Broken Okun's Law May be Sign of Unsustainable Supply Driven Economy

On Monday March 12, The Wall Street Journal puzzled over the apparent break down of a long-running relationship between economic growth and jobs. The relationship is called Okun's Law, after Yale University economist Arthur Okun. The basic relationship is that when economic growth exceeds its long-term trend the unemployment rate tends to fall at a rate of about half of the excess economic growth rate. This relationship has broken down recently as the employment rate has fallen despite weak economic growth.

I believe my Sagflation theme explains this breakdown, and offers an opportunity to look at Sagflation from a slightly different perspective. In summary, I believe the apparent breakdown in Okun's Law is an unsustainable situation in which supply is growing due to inexpensive credit (encouraging hiring) but demand is relatively stagnant due to historically high consumer debt levels (slow growth), resulting in falling productivity.

To get into the details let's review a couple key facts:

(1) Consumer debt ratio is relatively high: Consumer debt to after-tax income is 113% compared to an average of 85% during the 1990's. Debt service payments to income shows a healthier picture but if consumers are expecting interest rates to rise then they may focus more on the absolute level of debt rather than the debt service. That said, if the consumer believes interest rates may remain low for an extended period, which is the strategy of the Federal Reserve, then demand may increase for a period until either rates increase or expectations of rate increases begin. While debt-driven spending may drive markets for a period of time, this possible belief of low and stable interest rates is misplaced and temporary, in my opinion, and likely results in larger issues later on after debt levels have increased. Therefore, over the long-term I believe the historically high level of debt hinders economic growth.

Source: Federal Reserve         

(2) Corporate balance sheets are relatively healthy: Whether it is the record $1.2 trillion in cash on company balance sheets, or the record low yields on corporate debt, corporations are swimming in a deep pool of liquidity. This abundance of inexpensive capital enables companies to invest aggressively in their business, both offensively to take market share or defensively to avoid market share loss. Furthermore, I believe companies are encouraged to pursue riskier projects in search of returns, similar to how investors seem to be moving into higher risk asset classes. Indeed, capital expenditures have risen to levels near the peak prior to the start of the 2007 recession.

(3) Labor productivity moderation: At 0.4%, output per hour of labor grew at the smallest rate in 2011 of any year during the past decade. By BLS estimates, productivity actually turned negative in the first half of 2011. The slowing productivity improvements are one of the primary reasons many propose as the reason for the breakdown in Okun's Law. However, I believe it is merely a symptom of Sagflation rather than cause.

Source: Bureau of Labor Statistics         

To review my Sagflation thesis,

Sagflation, as I define it, is moderate to negative real economic growth combined with more volatile prices. The reasons for the relatively slow growth is a combination of a build-up in poorly allocated capital, creating excess supply, and subdued demand associated with a build-up of excessive debt. The price volatility is primarily a result of an overly aggressive monetary policy that repeatedly attempts to expand credit despite excesses in the economy.

The simple answer to the apparent breakdown between unemployment and economic growth is that the long-term sustainable growth rate of the economy may have declined. Thus when economic activity picks up even a bit the unemployment rate eases. This simple answer allows for the long history of Okun's Law to remain intact.

Of course the question then becomes, why has the long-term sustainable growth rate of the economy declined. In my mind, the answer is the causes of Sagflation, which are (a) high consumer debt levels, plus a (b) build-up of excessive supply, which both were encouraged by an (c) overly aggressive monetary policy.

The Federal Reserve has been encouraging investment spending by lowering interest rates. However, consumers hurt by the housing bust may be less willing to ramp-up purchases just because they have available credit. Instead, consumers may be more focused on their debt balance and the potential for interest rats to rise in the future. Therefore, demand stimulation has exhibited diminishing returns from monetary policies.

Businesses, however, generally have healthy balance sheets and access to inexpensive financing. Competition is driving investment spending as market share remains a primary concern. Given a relatively low cost of capital, businesses can continue to invest capital despite possibly slowing sales growth and shrinking margins. Thus excess capital continues to build-up in areas of the economy, along with employees to provide service, despite relatively weak economic fundamentals. Productivity declines as each additional man hour brings in fewer sales because demand has not been stimulated.

While not sustainable, if supply continues to grow and demand remains stagnant, you might expect to see weak economic growth, falling unemployment, and falling productivity.