Testing the link of unemployment to GDP growth

By Luca Sacco


Unemployment as well as GDP figures have undoubtedly been given utmost importance and in fact governments launch various initiatives aimed at keeping the unemployment rate stable and at increasing the GDP.

In the recent past, unemployment rates were of huge concern in European countries. The relentless rise in unemployment, particularly youth unemployment, was one of the most dramatic consequences of the crisis in the euro area. In fact, there were countries such as Spain where a quarter of the youths couldn’t find a job after completing their studies. To this extent, measures to tackle unemployment nowadays feature on the agenda of all European countries.

When it comes to the Maltese economy, how will the relation between the Maltese GDP and unemployment figures be reflected?

One of the well-known observed relationships which is used to relate Gross Domestic Product (GDP) and the unemployment rate is the application of Okun’s Law. According to the principle established by this law, there is a corresponding two percent increase in employment for every established one percent increase in GDP.

The reasoning behind this law is quite simple. It states that GDP levels are driven by the principles of demand and supply, and as such, an increase in demand leads to an increase in GDP. Such an increase in demand must be accompanied by a corresponding increase in productivity and employment to keep up with the demand.

However this rule may not exactly apply when it comes to modelling the Maltese economy. Indeed, from a working paper published recently by the Ministry for Finance, which modelled the relation between the GDP and unemployment in Malta using a data period between 1993 and 2012, it was estimated that a 1% increase in the country’s Gross Domestic Product has a contribution of a 0.1% decrease in the unemployment rate, which contributes to roughly a 180 increase in jobs.

This model reveals that the unemployment rate in Malta is less sensitive to aggregate demand conditions than that of other European countries. Indeed, it was estimated that in the average EU countries, a 1% increase in GDP reflects a decrease of 0.3% in the unemployment rate, almost three times as sensitive as that of Malta.

This is probably due to various factors related to the labour market as well as wage flexibilities. However, if one were to attribute the most important factors leading to the low Okun coefficient it would be the hoarding of labour during recessionary periods. This hoarding is locally motivated by several factors, including the avoidance of additional costs that would have to be sustained if employers were to hire new workers when demand returns to normal conditions, as well as the tradition of lifetime employment in established family run companies where the employer-employee relationship is so strong that the employer finds it difficult to fire workers. Another factor is the financial support by the Maltese government in order to retain workers during recessionary periods.

From this working paper it was shown that the impact of the manufacturing sector on the unemployment rate is significantly smaller than that caused by the service sector. Thus, it is suggested that the unemployment rate has been more sensitive to developments in the service sector even if one makes an allowance for the unequal size of both sectors. Such a result may run contrary to the general perception that the unemployment rate is more sensitive to developments in the manufacturing sector, probably due to a number of factors, including the more frequent firing observed in this sector. Therefore one may conclude that the challenge the manufacturing sector is currently facing is buttressed by government policies directly targeted to assist companies in this sector in times of economic distress.

While in some countries the 2007/08 crisis had left a very negative effect on the economy, to the extent that unemployment rates had experienced massive growth, other countries seem to have mitigated the effect of the crisis, thus experiencing no significant upward trends in their unemployment figures.

Malta is undoubtedly one of the countries which kept the unemployment rate steady throughout the years, in particular during the 2009 crisis. This would be clearly explained if we were to compare the unemployment rate during the crisis with the rate after the crisis. In fact, if we take January 2009, the Maltese unemployment rate stood at 6.3% while in January 2011, the figure was 6.4%. As one may clearly notice, no significant change was recorded.

At this stage, we take an opportunity to compare and contrast the performance of the labour market in Malta to three other countries: Cyprus, the Netherlands and Belgium.

With regard to Cyprus, the unemployment rates before the 2009 crisis ranged from 3.3% to 4.4%, which is considered to be among the best in Europe. However, in contrast to Malta, the crisis left a massive impact on Cyprus’s economic performance, resulting in huge increases in the unemployment rates month after month.

In fact, the unemployment rate as at January 2009 was recorded at 4% while in January 2011, this stood at 6.4%. From then on there was no turning back, and as a result the unemployment rate in Cyprus kept on rising continuously. In January 2012 the rate was 9.9%, increasing to 14.4% in January 2013 and 15.7% in January 2014.

Although to a lesser extent, the same thing happened in the Netherlands. The unemployment rate in January 2009 was only of 3.1%, going up to 4.5% in January 2010. In January 2011, the rate was practically the same, but increased again in January 2012 to 5%, 6% in January 2013 and even more in January 2014, to 7.1%.

When it comes to the Belgian unemployment trend, one may notice that this followed a unique trend. Before the crisis, the unemployment rates ranged from 6.8% to a maximum of 8%. This range was approximately maintained after the crisis, since from January 2009 up till now, the rates ranged from 7% to a maximum of 8.6%, resulting in no significant impact of the crisis on unemployment.

Back to Malta, if we were to consider the period 2007-2014 and compare GDP quarterly data with the same period in previous years, the only periods which had experienced a drop in the Maltese GDP were all quarters for 2009 as well as the last quarter of 2011 and the first quarter of 2012. All the remaining quarters during the years 2007-2014 experienced increases in their GDP.

The largest increase recorded was in the second quarter of 2008, where GDP was 5.2% larger than the second quarter of 2007. If we were to exclude 2009, in which we saw decreases in all quarters when compared to 2008, the least percentage growths were recorded during 2012. In fact, the GDP as at the second quarter of 2012 experienced only an increase of 1.1% over the same quarter in 2011. Similarly, the GDP during the third quarter of 2012 was 1% larger than that of the third quarter of 2012. If we were to further analyse the last quarter of 2013, as reported by the Central Bank of Malta, the Maltese economy expanded by 2.2% in annual terms during the last quarter of 2013, down marginally from 2.3% in the previous quarter. The growth in the last quarter of 2013 was entirely driven by domestic demand, mainly reflecting developments in inventories and private consumption.

With regard to Cyprus, a decrease in the GDP over the same period in the previous year was recorded for every quarter from the third quarter of 2011 up till the first quarter of 2014. The largest drop in GDP was experienced in the second quarter of 2013 when compared to the second quarter of 2012, which was of an amazing 6%.

Moreover, 2013 proved to be the year which recorded the most significant shocks in GDP over the previous year, seeing a 5% drop in the first quarter, 5.7% decrease in the third quarter and a 4.9% decrease in the last quarter. As stated previously, before the 2009 crisis Cyprus had been performing relatively well and was among the best performers in Europe. This is certainly reflected in GDP growth prior to the tail-in of its banking structure, where the percentages increases over the previous years ranged from 2.1% to 5.6%.

Compared to Malta, the Netherlands recorded a GDP decrease in all quarters of 2009 when measured against the respective quarters of 2008, the highest decrease being in the second quarter and the lowest in the last quarter. However, in contrast to Malta, while the Maltese GDP has been experiencing increases from the second quarter of 2012 up till the first quarter of 2014 when compared to the previous years, in the Netherlands the GDP has been decreasing in the same quarters and no major increases were recorded between 2010 and 2011, with the percentages increases ranging from 0.3% to only a maximum of 2%.

Next we move to Belgium and notice that in the first quarter of 2007 up till the third quarter of 2008, the GDP had been experiencing positive increases over the respective periods of the previous year. Having said this, the rate by which the increase was recorded had been decreasing over subsequent quarters, in fact in the first quarter of 2007, the increase was of 3.1% whereas in the third quarter of 2008, the increase dropped to 1.1%.

The Belgian GDP experienced a deterioration in 2009 when compared to 2008, with the highest decrease being of 4.3% recorded in the second quarter of 2009. Percentage increases were once again being experienced between 2010 and 2011, with slight decreases in 2012. Having said this, from the second quarter of 2012 to the first quarter of 2014, GDP seemed to have experienced only minor moves each quarter, with a 0.1% increase in quarter two of 2013 and a 1.2% increase in quarter one of 2014.

One may pinpoint the success of the government’s policies to safeguard jobs, due to the fact that labour hoarding has helped in containing the impact of negative developments in the manufacturing sector on the unemployment rate.

When one also considers the limited effectiveness that widespread expansionary fiscal policy would have on aggregate demand, it is easy to see why the government should continue offering such sector-specific firm-targeted financial support in times of economic distress, particularly because the manufacturing sector typically employs persons whose skills are not easily transferable to other sectors of the Maltese economy and would therefore risk becoming long-term unemployed.

Luca Sacco is a Trainee Statistician with PKF Malta