In 1962 the Council of Economic Advisers (CEA) to U.S. president John F. Kennedy (1917–1963) was trying to persuade him to stimulate an underperforming economy. Council members explained that the actual output of the economy was far below its potential or full-capacity output level. As a result, unemployment was excessive. An economy with high unemployment was not only socially unjust and oppressive, but also wasteful and inefficient. The unemployment rate was only the tip of the iceberg of a depressed economy troubled by enforced part-time work, lost overtime and promotion opportunities, discouraged job seekers, greater poverty, declining productivity, and rising government deficits. While there appeared to be a strong case to persuade policymakers of the benefits of reducing unemployment, there was only conjecture about the magnitude of the likely output and income gains. A more precise estimate of these gains was needed to clinch the argument.
The CEA settled on 4 percent unemployment as consistent with potential output. The issue was then how to use this unemployment figure to work out the value of the gap between actual and potential output that needed to be closed. The economist Arthur Okun (1928–1980), then working for the CEA, found a good shorthand approximation for the complicated interaction between employment and output: there was a three-to-one link between output and the unemployment rate so that each extra percentage point in the unemployment rate above 4 percent was associated with a 3 percent fall in output (or real gross domestic product [GDP]). This then yielded the following relationship:
P = A [1 + 0.03 (U – 4)].
So if unemployment (U ) = 4 percent, then potential GDP (P ) equaled actual GDP (A ). If U = 5 percent, the estimated gap between what the economy was capable of producing and what it was actually producing was 3 percent of GDP. This then provided an estimate of how much extra output and income needed to be generated to get the economy healthy again.
The relationship between unemployment and output that Okun had discovered was called Okun’s law. The economist James Tobin (1918–2002) regarded it as “one of the most reliable and important empirical regularities of macroeconomics” (Perry and Tobin 2000, Preface), and it provided a major part of the empirical justification for Kennedy’s tax cuts to stimulate the economy (Prachowny 2000). Okun’s law did not have precise theoretical underpinnings. It was a widely used rule of thumb. Okun had tried alternative ways to estimate the relationship but always got roughly the same answer, and he was delighted how well it stood up over time.
High-output growth is typically associated with a fall in unemployment as firms hire more workers to produce output. However, output growth must at least cover the natural increase in the labor force and the increased productivity of labor to prevent unemployment from rising. Output needs to grow in excess of this rate in order to reduce unemployment. Yet there may be lags in the relationship so that even if output growth rises, firms may delay new hiring until they are certain that the increased growth will persist. Furthermore, the nature of the unemployment will determine how easily it can be absorbed into new work opportunities. If it is cyclical unemployment (associated with temporary layoffs), then it will be absorbed more rapidly than structural unemployment (associated with jobs permanently relocated elsewhere in other industries or with a different skill mix). Even then an increased labor force participation rate, from those formerly outside the labor force, will mean that unemployment may not immediately fall. The relationship then is a very complicated one, and Okun’s law is only a rough forecasting tool.
Okun’s relationship will vary from country to country and over time. Empirical studies suggest that the Okun’s law coefficient increased over the 1981 to 2000 period compared to the 1960 to 1980 period. International comparisons find that the coefficient varies considerably across countries, with Japan in particular being an outlier, reflecting the different labor market arrangements in that country. Research has also focused on getting better estimates of the relationship using more sophisticated econometric techniques and alternative empirical specifications, and correcting for various biases in the estimation. Other studies have concentrated on breaking the relationship into its component parts or have used different measures of unemployment, such as the constant weighted unemployment rate, to account for differences in the composition of the labor force. Various lagged output measures have often been used. Some studies claim that the output-employment ratio is asymmetric; in other words, cyclical unemployment is more sensitive to falls in output growth than increases. There are even skeptics who dismiss concepts such as potential output, the output gap, and the full-employment target altogether and argue that governments should not be in the business of actively managing the economy.
Paul Samuelson acknowledged Okun as the wisest and most creative economic policy adviser of his time. Edmund Phelps called him the foremost practitioner of macroeconomics in the United States. Okun attempted to translate theoretical ideas and concepts into operational guides or computational shortcuts that would be of direct use to policymakers. His widely used rule of thumb has remained one of the most enduring stylized facts in macroeconomics. It continues to attract the interest of applied researchers and features in most macroeconomics textbooks, and it is through this “law” that generations of students come across Okun’s name.
SEE ALSO Productivity; Unemployment
Lodewijks, John. 1988. Arthur M. Okun: Economics for Policymaking. Journal of Economic Surveys 2 (3): 245–264.
Pechman, Joseph A., ed. 1983. Economics for Policymaking: Selected Essays of Arthur M. Okun. Cambridge, MA: MIT Press.
Prachowny, Martin F. J. 2000. The Kennedy-Johnson Tax Cut: A Revisionist History. Cheltenham, U.K.: Elgar.