How much output growth would this involve? An Okun’s Law type relationship also works pretty well for the euro area as a whole, and gives a coefficient close to the US level:Glad you asked Paul. First I don't have a problem with the calculation that Euro block unemployment is 4% greater than it could and should be. The astonishing implication is that Euro block economies could endure unemployment as low as 6% without suffering ever rising inflation. I see no reason to doubt this. Even the famously dysfunctional Italian economy managed it (the stability of inflation is even more striking if one looks at wages not consumer prices -- the ups and downs of the consumer price inflation rate in the graph in the linked post correspond to sharp increases and decreases in the price of oil -- no new graph as this is not this post's topic).
[graph] So a 4 percentage point decline in unemployment would, if the historical relationship holds, mean 8 percent more in real GDP — that is, this naive calculation puts the euro area output gap at 8 percent, which is huge.
Should we take this seriously? If not, why not?
But I am not so convinced by the Okun's law estimate and calculation. Krugman's estimate ( and Okun's) is a simple regression with no lags or leads. The regression is valid if unemployment is a function of current output so the immediate effect of a downturn is equal to the long run effect of a prolonged depression. However, in practice employment adjusts slowly in recessions with the peak of unemployment typically occurring after the trough of GDP. I think the coefficient of GDP growth on the change of unemployment reflects this slow adjustment of employment. I'd guess a long run Okun's relationship would give a number closer to labor's share so two thirds, maybe 1 but not 2. I won't estimate this coefficient using changes from 2007 to 2014 for different Euro group countries (although I should). It implies an output gap of roughly 3 to 4% which I find highly plausible.
I think this implies an average allowed deficit of 4.5 to 5% of GDP (IIRC the Eurocrats calculate that a 1% output gap causes the deficit to increase by 0.5% of GDP based on increased transfers as well as reduced tax revenues). *The pun in the title doesn't fit the content of the post and set a very bad example, which may have influenced me and led me aweigh from the balanced prose path appropriate for serious topics)