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In his Economix piece this week, Casey Mulligan picks up on his theme from last week that unemployment insurance (UI) benefits may not boost spending in aggregate, since the money needed to pay benefits is withdrawn from other spending. He agrees with my earlier point that the money is not coming from current tax revenue, but rather from deficit financing, then says that:

"But that 'financing channel' still does not make the payments free from the perspective of today’s economy.

Suppose the government has been borrowing the money to pay for unemployment benefits. It borrows money by selling bonds. The purchasers of those bonds have less to spend on something else."

Actually, most or all of the money that would be used to buy the bonds is a reallocation from other savings, at least at a time like the present when the economy is in a serious downturn. In effect, bond buyers will use either deposits or sales of other assets (e.g. stocks or bonds of private companies) to buy up government bonds. This has no direct effect on their consumption.

In other times this could lead to an increase in interest rates, which would discourage other spending to some extent, however this effect is likely to be trivial or altogether non-existent in the current environment. Banks have vast amount of excess reserves sitting idle.The government's sale of bonds will likely pull in some of these excess reserves. If UI benefits are associated with a boost to growth, and therefore more total deposits, then the net amount of excess reserves in the system may decline slightly, but as long as we still have vast amounts excess reserves, the impact on the interest rate will be trivial, as will the impact on spending.

The extreme case can be seen when the Fed is the buyer of the bonds. In that case, there would actually be an increase in the excess reserves of the system as a result of the government's sale of bonds, and therefore no increase, and possibly even a decrease, in interest rates. In that case, the government spending is a pure gain to demand and to the economy.

In this scenario, safety net spending boosts growth and employment. It does not impose a cost on the rest of us. More generally, it makes sense to think of UI benefits and other safety net programs as being like other forms of insurance. We pay some price for it in the good times -- output is somewhat lower than it otherwise would be -- so that we can be protected in the bad times.

This means that in the bad times (e.g. your house burns down) insurance is unambiguously beneficial. Whether it is providing good value over the good and bad times taken together depends on the exact conditions of the policy.

Source: Unemployment Insurance And Spending: Bond Purchases Are Reallocations From Other Saving