Savvy investors will keep a close eye on unemployment. They will be watching the unemployment rate closely and monitoring for changes in the labor market. Doing so is essential because the labor market and the unemployment rate might just be the biggest single indicator in regards to whether the economy is expanding or shrinking. There are many other important indicators, of course, but unemployment is something that every investor should pay attention to.
If high numbers of people are getting laid off or losing their jobs, then it is almost inevitable that the economy will end up shrinking. At the very least, rising unemployment rates and mass layoffs will rock the market, causing turbulence. Oftentimes, governments are forced to react with stimulus measures before the economy falls into a recession or depression. Stimulus is good, market turbulence is generally not good. (Unless your short selling or using another method to make money off of declining markets).
Understanding What the Unemployment Rate Is
The unemployment rate is a statistical measure used to determine how many people are out of a job. Importantly, these are people who want to work, perhaps they even need to work in order to afford their bills, and yet they cannot find gainful employment. A high unemployment rate can cause a lot of suffering. Since the economy is largely dependent on consumer consumption, if more consumers become unemployed, they consume less.
On the other hand, if the job market is tight, incomes tend to rise, people often start spending more, and rising consumption in turn tends to boost markets. As companies secure more revenues through consumer purchases, they can expand their workforce, and make investments. In an ideal situation, this will set off an entire chain of events with the economy expanding, unemployment dropping, and the whole cycle starting over again.
On the other hand, the exact opposite can happen. Employers start to cut back on investments and reduce their work force. People lose their jobs and have less money to spend. Businesses make less money and the whole process starts over again.
Unemployment and Okun’s Law
Based on the information outlined above, the employment rate is now one of the most closely watched indicators for economists and investors alike. In fact, the employment rate has been found to have a very large impact on the gross national product, or the GNP. In the United States there is something called Okun’s Law. For every 1 percent fall in the unemployment rate, the GNP will rise by 3 percent.
This correlation between the rising GNP and the falling unemployment rate is known as the Okun coefficient. Arthur Okun, the discoverer of Okun’s Law, was an economist who taught and worked at Yale. Most of his career’s major work focused on the relationship between employment and production. Obviously, for most investors a growing economy is a good thing.
As the economy grows, more companies will do well, producing more profits and selling more goods. Okun wanted to delve deeper and figure out just how much of an impact employment had on the gross national product. The reason the gross national product rises when more of the labor force is employed is pretty simple. More people working means more people are producing goods and services. So as employment increases so too does the GNP.
Short Comings of Okun’s Law
It should be noted that there are many short-comings to Okun’s law. First, it has only been calibrated to work with the United States economy, and so can’t be applied directly to economies elsewhere. If you want to know what will happen in the United Kingdom’s economy, or China’s economy, you’d have to develop formulas specifically for these economies. Further, even in the United States, the law only proves to be accurate between 3% and 7.5%. If the unemployment rate is outside of those ranges, Okun law is no longer relevant.
Many economists have created Okun coefficients for different countries. Often, the coefficient is actually higher than in the United States because the labor force itself is more flexible. These numbers are useful for planning national and economic policies. It should also be noted that with the United States economy undergoing a major shift, shifting away from industrial production and towards a technology and services based economy, it’s questionable whether
The health of the labor force has an impact on numerous other factors. For example, inflation and unemployment are closely intertwined. So too are education rates, poverty, government spending, and numerous other things.