Volume 6 No 1 (2016) | ISSN 2158-8708 (online) | DOI 10.5195/emaj.2016.92 | http://emaj.pitt.edu Okun’s Law and Long Term Co-Integration Analysis for OECD Countries (1987-2012) Bilal Kargı Aksaray University | bilalkargi@gmail.com Abstract Even though, there are so many so long discussions on the relation between population increase and economic growth, today, general opinion tends to believe that there is a direct relation between population increase and economic growth. This opinion is supported by some empirical studies. Despite an economical growth caused by directly with population growth, it is known that there is a reverse relation between unemployment and growth known as Okun’s Law. This relation, suggesting that every 1 point decrease in unemployment induces a 3 point increase in growth, is tested for many countries. In this study, this hypothesis of Okun is examined and it is found to be true for selected 23 countries, even with the difference in coefficients. At the same time, long term relation between growth and unemployment is tested with the use of time series analysis and long term relation is found for 14 countries. Additionally, tests done for all 34 OECD countries showed that reversed relation between unemployment and growth is valid and they are co-integrated in long run. In this study, countries are categorized according to growth rate as “low”, “normal” and “high” and a consistent unemployment rate for countries with high growth rate could not be seen. In the case of countries with lowest growth rate, generalization that they have quite high unemployment rate can be made. JEL Classification: O40, O57, J64. Keywords: Economic Growth, OECD Countries, Unemployment. New articles in this journal are licensed under a Creative Commons Attribution 3.0 United States License. This journal is published by the University Library System of the University of Pittsburgh as part of its D-Scribe Digital Publishing Program, and is cosponsored by the University of Pittsburgh Press. Volume 6 No 1 (2016) | ISSN 2158-8708 (online) | DOI 10.5195/emaj.2016.97 | http://emaj.pitt.edu | mailto:bilalkargi@gmail.com http://www.library.pitt.edu/ http://www.pitt.edu/ http://www.library.pitt.edu/articles/digpubtype/index.html http://www.upress.pitt.edu/upressIndex.aspx http://creativecommons.org/licenses/by/3.0/us/ Volume 6 No 1 (2016) | ISSN 2158-8708 (online) | DOI 10.5195/emaj.2016.97 | http://emaj.pitt.edu Bilal Kargı Emerging Markets Journal | P a g e |39 Okun’s Law and Long Term Co-Integration Analysis for OECD Countries (1987-2012) Bilal Kargı 1. Introduction A. Okun (1962), to explain relation between unemployment and growth, stated that an increase in employment should induce an increase in the level of GDP and unemployment will cause GDP to decrease. This reverse relation between GDP and unemployment is defined as Okun’s Law (Mankiw, 2009: 260-263; Plosser and Schwert, 1979; Lang and De Peretti, 2009; Teck, 2012). There are some special cases for Okun’s Law. Increase of working hours of current employees may create increase in GDP, if it does not cause increase in unemployment (Knotek 2007; Levine, 2013). While average unemployment rate of the period 1970 to 2012 for OECD countries (OECD.StatExtract) was 5.586%, it is found to be 8.430% when calculated for the period 2000 to 2012. GDP is increased 2.747% for the period 1970 to 2012, but for the period 2000 to 2012, it increased 1.871%. Both data are given in the Graph 1. GDP graph starting from 1970 also shows 1974, 1981 and 2008 crisis. Most influential crisis is the 2008 crisis in the way of its affecting unemployment mostly. Especially at the end of 80’s, unemployment rates started to increase while GDP continued its characteristic movements. Reason of this can be shown as; developments in the use of technology and directing to non-OECD countries with cheap facilities and labor force. Graph 1: GDP growth rate (Red) and unemployment (Blue) It is seen that; unemployment rates show a continuous trend to increase. Difference between the two variables is 5.586-2.747 (2.839%) in the period 1970 to 2012; 7.242-2.303 (4.939%) in the period 1989 to 2012 and 8.430-1.871 6.559% in the period 2000 to 2012. Total GDP for OECD was 3.1 trillion US Dollars in 1970; it has reached 46.1 trillion US Dollars at 2012. This shows that GDP increased 14.87 times. Technically, Okun’s Law suggests that, 3% increase in GDP causes a 1% decrease in unemployment (Caraiani, 2010; Elshamy, 2013). Relation between unemployment and growth states the positive effects of power of trade associations and labor costs, when unemployment rates are low and growth rates are high. Besides, efficient trade union bargains in labor market may create negative effects on growth rate (Adjemian, Langor and Rojas 2010). In this study, unemployment and growth data of 23 OECD countries are used. Firstly, Okun Difference Equation (ODE) is used to calculate needed GDP increase to have constant unemployment rate. Then, with the use of time series analysis, long term relation of the two variables is studied. 2. Literature Review First of all, for the different periods and methods, data sets may give different results. For example, while it is observed by Bankole and Fatai (2013) that hypothesis is invalid for Nigeria; Amossoma and Nwosa (2013) found that it is valid. Some studies had gathered results contrasting Okun’s Law. For instance, Ting and Ling for Malaysia and Habees and Rumman (2012) for Arabian countries and Jordan showed that, there is no absolute relation between unemployment and growth. Lal and others (2010), for some developing Asian countries, showed that Okun’s Law is not applicable. Tillmann (2010) stated that the relation started to get weak from 90’s. There exist studies showing partial validity for Okun’s Law. Some findings are as follows: The relation is unstable for USA and Canada (Beaton, 2010); partially valid for Germany (Oberst and Oelgemöller, 2013); valid with low rate for Central and East Europe (CEE) countries (Hutengs and Stadtmann, 2013); strongly valid for young population and weak validity for old population in Euro zone (Hutengs and Stadtmann, 2012). Also, there are different coefficients for different countries and these coefficients vary in time, while the relation is valid in the opposite way for Euro zone countries (Zanin and Marra, 2012). Using the Italy example, Busetta and Corco (2012) found results suggesting that there might be regional differences. In another study on regional differences, Kangasharju and others (2012) found similar results and pointed the decrease tendency of coefficients. In their study on Volume 6 No 1 (2016) | ISSN 2158-8708 (online) | DOI 10.5195/emaj.2016.97 | http://emaj.pitt.edu Okun’s Law and Long Term Co-Integration Analysis for OECD Countries (1987-2012) Page |40| Emerging Markets Journal relation of unemployment in crisis periods and growth, for USA and EU, Cazes, Verick and Hussami (2011), and Gordon (2010a; 2010b; 2011) found that after global crisis, coefficients for USA, Canada and Spain showed sudden increases. In addition to this, these increases are quite sudden compared to crisis before 2000 and coefficients are lower for economies with high labor protection, like Germany. However, many studies provide empirical evidences strongly showing the relation Okun predicts between unemployment and growth. For example; Ball, Leigh and Loungani (2013) for USA and Moazzami and Dadgostar (2009) for 13 OECD countries (for OECD other study: Lee, 2000; Hopkin and Blyth 2012) found that in order to decrease unemployment 1%, increase in GDP should be between 2.6% - 4.7%. Biggest coefficients in long term are calculated for Canada, Finland, Norway and USA and these countries experienced the effect of economic growth on employment the fastest. In their study for 15 OECD countries, Sögner and Stiassny (2000) found that; there is constant Okun relation for Austria, Belgium, Canada, Italy and USA. There are deviations in Okun’s Law for Sweden, Germany, Denmark, Finland, France, Great Britain, Japan, Netherlands, Norway and Switzerland. Herwartz and Niebuhr (2011) showed Okun relation for EU countries, whereas supporting the cause of the differences among the countries with the structural characteristics. Besides, Huang and Lin (2008) for USA and Villaverde and Maza (2008) for Spain found empirical evidence for strong relations. Similar results are found in other country studies (Bakas and Papapetrou, 2012; Ibragimov, Karimov and Permyakova, 2013; Giha, Leat and Renwick, 2012; Mosikari, 2013; Tingii and Lingii, 2011). Finally, Boulton (2010), for 10 Western Europe countries, showed that 4% increase in growth causes 1% decrease in unemployment. Concerning Romania, Andrei, Vasile and Adrian (2009) found that, 0.5% decrease in growth causes 1% increase in unemployment. In an analysis on developed countries, Kitov (2011); and Kitov and Kitov, (2012) calculated that the lowest coefficient as 0.4 belonging to Australia and highest as 0.84 belonging to USA. In their study, Huang and Yeh (2013) found that GDP and unemployment variables are co-integrated in long term. Also, they found that these two variables are reversely and strongly related in both long and short term. In a survey study (for Wall Street economists, Mitchell and Pearce, 2009) on G7 countries with professional economists, Pierdzioch, Rülke and Stadtmann (2011) showed that reverse relation between growth and unemployment predicted by economists is parallel to Okun’s Law. 3. Data and Methodology The data belonging the period between 1987 and 2012 was taken from the OECD database. An analysis was done for 23 OECD countries’ data and total OECD data. First thing in the analysis was to calculate “Okun Coefficient” of countries with the regression relation Okun predicted. Growth rates were categorized as “low” (between 0%-2%), “normal” (between 2%-4%) and “high” (4%+). In the second step of analysis, the data time series and co-integration relation were tested. For this reason, firstly for each country; i) the growth and unemployment data were tested with unit root tests (Dickey and Fuller. 1979) ii) The two stepped Engle- Granger (1987) test was applied. Same process was done on sum of growth and unemployment data of 34 OECD countries. First condition, to decide whether series are co-integrated in long term or not, were to have stationary series at same level. 4. Empirical Results Table 1 shows the results of equation 1 for each country. Regression constants are given in b0. b1GDP gives negatively expected coefficient of GDP variable in regressions, known as Okun coefficient. “Average unemployment” (Avg. UNE) and “Average Growth” (Avg. GRW) rates, calculated from the data set of the period 1987 to 2012, are also given on Table 1. According to this, the highest average unemployment rate is 15.46%, which belongs to Spain and the lowest average unemployment rate is 3.25%, which belongs to Luxembourg. The highest average growth rate is for South Korea with 5.91%, and the lowest is for Italy with 1.3%. According to Table 1, average unemployment rate for OECD countries is 6.87%. Mean of average growth rates for the countries with higher average unemployment than this mean (UK, Turkey, Spain, Portugal, Italy, Ireland, Germany, France, Finland, Chile, Canada, Belgium, and Australia) is 3.5%. So, the ratio between average unemployment and average growth is almost two (0.687/0.350=1.96). So it can be said that, this reverse relation of unemployment and GDP is one- to-one for the countries with highest unemployment rate. Mean of average unemployment rates for the countries with lower average unemployment than OECD mean (US, Sweden, Norway, New Zealand, Netherlands, Mexico, Luxembourg, South Korea, Japan and Denmark) is 4.80. Average of average growth rate for these Volume 6 No 1 (2016) | ISSN 2158-8708 (online) | DOI 10.5195/emaj.2016.97 | http://emaj.pitt.edu Bilal Kargı Emerging Markets Journal | P a g e |41 countries is 2.76. Even though, this ratio is lower than OECD average, it is pretty close. Ratio between unemployment and GDP is lower (0.480/0.276=1.74) for economies with low unemployment rate. Then, findings suggest that average of growth rate is lower (2.76<3.50) for countries with lower unemployment rate than OECD average. Shortly, growth rate occurring when the unemployment is high is higher than growth rate occurring when the unemployment is low. High unemployment creates high growth; low unemployment creates low growth. This is the relation Okun claims. Table 1: Okun’ regressions: u - u-1 = bo + b1(y)+e (difference model) Country bo b1(GDP) Avg. UNE Avg. GRW bo / b1 Australia 1,139776 - 0,391112 6.919 3.301 2,91419 Belgium 0,495702 - 0,295806 8.096 1.986 1,67576 Canada 0,841631 - 0,375152 8.173 2.484 2,24343 Chile 1,379607 0,275437 8.23 5.698 5,00879 Denmark 0,605353 - 0,360756 5.988 1.358 1,67801 Finland 0,879881 - 0,355040 9.13 2.138 2,47825 France 0,583921 - 0,307495 9.423 1.805 1,89896 Germany 0,284049 - 0,151278 7.857 1.833 1,87766 Ireland 1,595931 - 0,342655 10.2 4.871 4,65754 Italy 0,281676 - 0,216006 9.153 1.18 1,30401 Japan 0,220478 - 0,103351 3.803 1.651 2,13329 Korea 1,118544 - 0,192760 3.369 5.911 5,80278 Luxembou rg 0,328280 - 0,054827 3.257 4.085 5,98756 Mexico 0,644013 - 0,208315 3.78 2.84 3,09153 Netherland s 0,487941 - 0,231328 4.769 2.268 2,10930 New Zealand 1,050341 - 0,374662 6.407 2.4 2,80343 Norway 0,237443 - 0,129464 4.134 2.337 1,83404 Portugal 1,034295 - 0,341197 6.969 2.179 3,03137 Spain 2,512723 - 0,921603 15.469 2.559 2,72647 Sweden 0,954893 - 0,340653 6.488 2.169 2,80312 Turkey 0,638043 - 0,157970 8.526 4.224 4,03901 United Kingdom 0,564312 - 0,290173 7.061 2.363 1,94474 United States 1,255776 - 0,449484 6.026 2.656 2,79381 OECD - Total 0,716469 - 0,274117 6.873 2.438 2,61373 Calculated bo / b1 coefficients are the “Okun coefficients” and they indicate the needed economic growth rate to prevent unemployment rate. Countries with highest unemployment, Chile (8.23), Ireland (10.2) and Turkey (4.03), need growth rates higher than 4% to prevent unemployment rate to increase more than current rate. Countries with high calculated Okun coefficient, South Korea (5.80) and Luxembourg (5.98) need growth rate more than 5%. Lowest Okun coefficient is calculated for these countries: Italy (1.30), Belgium (1.67), Denmark (1.67), Norway (1.83), Germany (1.87), France (1.89) and UK (1.94). These countries have two basic common points: i) Average unemployment is higher than OECD average (except Denmark and Norway) and ii) Average growth rate is lower than OECD average. The second part of our analysis is time series analysis and to do this, firstly, Dickey-Fuller unit root test is applied to unemployment and growth data of each country. Findings are given in Table 2 . “ADF” column of Table 2 shows ADF statistics of variables for “level” values. Values in parenthesis show the critical value for 5% meaning value of applied test. For ADF