Spinning Okun's Law

It’s the season for debating the effects of a historic increase in government spending on the economy.

The proposal on the table from Obama, is to increase government spending by about $775 billion over the next two years. About $300 billion of this would come as tax cuts of various kinds, and the rest as handouts to state and local governments and pork-barrel spending.

Why are we doing all this? Well, to make the economy better, of course. But precisely what does it mean to “make the economy better”?

I told you yesterday that, although the global economy and the global financial system face deep, systemic imbalances that have nothing whatsoever to do with the business cycle, the perception by policymakers and ordinary people is very different. The common view is that our biggest problem is an economic recession. And even more specifically, an increase in unemployment that results from reductions in industrial output, or GDP.

As I said, the whole situation is being oversimplified as a need to change two widely-reported statistics. The objective of the largest proposed increase in government spending for decades is not to do anything long-term positive for the the economy. Rather, it’s to increase reported GDP and to reduce reported unemployment.

So in this context, let’s try to understand the claims that are being made by advocates of increased spending. (I’ll leave for another time the issues of increased national indebtedness, misallocated resources, and increased government control over the economy, since the neo-Keynesians have already told us that we should sweep those effects under the carpet for now.)

The basic theory is contained in something called Okun’s Law. This is the empirical relationship between real GDP and the unemployment rate. In plain language, Okun posits that a 1% change in the unemployment rate is correlated with an inverse change of between 2% and 3% in real GDP.

Note that there’s nothing causal or even rigorously theoretical about this relationship. It’s just an observation obtained by regressing historical US data over the last fifty years or so. This hasn’t stopped even Nobel-Prize winning economists from invoking it to justify a massive increase in government spending.

Here are two ways this might work.

First, look at the current rate of economic contraction. We have yet to see any statistics for the fourth quarter of 2008, but it’s plausible that US GDP contracted at an annual rate of anywhere from 3 to 6 percent in Q4. Let’s suppose this rate will continue through 2009. Starting from today’s already-high unemployment rate near 7%, you could use Okun’s Law to project a future unemployment rate of anywhere from 8% to 10%.

The other view is to add fiscal stimulus to the mix. Let’s say the government borrows and spends an additional $400 billion in each of the next two years. There’s a lot of controversy and a lot of fudging over the exact multiplier that should be used to project the effect of this spending on GDP. That matters a lot, so I’ll come back to it in a moment.

Let’s say the multiple is something like 1.25, a number which is as arguably plausible as a range of others. That turns $400 billion in fiscal spending into $500 billion of GDP, an increase of about 3.5%. By Okun’s Law, you’ve automatically reduced unemployment by an amount that could be near to 1.5%.

And then a year from now, you (meaning Obama, Congressional Democrats, and the Keynesian pundits) declare victory over unemployment. If the actual rate turns out to be a number like 9%, you say that it would have been 10.5% without the stimulus, and that you “saved or created” about 2 million jobs.

Keep in mind how this is all working: we’re using the unemployment rate as a fully-regressed proxy for all that is good and well in the body-politic of the United States. If you can say that you kept unemployment lower than it would have been this year, then you’ve done what you had to do. And if you can plausibly say that someone evil (for example, Senate Republican leader Mitch McConnell) prevented you from decreasing the unemployment rate further, that’s a political bonus.

That’s why the advocates of higher government spending are already starting to lower expectations. They’re already saying that the stimulus must be reduced in size, or it won’t be approved by Senate Republicans. But of course, they’ll say that any reduction in the size of the stimulus (or any deviation from the desired mix of spending and tax cuts), will automatically reduce the expected gains in employment.

You’ll be told a year from now, by people who fully expect that they can snow you with economic jargon, that Republicans are to blame for high unemployment.

But there’s a lot wrong with the analysis, besides the inappropriate use of empirical rules-of-thumb by highly-credentialled professional economists who should know better.

We’ve been told by Obama that nearly half of his proposed stimulus will take the form of tax cuts. This gets us back to the multiplier effect of government spending on GDP.

Straight government spending on pork-barrel projects (also known as “critical infrastructure to make America competitive in the 21st Century”) is often assumed to multiply by about 1.5. You get half again as much GDP growth from a given amount of spending. Tax cuts are said to be considerably less efficient at goosing GDP.

This is fine as far as it goes. But I think that the multipliers of either spending (which ultimately functions as a money gift to unionized labor) or tax-cutting are greatly overstated in the current economic environment.

Why? Simply because there has been a sea-change in America’s consumption habits. For at least the foreseeable future, Americans will be much more interested in saving up their money than in consuming it. If you contrive to put money in their pockets, they’ll save more of it in the bank than you probably expect. And those savings will disappear inside the liquidity trap that’s keeping private credit from being formed in the US today.

That means the effect of government stimulus on GDP growth will be muted. And because the stimulus will do far less than expected to increase actual consumer demand, it means the Okun’s Law effect on unemployment will be muted as well.

But none of this will be evident from the reporting that you’ll hear over the next two years. We’ll be told that the stimulus worked, but should have been far bigger than it was. You’ll hear not that the stimulus didn’t actually do what it was supposed to do, but rather that the problem turned out to be far bigger than even our worst-case scenarios anticipated.

And next year, they’ll be back for a whole lot more stimulus.

This isn’t good, people.