Is Okun's Law Really Broken?

“Okun’s law” is a much-loved rule of thumb — it links increases in the unemployment rate with decreases in output.? The red dots in the chart below illustrate?Brad DeLong‘s version of this rule, which relates the change in output over the past eight quarters with the change in the unemployment rate.? Most of these dots lie pretty close to the dashed line, which suggests a stable relationship.? Based on this rule, and the relatively mild decline in measured output, you might have expected the unemployment rate to have risen by 3.5 percentage points over the past two years, to about 8 percent.? But the dots at the top left show what actually happened-unemployment rose by something closer to 5.5 percentage points, and the unemployment rate is closer to 10 percent.? That’s a big difference.? And it has led?many commentators to ask whether Okun’s Law is broken.
But perhaps the problem isn’t Okun’s Law.?? Perhaps the problem is how we measure output growth.? In fact, there are two measures of output growth-the usual measure, which adds up total spending in the economy, and the alternative, which adds up total income.? In theory, the two should be exactly the same. In practice, they have been very different during this recession.? The blue dots show recent changes in this alternative measure of output.? These GDI numbers suggest that output growth actually declined much more sharply than had been widely understood.? Based on this alternative measure, the recent sharp rise in unemployment is no mystery at all. (Indeed, the 2008 data suggest that the real mystery may be why it didn’t rise faster, earlier.)

There’s a simpler way to show all this: Let’s map out Okun’s Law using this alternative income-based measure of output.? That’s what is shown in the figure below.? The rise in unemployment seems quite consistent with these alternative output data. If anything, the puzzle now appears to be why unemployment didn’t rise by more in early 2008, given the very weak state of this income-based measure of output.

What’s good news for Okun’s law, though, is bad news for the economy.? This alternative measure of output growth suggests that the recession may have been deeper, and longer-lasting than previously thought, although data for the fourth quarter aren’t yet available. While many economists believe the recession ended in the second quarter of 2009, this income-based measure of output kept shrinking in the third quarter, too.? And while the expenditure-based measure is back to its level from the third quarter of 2006, the income-based measure suggests that output is still 3.5 percent below that level.? That’s a pretty big hole to dig out of.
Which is the right measure of output to focus on?? It’s still an open question, but some?interesting recent research by the Fed’s?Jeremy Nalewaik suggests that we should be thinking harder about the income-based measure. And Jeremy has promised further new results, which he’ll present at the?forthcoming Brookings Panel.