Guest Post: It's Far Deeper Than Broken Okun

Tyler Durden's picture

Submitted by Jeff Snider, President & CIO, Atlantic Capital Management

It's Far Deeper Than Broken Okun

ZeroHedge’s post on the apparent breakdown of Okun’s “Law” (http://www.zerohedge.com/news/okuns-law-latest-casualty-central-planning...) highlights the ongoing tragicomedy of how the science of central economic planning eventually confounds, and then consumes itself.  Economics is, after all, a social “science”, an elaborate study of human beings and, most importantly, human interactions.  Robert Okun, for his part, merely observed in 1962 that when “output” (whatever statistical measure is en vogue) rises by 3%, the unemployment rate seems to fall by 1%.  For some reason, economics assumes that if it is true in the past, it will be true forever, so it was written into the canon of orthodox economic practice.

Economics has inferred causation into that relationship, giving it a layer of permanence that may not be warranted.  Econometrics has always had this inherent flaw.  The science of modern economics makes assumptions based on certain data, and then extrapolates them as if these assumptions will always and everywhere be valid.  There is this non-trivial postulation that correlation equals causation.  In the case of Okun’s Law, it seems fully logical that there might be causation since it makes intuitive sense – more economic activity should probably lead to more jobs, and vice versa.  But to assume a two-variable approach to something that should be far more complex is more than just dangerous, it is unscientific. 

In fact, Okun’s Law has already been adjusted somewhat, most famously by Ben Bernanke and Andrew Abel in their 1991 book.  It was upgraded to a 2% change in output corresponding with a 1% inverse change in unemployment.  Apparently with the economic “success” of that period, Okun needed a re-calibration.

Any such academic exercise means a careful review and study of the time series of economic data.  Most of these academic papers focus on finding a new regression or other statistical relationship that better “fits” erstwhile independent variables into each other’s gravity.  As it was with Bernanke and Abel, Okun’s law in 2000, updated by the new data set of the Great “Moderation”, needed to harmonize with the new data series of the 1980’s.  Bernanke and Abel were not disagreeing with Okun, rather they were measuring some of the additional complexity that goes into the relationship between output and employment.

The academic sense of understanding the economy requires ceteris paribus.  In order to make econometric models manageable and statistically meaningful, complexity has to be trimmed and managed.  It is far easier to incorporate simple relationships that appear to work over specific periods of time than to try to estimate the massive and dynamic complexity that the real world exhibits.  The grand mistake of economics is this sense of permanent simplicity.

In terms of broken Okun, simplicity has meant that it only measures the quantity of jobs.  Okun’s practitioners assume, ceteris paribus, that a new job is a near-perfect substitute for an existing job (or a lost job from the current dislocation).  In the case of job growth since the recession trough in 2010, though, “new normal” jobs are not perfect substitutes for lost bubble/artificial jobs.  Newly created employment just does not produce the same wage income as the previous bubble paradigm (a lot of this disparity can be seen by the greater proportion of part-time jobs, far more than economic models predict).

This complexity and nuance extends even beyond wage income.  A job in the preceding artificial period also meant easy access to cheap credit money.  So job growth during the twenty plus years previous to 2007 meant both wages and available credit money (NINJA were not marginally significant until the very late bubble period).  New jobs in 2010, 2011, or 2012 (and likely beyond) not only produce less wage income, there is no additional boost through credit, and therefore less marginal economic activity per new job unit.  So numerically, the number of jobs, unqualified by any additional measurements, has grown without living up to the expected output growth (of course there are other factors as well, especially the negative effects of ZIRP on savers and the corporate preference for financial innovation over productive innovation, as well as the negative effects of commodity prices acting out central bank inflation expectations, but those would mean that money itself has changed in terms of how it relates to the economy – the academic sense of velocity – which should lead to all sorts of soul searching among monetary policy planners).  On an apples-to-apples basis, new employment simply does not and cannot match the artificial boost of the preceding period, so a simple number quantification is less than useful.  

Instead of questioning these simplified relationships and laws, mainstream economics attempts to explain all of this through a hugely negative output gap (in other words, the theories are correct, the results are flawed).  Believing that past relationships still hold on largely untransformed terms, they believe that the economy should be growing much faster than it has.  To make up that massive gap, the Fed embarks upon its real dual mission of making sure no large credit creators ever fail (money elasticity) while pushing investors into “risk” (and out of the supposed paradox of thrift) by making safety or saving expensive.  The Fed keeps banging its head against the wall, trying greater and more costly interventions all in the vain attempt to close the theoretical output gap that does not really exist (results over theory).  If economics would see that the previous paradigm of leveraged wage income is what is permanently broken (along with economic circulation through asset inflation, commonly known as the wealth effect), it might be able to conclude that the Great Moderation was really nothing more than artificial growth that won’t be returning.  Then punishing the economy through intervention might be seen as counterproductive as it has really been.

If that artificial paradigm is now past tense, then so many of the “laws” upon which the social science of economics rests should also be rethought.  This is particularly true since mainstream economics (especially econometrics) “grew up” during the Great Inflation and Great “Moderation” – the very periods of over-active central banking and credit production.  Just because a relationship held during that specific time period does not mean it should then be extrapolated through all time.  Economics is not physics, what seems to hold today may not hold tomorrow (this should be very apparent when a theory or set of beliefs fails to exhibit predictive ability).  The real economic world is one marked by dynamic processes that are not well understood by academic theories wedded to their elegant, but ultimately static, mathematical constructions.  Structured finance and securitizations, as an example, worked extremely well under static assumptions (such as real estate prices only move in one direction), but once the dynamic world moved beyond statistically assumed financial tolerances it was a total disaster.  The paradigm shifted but the theories and causal assumptions did not until after it was all over – again, not a very scientific result.

Economics should be undergoing a more rigorous examination of its philosophical bonafides, especially since it has shown very little predictive capacity (hard science needs to be both predictive and replicable, a standard economics has not, nor will ever, meet).  The foundations of mainstream economic thought should be shuddering at the prospect of being so wrong so often.  Every assumption and relationship should be re-evaluated as to whether it was really true in the universal, timeless sense, or whether it was simply captured by a specific pattern in a defined and limited data series (such as the over-worn trope that low interest rates are always stimulative).

For impartial observers, there was a rather clear demarcation between the “new normal” of this recovery and the artificial bubble period, turbo-charged by trillions in securitized debt, that preceded it.  Okun’s law is not broken, it was simply never a law or rule of thumb to begin with.  Bernanke and Abel were probably correct that a 2% output change led to a 1% inverse change in unemployment at the time they wrote their book.  The hubristic mistake of modern economics is believing Okun, and every other economic law, to be a universal property of all economic systems at all times.  The world is more complex than that, and capable of changing in ways that cannot be oversimplified.  Sometimes correlations are coincident to larger interactions and patterns, and not causation at all.

Real estate prices do, in fact, go down as well as up.  Low interest rates do not always stimulate economic activity.  Most importantly, economic potential is not simply a measure of economic output from 2003-2007.  Every economic and monetary intervention (all that ails this current economic age) flows from this mistake of oversimplification and pattern bias.  There would be no need to punish savers.  There would be no special place afforded to the oversized behemoths of credit production and finance.  Hell, there would be no place for the overgrown financial economy to begin with if economists would admit that the world does not easily fit within the Garbage In Garbage Out confines of mathematically modeled oversimplifications. 

The biggest simplifying mistake in economic history was believing that a centrally planned, debt-based economy was a near-perfect substitute for a real capitalist economy, working bottom-up through unfettered price discovery, that values real production.  That such soft central planning apparently worked during the Great Moderation is nothing more than pattern bias, a flawed theory captured by a unique data set of oversimplified variable relationships.  The fact that it is all breaking down now is solid evidence of that paradigm shift, an invalidation of previous assumed causal relationships, not some ephemeral headwinds. 

Economics is really nothing more than opinionated interpretations and analysis.  But this kind of subjectivity does not jibe with central planning.  Economic control is much easier to accomplish if it is conducted under the veneer of objectivity and science, especially when your marginal goal is historic impoverishment through debt.  Although, that might be too harsh for most economists since they simply believed their own theories, including the idea that the marginal pace setter of artificial economic activity, asset price inflation, only moves in one direction.  Their scientific observations of the Great “Moderation” told them so, and so they remained captured by their own work.  The fact that an entire asset class had collapsed during all that moderation should have been a huge and unmistakable warning to economists to truly observe and learn the dangers of extrapolation and the short-comings of trying to create a science out of pattern bias and oversimplification before deliberately charting a course for historic impoverishment.  But even that oversimplifies what might really be the problem here – that modern economics is not only not a science, it is an ideology.

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lolmao500's picture

Okun law is broken because all the ``growth`` is deficit government spending and ``banking profits`` based on virtual and mark-to-unicorn assets.

AgShaman's picture

Virtual and mark-to-unicorn assets?

Is that something like painting price targets....soze they know where to shit the skittles for us?

withnmeans's picture

Don't forget this mark-to-unicorn asset process is only possible if you possess pixy dust "printing machines", and a massive amount of green ink and paper, paper, paper.....

Mr Lennon Hendrix's picture

Is the BoJ buying ETFs again or what?  Because that spike on the Nikkei is unreal.  The big money came in half way through the spike too, and at the end.  Unreal.

Silver Bug's picture

I think we can all agree, theres more than just Okun broken.

 

http://ronpaul2012blog.blogspot.com/

sgorem's picture

i love this place. ZEROHEDGE FOREVER BITCHEZ!!!!! Tylers for presidente! and the sheeple fall asleep watching "dancing with.....", "da grammy's".......or whatever........

WonderDawg's picture

Or, as the article stated, it was never a law at all.

StormShadow's picture

Saying that GDP rising 2-3%=1% drop in unemployment makes sense. 

To say that dropping unemployment by 1% by fudging the living shit out of the unemployment #s (as was just done) is gonna result in GDP rising 2-3% is utter nonsense.

geneb's picture

That's what she said.

jerry_theking_lawler's picture

jesus Tyler....where do you find the time....

 

you must have empty red bull and 5 hour energy cans laying all over the place....

LowProfile's picture

There's more than one Tyler, and you seem to have overlooked that this is a guest post.

Kimo's picture

If you think this is good, you should see Tyler's other web site!

non_anon's picture

Okun took over Occam's razor?

bigwavedave's picture

more jobs yes. but in china. doh!

StormShadow's picture

Hell, I'll move to China for a job.  Yeah, wages may be a tad bit on the low side, but hell rent's gotta be damn near free with all the empty apartment buildings they go over there.  Damn, maybe that was their plan all along.  Build it and they will come!

LetThemEatRand's picture

Whether The Bernank is just a useful idiot is open to debate.  But it seems pretty clear that most of the guys who run the world know exactly what they are doing and understand how money and economies work quite well.  They have figured out how to redistribute massive wealth into their private pockets by growing debt in everyone else's.  It's good to be the .01%.

Sophist Economicus's picture

Whether The Bernank is just a useful idiot is open to debate....

 

Tis true, but the fact that you are a most unuseful idiot there is no doubt....Didn't know the union halls were having people work the night shift trolling   LOL

LetThemEatRand's picture

Ad hominem -- how quaint.  Gotta love Randers and their big brains, great ideas and compelling arguments in favor of their ideology.

StychoKiller's picture

Everyone that disagrees with you is NOT necessarily a disciple of Ayn Rand; check your premises.

LowProfile's picture

Correlation does not necessarily imply causation.  Where did I just read that...  Hm...

...Guess he doesn't actaully READ the articles on ZH...  He just trolls 'em!

Mr Lennon Hendrix's picture

He calls out an arguement as ad hom, and then uses ad hom.  HAHAHA!!!  That shit was funny.  You're funny Rand!

LongSoupLine's picture

Any "law" with inferrences to "data" that is inherently not only flawed, but simply outright false, manipulated and manufactured is a law that will quickly be referrenced over to chaos theory.

Hence, we are in Chaos Theory territory with multiples upon multiples of bifurcation points.

In conclusion...silver...bitchez.

Mr Lennon Hendrix's picture

Where the hell is this butterfly everyone speaks of?

LongSoupLine's picture

It's now "Mothra"...in Japan today (how appropriate).

Rincewind's picture

This is all very true and in line with Steve Keen's work. I truly believe that all these economists and financial wizards are just playboys lacking proper scientific and mathematical backgrounds.

It makes me sick and angry how these shitheads run everything to the ground with their flawed theories.

sasebo's picture

Want to see how stupid & incompetent Mr. Bernanke & all the other useless asshole economists really are? Read the paper by Claudio Borio and Piti Disyatat of the Bank of International Settlements, “Global imbalances and the financial crisis”. These guys knocked the shit out of Bernanke last May & he still hasn't been able to respond. Just too stupid I guess.

Any body remember asshole Bernanke's stupid theory about foreign savings causing the 08 crisis? Well Mr. Borio & Mr. Disyatat knock the shit out of that stupidity.   

Mr Lennon Hendrix's picture

The BIS has been calling out Keynesian policy since before the Fall of '08.  The BIS will have the final say.  Interesting though that Bernanke is a shareholder of the BIS.  So is Obama, and Greenspan.

sasebo's picture

Evidently these guys couldn't care less about bernanke owning stock -- they knocked the shit out of him anyway. Still no response.

Mr Lennon Hendrix's picture

Well yeah, they'll leave him hanging on a lampost with a few million tucked in his trousers, so what?  Fiat is nothing to the guys at the top.  They own CORPORATIONS.

sasebo's picture

I just don't understand why no response. Surely B. & others are aware of the paper even though there evidently was a big effort to suppress it. And these are the guys who keep an eye on all the CB's. They aren't just some knuckle heads.

Mr Lennon Hendrix's picture

B thinks he is safe on the inside.  He doesn't know that the devil would sell his brother out for a daydreamOops.

trebuchet's picture

they finger credit creation as the culprit. 

 

The problem with that argument is that credit has been created since double entry book keeping was invented and probably before

 

just like current account and financing imbalances were around for many centuries

 

if only things were that simple the DSGE models would have had those issues to pat long itme ago

 

 

sasebo's picture

I think the point they're making is that there's credit & then there's credit. Like where would all the big banks be without Bernanke creating all the funny money?

valkir's picture

Okun and Occam argue abour razor,with Onan.

Archon7's picture

It's possible to fit straight lines to gentle curves, and still do a pretty good job of predicting things... as long as the curve remains "gentle".  If the curve goes parabolic off one end or the other of the data series your straight line model no longer works.

Caviar Emptor's picture

 

 

SF Fed President Williams: "Vital that we keep the monetary policy throttle wide open"

Yeeeehaaaa!!!

It's gonna be  a biflation jam_bo_ree!!!

And he goes even further:

 

This will help lower unemployment and raise inflation back toward levels consistent with our mandates. And we want to do so quickly to minimize total economic damage. The longer we miss our objectives, the larger the cumulative loss to the economy.

 

http://www.calculatedriskblog.com/2012/02/sf-fed-president-williams-vita...

He and Ben will be fiddling while Rome is burning. And Athens. And Madrid. And Lisboa. Don't forget Damascus, Cairo, Ankara, Bagdad, Muscat, Kabul, Islamabad and a few others. 

Archon7's picture

Sweet jeebus, they want to crash the system.

Mr Lennon Hendrix's picture

I read it wrongly the first run through, but I have had a beer.

This will help lower unemployment and raise inflation back toward levels consistent with our madness.

FreeNewEnergy's picture

New jobs in 2010, 2011, or 2012 (and likely beyond) not only produce less wage income, there is no additional boost through credit, and therefore less marginal economic activity per new job unit.

 

Show some proof, otherwise, your elegant exposition of the world's economic problems are nothig more than neat prose and speculation.

chinaguy's picture

Ouch newbie & FFS review the trend of withholding taxes...in spite of "new" jobs added or the amount of temp jobs added compared to full time - per BLS data - or shit retail jobs added compared to professional jobs lost.

This site assumes you have a modicum of background & does not intend to hold your hand every step of the way.

Not saying you shouldn't call "BS" if the shit sticks, but don't make an ass of yourself.

 

LowProfile's picture

Dude, seriously.  STFU and go read something, like, Idunno... The last three months of ZH.

hyper-critical's picture

Guest posts from Atlantic Capital are always a treat

sgorem's picture

i have only one question about all of this shit, ie., fraudsters, corrupt .gov, banksters, brokers, politicos, dealers, etc., when in the hell is someone going to die?

NorthPole's picture

Not even in Greece has a single member of the political and financial elite been indicted, let alone served time. Hell! Messrs Papademos ( centeral bank chief 1994-2002, personally responsible for the book-cooking) Papandreou ( prime minister, son of one and grandson of another one ) and Samaras ( chieftain of Papandreou's main competition ) are still in charge. And that's in a country where it should be painfully obvious to anyone with half a brain that those are the very people who have collectively been raping the country and its citizens in the rear end for decades and their place is -at best- in jail!

 

So answering your q: don't hold your breath.

FreeNewEnergy's picture

Man, that did not come off properly. Sorry. Nice work. keep it up, The despots are desperate.

Zgangsta's picture

Mmmmm....

http://www.businessweek.com/news/2012-02-13/bank-of-japan-adds-to-moneta...

For a midnight snack, nothing hits to spot like some good old QE!