fitted” chart mean for US unemployment, especially in the epic decoupling period that started some time in 2009, just as the labor force participation rate imploded? It means the following: instead of a 5.1% unemployment rate in August, the true unemployment rate in the “land of the free” has been rising ever since the financial crisis, and has been above 12% for the past three years.
So, dear Janet Yellen, there you go. If you are still confused why there is still so much slack and so little wage growth in the economy despite the 5.1% “reported” unemployment number, now you know the answer.
And since the Fed is supposedly contemplating tightening monetary conditions, if indeed the true, unmassaged for political reason unemployment rate is just above 12%, you may want to reconsider that rate hike.
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