Okun’s Law, Productivity Innovations, And Conundrums in Business Cycle Dating

The NBER business cycle dating process has traditionally mixed together the fundamental component of business cycles, changes in real output, with changes of employment. This paper makes the case that these long and variable lags disqualify for business cycle dating all the components of labor market behavior, including aggregate hours of work and payroll employment. By definition real GDP is equal to output per hour times aggregate hours of work. This " output identity " can be extended to subdivide aggregate hours into the product of hours per employee, the employment rate, and the labor‐force participation rate (LFPR). This paper provides a consistent analysis of the output identity, taking as its point of departure Okun's Law, a rough prediction that a cyclical deviation of output from trend would be divided between a 2/3 response of aggregate hours and a 1/3 response of productivity. In turn, the Okun characterization subdivided the 2/3 hours response into 1/3 for the employment rate, 1/6 for hours per employee, and 1/6 for the LFPR. The paper decomposes data on the components of the output identity into trends and deviations from trends, or " gaps ". Its regression analysis reveals regular features of postwar business cycles, including lags of hours and employment behind output and leads of productivity changes ahead of output changes. While Okun's Law was roughly accurate until 1986, regressions for the post‐1986 period turn Okun's Law on its head. The elasticity of changes in the hours gap to the output gap was 0.74 before 1986, close to Okun's 2/3, but rose after 1986 to 1.2. Productivity no longer exhibits procyclical fluctuations, rendering as obsolete both the Real Business Cycle model and those aspects of modern macro that include productivity shocks as an explanation of business cycles. Productivity grows slowest in the later stages of the business cycle expansion and most rapidly in the early phase of the business cycle recovery. And this is nothing new. The " end‐of‐expansion " slowdown in productivity growth and the " early recovery productivity bubble " were identified in economic research more than three decades ago. Hypotheses suggested here for changes in behavior focus on the role of collapses in profits and the stock market in 2000‐02 and 2007‐09 in creating unprecedented pressure on business executives (whose compensation more than before depends on stock options) to cut costs drastically. But the 2007‐09 downturn was much bigger than 2000‐02; …