Unemployment Rates and Benefits: The Incentive Effect

by: Ryan Avent

During a weekend talk show appearance, Michelle Malkin declared that unemployment benefits were generating higher unemployment rates. A number of economists pushed back against that claim, leading Casey Mulligan to write:

The gurus say that incentives do not matter, at least until this recession is over...

Professor Krugman is also saying this week that this recession has nothing to do with bad incentives to earn labor income. (Bless him for citing me! When this is all over, I would love to have a monopoly on teaching the "old fashioned" laws of economics.)
I don't quite understand this obsession with UI-apologetics, because UI (unemployment insurance) is just one of many policies that collectively (and some by themselves) create terrible incentives...

According to Professor Krugman, I am the only one crazy enough to suggest that a list of bad incentives like this might actually show up in the aggregate data!

Mr Mulligan seems to be using one point, on which he is correct, to make another, on which he is very wrong. Unemployment benefits clearly do provide an incentive to stay out of work longer. Holding other things constant, we would expect an increase in the generosity of unemployment benefits to lead to more joblessness.

But that does not mean that in the absence of unemployment benefits the unemployment rate would be lower, because one cannot hold other things constant while changing benefits. In particular, one can't hold the consumption of the unemployed constant while changing benefits.

The recession was clearly caused by a series of significant shocks—asset price crashes, an oil price spike, and a major financial crisis—all of which contributed to a broad shortfall in aggregate demand. This demand shortfall led to widespread job cuts. Those being laid off turned to unemployment insurance, which allowed households to avoid huge cuts in spending, and which dampened the economy's downward trajectory. In the absence of unemployment benefits, workers facing job loss would have been forced to liquidate assets to pay for basic necessities (adding to downward pressure on the value of assets of all sorts and leading to an increase in personal and financial institution defaults) and reduce spending sharply, magnifying the initial demand shock.

In addition to a significant increase in human suffering, this would have led to a much steeper and more rapid rise in the unemployment rate.

Mr Mulligan appears to be arguing that the incentive effect of unemployment insurance entirely offsets the demand stabilization effect—that if only government hadn't given workers a hand amid the most serious demand shock the world had seen since the Great Depression, those workers would have quit messing around and gotten new jobs, preventing such a large rise in the unemployment rate from materializing.

This is just daft. Yes, without unemployment insurance the newly jobless would have quickly gone back to work—selling possessions for a pittance, working off the books at sub-minimum wage rates, scraping by on charity (nasty incentive effects there, too), begging, stealing, and scavenging—and the country would have been far worse off. For millions of Americans, there was simply no real work to be had at positive wage rates during the worst months of the downturn. Forcing those labourers to get by with no assistance would have been economically catastrophic, and cruel.

This article originally appeared on The Economist.com