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Wednesday, February 25, 2015

Unemployment Benefits: The Government Gets What It Pays For

Have the perverse incentives been proved?

Just about everyone agrees that incentives affect behavior, but economists really mean it. That’s because economists take the logic of incentives further than most other people are willing to. Such analysis often reveals that government policies have unintended consequences that seem shocking to the average person. The list includes welfare programs that lead to higher rates of birth out of wedlock, seatbelt laws that lead to more pedestrian deaths, and even the possibility of changes in estate taxation that lead to people strategically timing their deaths.

But perhaps one of the most perverse distortions comes from unemployment benefits. Economists argue that these can provide an incentive for people simply not to work. Indeed, a new NBER working paper by Marcus Hagedorn, Iourii Manovskii, and Kurt Mitman estimates that the abrupt end of unemployment benefit extensions led to 1.8 million additional new US jobs created in 2014.

The theory here is straightforward: when the government subsidizes an activity, other things equal, people will engage in more of it.

If politicians want to encourage more people to go to college, what do they do? Provide financial support, either directly in the form of tuition assistance, or indirectly through loans with lower interest rates than students could obtain in a free market. If politicians want to encourage people to reduce their consumption of fossil fuels, they might offer tax rebates for the purchase of electric cars or insulation in their homes.

By the same token, then, suppose that politicians wanted to encourage laid-off workers to refrain from accepting a new job. What would they do? Naturally, they would offer to send the jobless workers checks so long as they remained unemployed. This logic, of course, is exactly why “unemployment insurance benefits” are perverse. Even though their avowed purpose is to provide a safety net for those unfortunate enough to lose work, it is undeniable that the existence of such a program provides an incentive for job seekers to prolong their search for new positions.

Whenever an economist proposes something “heartless” in this fashion, the tenderhearted critic reacts with outrage and points out that real human beings aren’t the soulless robots that populate economic models.

This is certainly true, but it misunderstands the claim. The economist is not arguing that the existence of government unemployment benefits will cause every single worker to “rationally” remain on the couch. Rather, a more nuanced model of the labor market is one of “search,” where job applicants and employers are trying to find each other. The longer the search lasts, the better the match will be, but of course the longer the spell of unemployment. By introducing financial payments during unemployment, the government tips the scales in favor of a longer search before accepting an offer. It might not change the behavior of any particular worker, but with a pool of many millions of unemployed people, surely a generous unemployment insurance program will have a noticeable impact.

I hasten to point out that it’s not merely Chicago-school or Austrian economists who subscribe to this view. For example, Paul Krugman, Robin Wells, and Kathryn Graddy wrote in the 2010 edition of their popular textbook:

People respond to incentives. If unemployment becomes more attractive because of the unemployment benefit, some unemployed workers may no longer try to find a job, or may not try to find one as quickly as they would without the benefit. Ways to get around this problem are to provide unemployment benefits only for a limited time or to require recipients to prove they are actively looking for a new job.

So we see that this view really is standard among professional economists. (This fact led to some awkwardness when Krugman in early 2014 excoriated heartless Republicans for endorsing this theory, without mentioning that he himself included it in his textbook.) The only argument is over the empirical size of the effect.

Here is where the new NBER paper provides results that surprised many readers.

Keynesian economists in particular argue that the supply-side impact of unemployment benefits is swamped during a slack labor market by the direct demand-side impact. In other words, many Keynesians argue that during the Great Recession, the frequent extensions of federal unemployment benefits increased employment, because the checks allowed unemployed workers to continue spending and hold up aggregate demand. That is why it was so significant that the authors of the new paper found the following (from their abstract):

We measure the effect of unemployment benefit duration on employment. We exploit the variation induced by the decision of Congress in December 2013 not to reauthorize the unprecedented benefit extensions introduced during the Great Recession. Federal benefit extensions that ranged from 0 to 47 weeks across U.S. states at the beginning of December 2013 were abruptly cut to zero.… In levels, 1.8 million additional jobs were created in 2014 due to the benefit cut. Almost 1 million of these jobs were filled by workers from out of the labor force who would not have participated in the labor market had benefit extensions been reauthorized.

The interested reader can directly consult the paper to review the particular econometric technique the authors used to try to tease out causation from correlation (relying on discontinuities at state borders, for example).

The interesting takeaway for the general reader is that the surprisingly robust growth in the US economy in 2014 may have been due to Congress’s late 2013 decision to cease extensions of unemployment benefits. In short, when the federal government stopped sending checks to people who remained unemployed, more of them found work.

  • Robert P. Murphy is senior economist at the Independent Energy Institute, a research assistant professor with the Free Market Institute at Texas Tech University, and a Research Fellow at the Independent Institute.